Excel Professional Services, Inc.

Management Firm of Professional Review and Training Center (PRTC)

(LUZON) Manila 87339344 * Calamba City, Laguna * Dasmariñas City, Cavite * Lipa City,

Batangas (0917) 8852769 * (VISAYAS) Bacolod City (034) 4346214 * Cebu City (032)

2537900 loc. 218 (MINDANAO) Cagayan De Oro (0917) 7081465 * Davao City (082) 2250049

AUDITING THEORY
AT.3008 – Understanding the Entity R.C.P. SOLIMAN/ K.J. UY and its Environment MAY
2021

Reference:
a. PSA 315 (Redrafted), Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and its Environment

DISCUSSION QUESTIONS
d. The shareholders.
Introduction—Importance of Understanding the Required Understanding
Entity, Its Environment, and Its Internal Control
5. The auditor’s understanding of the
1. The reasons why an auditor should obtain an client encompasses
understanding of the entity and its environment,
including internal control, include a. b. c. d.
External factors (e.g.,
a. b. c. d. industry and regulatory Yes Yes Yes Yes
To determine materiality. Yes Yes Yes Yes issues)
To consider appropriateness of accounting policies Nature of the entity Yes Yes Yes No
and disclosures. Yes Yes Yes No Accounting policies Yes Yes Yes Yes
To identify areas of audit emphasis. Yes Yes Yes Yes Entity objectives, strategies, Yes No No Yes and
To set expectations for results of analytical business risks
procedures. Yes No No Yes Financial performance Yes Yes No No measurement and
To design further audit procedures. Yes Yes No No review
To evaluate audit evidence. Yes Yes Yes Yes Internal control Yes No No No
To appropriately apply
professional judgment and 6. Business risks refer to
a. The entity’s operations, its ownership and
skepticism. Yes Yes Yes Yes governance, the types of investments that it is
making and plans to make, the way that the entity
2. An auditor who accepts an audit engagement and does is structured and how it is financed.
not possess the industry expertise of the business b. The overall plans for the entity.
entity should: c. The operational approaches by which management
a. engage financial experts familiar with the nature of intends to achieve its objectives.
the business entity. d. The result of significant conditions, events and
b. obtain a knowledge of matters that relate to the circumstances, actions or inactions that could
nature of the entity’s business. adversely affects the entity’s ability to achieve its
c. refer a substantial portion of the audit to another objectives and execute the strategies or the setting
CPA who will act as the principal auditor. of inappropriate objectives and strategies.
d. first inform management that an unqualified
opinion cannot be issued. 7. Select the incorrect statement:
a. Business risk is broader than the risk of material
3. An understanding of a client’s business and industry misstatement.
and knowledge about operations are essential for b. Most business risks do not have financial
performing an adequate audit. For a new client, most consequences, though they may have an effect on
of this information is obtained: the financial statements of an entity.
a. from the predecessor auditor. c. Usually, management identifies business risks and
b. from the Securities and Exchange Commission. develops approaches to address them.
c. from the prior year working papers and permanent d. Smaller entities often do not set their objectives
file for the client. and strategies or manage the related business risks
d. at the client’s premises. through formal plans or processes.

4. Who is the most knowledgeable about the entity’s
operations and financial reporting? a. The auditor.
b. The regulatory bodies.
c. The management and those charged with
governance.
Procedures to Obtain Understanding
8. What are the auditor’s procedures and sources of
information to obtain understanding of the entity and
its environment, including internal control? a. Risk
assessment procedures (RAP).

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EXCEL PROFESSIONAL SERVICES, INC.

b. Information obtained in prior period audits. Examples include

c. Discussions among the audit team.
d. All of the above. a. b. c. d.
Business activities and
Risk Assessment Procedures operations Yes Yes Yes Yes
Documents and records Yes Yes Yes No
9. The main purpose of risk assessment procedures is to Business report and minutes of
a. Obtain an understanding of the entity and its meetings Yes Yes Yes Yes
environment, including its internal control, to Tours of facilities Yes No No Yes
assess the risks of material misstatement at the Walkthrough Yes Yes No No
financial statement and assertion levels.
b. Test the operating effectiveness of controls in
preventing, or detecting and correcting, material 15. Evaluations of financial information made by a study of
misstatement at the assertion level. plausible relationships among both financial and non-
financial data. It also encompasses the investigation of
c. Detect material misstatements at the assertion
identified fluctuations and relationships that are
level.
inconsistent with other relevant information or that
d. All of the above
differ from expected values by a significant amount.
a. Audit planning c. Analytical procedures
10. Which of the following is least likely to be considered a
b. Audit evidence d. Inspection
risk assessment procedure? a. Analytical procedures.
b. Confirmation of ending accounts receivable.
16. Analytical procedures are used in an audit because it is
c. Inspection of documents.
assumed of financial statements that (i.e., the basic
d. Observation of the performance of certain
premise of analytical procedures)
accounting procedures.
a. management fraud can be discovered using such
procedures.
11. Which of the following is least likely to be considered a b. it is plausible that no relationship among data
risk assessment procedure? exists.
a. Inquiries of management and others within the c. analytical procedures are used as tests of controls.
entity.
d. plausible relationships among data may reasonably
b. Test of operation of bank reconciliation. be expected to exist and continue in the absence of
c. Inquiries of external legal counsel. known conditions to the contrary.
d. Review of external financial publications.
17. Analytical procedures enable the auditor to predict the
12. In obtaining an understanding of the entity and its balance or quantity of an item under audit.
environment, the auditor performs inquiries within the Information to develop this estimate can be obtained
entity that may be directed to different levels of from all of the following, except
authority who may have information about risks of a. Comparison of financial data with data for
material misstatement such as comparable prior periods, anticipated results (e.g.,
budgets and forecasts), and similar data for the
a. b. c. d. industry in which the entity operates.
Management and those b. Study of the relationships of elements of financial
responsible for financial data that would be expected to conform to a
reporting Yes Yes Yes Yes predictable pattern based upon the entity’s
Those charged with Yes Yes Yes No experience.
governance c. Study of the relationships of financial data with
Internal auditors Yes Yes Yes Yes relevant nonfinancial data.
Legal counsel Yes No No Yes d. Tracing transactions through the system to
Marketing and sales personnel Yes Yes No No determine whether procedures are being applied as
Production personnel Yes Yes Yes Yes prescribed.

13. Inquiries directed towards internal audit personnel may

18. In performing analytical procedures, the auditor
most likely
develops expectations or predictions of recorded
a. Relate to their activities concerning the design and balances or ratios. Examples of analytical procedures
effectiveness of the entity’s internal control and include
whether management has satisfactorily responded
to any findings from those activities
a. b. c. d.
b. Help the auditor in understanding the environment
Predicting current year sales
in which the financial statements are prepared
based on prior year trend. Yes Yes Yes Yes
c. Relate to changes in the entity’s marketing The use of standard costs and
strategies, sales trends or contractual
variance analysis. Yes Yes Yes No
arrangements with its customers Expecting increase in accounts
d. Help the auditor in evaluating the appropriateness receivable due to
of the selection and application
corresponding increase in
of accounting policies sales. Yes Yes Yes Yes
Expecting the same level of
14. When an auditor obtains an understanding of the entity industry average inventory
and its environment, observation and inspection turnover. Yes Yes No Yes
provide support for inquiries and direct evidence about Expecting increase in labor costs
the entity and its environment. due to increase in number of

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EXCEL PROFESSIONAL SERVICES, INC.
hours worked. Yes Yes No No
Recalculating depreciation based
on company policies. Yes No No No
19. The auditors use analytical procedures during the
course of an audit. The most important phase of
performing these procedures is the:
a. Vouching of all data supporting various ratios.
b. Investigation of significant variations and unusual
relationships.
c. Comparison of client-computed statistics with
industry data on a quarterly and full-year basis.
d. Recalculation of industry date.
20. In performing analytical procedures, significant
differences between expectations and recorded
amounts should be investigated and evaluated.
Significance is largely a function of ________ and the
desired degree of assurance to be provided.
a. Materiality
b. Auditor’s preference
c. Inherent risk
d. Control risk
21. In performing analytical procedures, significant
differences do not necessarily result in
a. Evaluation of how expectations were developed.
b. Inquiries of management.
c. Corroboration of management responses with other
audit evidence.
d. Performance of other procedures and consideration
of risks of material misstatement due to fraud.
22. As a form of analytical procedure, test of
reasonableness
a. is based on the assumption that performance will
continue in line with previous performance or
industry trends unless something unusual is
happening in the company.
b. is similar to financial statement analysis, and is
highly effective technique to highlight account
balances that are out of line and may signal the
potential for fraud.
c. tests whether a recorded amount is reasonable
with regards to the auditor’s expectation.
d. involves time-series analysis by examining trends
in relationship with previous results.
23. The following statements are true regarding analytical
procedures except
a. Should be applied in planning all financial
statements audit to determine the nature, timing,
and extent of other audit procedures.
b. Used as substantive tests may sometimes be more
effective or efficient than tests of details.
c. Should be applied in the final stage of the audit as
an overall review.
d. Used to obtain understanding and test the
operating effectiveness of internal control.
24. For all audits of financial statements made in
accordance with PSAs, the use of analytical procedures
is required to some extent
In the As a As an overall
assessment of substantive review at the
risks of material audit completion
misstatement procedure stage
a. Yes No Yes
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b. No Yes No
c. No Yes Yes
d. Yes No No
25. Analytical procedures used in planning an audit should
focus on
a. Reducing the scope of tests of controls and
substantive tests.
b. Providing assurance that potential material
misstatements will be identified.
c. Enhancing the auditor’s understanding of the client’
s business required to identify areas of heightened
risk.
d. Assessing the adequacy of the available evidence.
26. Which of the following nonfinancial information would
an auditor most likely consider in performing analytical
procedures during the planning phase of an audit?
a. Turnover of personnel in the accounting
department.
b. Objectivity of audit committee members.
c. Square footage of selling space.
d. Management's plans to repurchase stock.
27. In which of the following stages of audit analytical
procedures tend to use detailed and disaggregated
data
a. Planning.
b. Substantive procedures.
c. Overall review.
d. All of the above.
28. Two analytical procedures available to the auditor are:
• Compare current year’s balances with the
preceding year.
• Compare details of a particular account’s balance
with the preceding year.
Shortcomings of these two procedures are that:
a. the first ignores effects of tests of controls and the
second fails to consider possible changes in client
personnel.
b. the first fails to consider growth or decline in
business activity and the second ignores
relationships of data to other data.
c. both fail to consider growth or decline in business
activity and ignore relationships of data.
d. it is difficult, time consuming, and, therefore,
costly to perform these procedures.
29. An auditor compares 2019 revenues and expenses with
those of the prior year and investigates all changes
exceeding 10%. By this procedure the auditor would be
most likely to learn that
a. An increase in property tax rates has not been
recognized in the client's accrual.
b. The 2019 provision for uncollectible accounts is
inadequate, because of worsening economic
conditions.
c. Fourth quarter payroll taxes were not paid.
d. The client changed its capitalization policy for small
tools in 2019.
30. Auditors try to identify predictable relationships when
using analytical procedures. Which of the following
accounts would most likely yield the highest level of
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EXCEL PROFESSIONAL SERVICES, INC.

evidence regarding relationships that involve PSA 315 regarding the discussion among engagement
transactions? team as part of understanding the entity and assessing
a. Accounts payable risks of material misstatement. Which is incorrect?
b. Accounts receivable a. The discussion shall focus on the susceptibility of
c. Payroll expense the entity’s financial statements to material
d. Advertising expense misstatement, and the application of the applicable
financial reporting framework to the entity’s facts
Use of Information Obtain in Prior Period Audits and circumstances.
b. The discussion allows the engagement team
31. Statement 1: In performing an audit for the current members to exchange information about the
year, the auditor may use prior period information only business risks to which the entity is subject.
after procedures have been performed to evaluate its
current relevance. c. The discussion assists the engagement team
members to gain a better understanding of the
Statement 2: The auditor may consider pertinent potential for material misstatement of the financial
information obtained from client acceptance statements.
procedures, previous engagements for the client, and d. The discussion shall, in all cases, include all of the
other sources. members of the engagement team to attend and
be
DO-IT-YOURSELF (DIY) DRILL
a. True, true c. False, true informed of all of the decisions reached.
b. True, false d. False, false
Documentation
32. To obtain an understanding of a continuing client's
business, an auditor most likely would 35. The following statements relate to documentation
a. Perform tests of details of transactions and requirements about the auditor’s understanding of the
balances. client. Which is incorrect?
b. Review prior year working papers and the a. The auditor shall document the risk assessment
permanent file for the client. procedures performed.
c. Read current issues of specialized industry journals. b. The discussion among the engagement team, and
d. Reevaluate the client's internal the significant decisions reached may be
control documented in a memorandum or minutes of
environment. meeting
c. The documentation shall include key elements of
Brainstorming Among Engagement Team the understanding obtained regarding each of the
aspects of the entity and its environment including
33. Who among the following should lead and preside the the sources of information from which the
sharing of insights and discussion about the understanding was obtained
susceptibility of financial statements to material d. For recurring audits, certain documentation may be
misstatement? carried forward without the need to consider to any
a. Partner c. Senior update to reflect changes in the entity’s business or
b. Manager d. Assistant processes.

34. The following matters relate to the requirements of
1. The purpose of risk assessment procedures is to
a. Obtain an understanding of the entity and its
environment
b. Reduce detection risk
c. Evaluate management ability
d. Determine the operating effectiveness of controls
2. The primary objective of procedures performed to
obtain an understanding of the entity and its
environment is to provide an auditor with:
a. Knowledge necessary for risk assessment and audit
planning.
b. Audit evidence to use in assessing inherent risk.
c. A basis for issuing an opinion on the financial
statements.
d. An evaluation of the consistency of application of
management's policies.
3. The audit team gathers information about a new
client's business and industry in order to obtain:
a. an understanding of the clients internal control
system for financial reporting.
- now do the DIY drill –
b. an understanding of how economic events and
transactions have an effect on the company's
financial statements.
c. information about engagement risk.
d. information regarding whether the company is
engaging in financial statement fraud.
4. Which of the following are the most common
techniques used in obtaining knowledge of a client in
the planning phase of an audit engagement?
a. Confirmation, enquiry, analysis, reperformance
b. Enquiry, analysis, observation, inspection
c. Enquiry, analysis, observation, reperformance
d. Vouching, tracing, discussion, analysis
5. The auditors are planning an audit engagement for a
new client in a business that is unfamiliar to the
auditors. Which of the following would be the most
useful source of information for the auditors during the
preliminary planning stage when they are trying to
obtain a general understanding of audit problems that
might be encountered?
a. Client manuals of accounts and charts of accounts.
b. Established Industry Audit Guides.

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EXCEL PROFESSIONAL SERVICES, INC.
c. Prior-year working papers of the predecessor
auditors.
d. Latest annual and interim financial statements
issued by the client.
6. Which of the following is least likely to be included in
an auditor's inquiry of management while obtaining
information to identify the risks of material
misstatement due to fraud?
a. Are all financial reporting operations at one
location?
b. Does it have knowledge of fraud or suspect fraud?
c. Does it have programs to mitigate fraud risks?
d. Has it reported to the audit committee the nature
of the company's internal control?
7. Inquiries directed towards those charged with
governance may most likely
a. Relate to their activities concerning the design and
effectiveness of the entity’s internal control and
whether management has satisfactorily responded
to any findings from those activities
b. Help the auditor in understanding the environment
in which the financial statements are prepared
c. Relate to changes in the entity’s marketing
strategies, sales trends or contractual
arrangements with its customers
d. Help the auditor in evaluating the appropriateness
of the selection and application
of certain accounting policies
8. Which one of the following is a valid source of
information about the client's processes? a.
Management inquiry
b. Review of the client's budget
c. Tour of client’s plant and operations
d. All are valid sources.
9. Which of the following is not an information source for
developing analytical procedures used in the audit?
a. Relationships among financial statement
elements
b. Relationships between financial and relevant
nonfinancial data
c. Comparison of financial data with anticipated
results (e.g., budgets and forecasts)
d. Comparison of current year financial data with
projections for next year's financial results
10. Which of the following is not a typical analytical review
procedure?
a. Study of relationships of the financial information
with relevant non-financial information.
b. Comparison of the financial information with similar
information regarding the industry in which the
entity operates.
c. Comparisons of recorded amounts of major
disbursements with appropriate invoices.
d. Comparisons of the financial information with
budgeted amounts.
11. Which of the following is not an example of analytical
evidence?
a. Compared inventory turnover by major class with
the prior year on a monthly and quarterly basis.
b. Compared gross profit percentages by major
product classes with the prior year.
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c. Examined monthly performance reports and
investigated significant variations from budgeted
amounts.
d. Examined invoices for plant asset additions to
determine whether the client had erroneously
recorded ordinary repairs as plant assets.
12. What type of analytical procedure would an auditor
most likely use in developing relationships among
balance sheet accounts when reviewing the financial
statements of a nonpublic entity?
a. Trend analysis. c.
Ratio analysis.
b. Regression analysis. d. Risk analysis.
13. An auditor compares year-to-year account balances in
order to perform analytical procedures. This is an
example of:
a. Vertical analysis c.
Trend
analysis
b. Internal control analysis d. Ratio analysis
14. Analytical procedures used in planning an audit should
focus on identifying
a. material weaknesses in internal control.
b. the predictability of financial data from individual
transactions.
c. the various assertions that are embodied in the
financial statements.
d. areas that may represent specific risks relevant to
the audit.
15. In performing an audit, which one of the following
procedures would be considered an analytical
procedure?
a. Comparing last year’s interest expense with this
year’s interest expense.
b. Comparing signatures on checks with the
signatures of authorized check signers.
c. Reviewing initials on received documents
d. Reviewing procedures followed in receiving,
depositing, and disbursing cash.
16. Which of the following is least likely to be comparable
between similar corporations in the same industry line
of business?
a. Accounts receivable turnover
b. Earnings per share
c. Gross profit percent
d. Return on assets before interest and taxes
17. An example of an analytical procedure is the
comparison of
a. Financial information with similar information
regarding the industry in which the entity operates
b. Recorded amounts of major disbursements with
appropriate invoices
c. Results of a statistical sample with the expected
characteristics of the actual population
d. EDP generated data with similar data generated
by a manual accounting system
18. Analytical procedures are
a. Never required
b. Required for planning, substantive testing, and
overall review of the financial statements
c. Required for planning and overall review of the
financial statements
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EXCEL PROFESSIONAL SERVICES, INC.

d. Required during planning only

19. Which of the following statements is not correct?

a. Analytical procedures are used to isolate accounts
or transactions that should be investigated more
extensively.
b. For certain immaterial accounts, analytical
procedures may be the only evidence needed.
c. In some instances, other types of evidence may be
reduced when analytical procedures indicate that
an account balance appears reasonable.
d. Analytical procedures use supporting
documentation to determine which account
balances need additional detailed procedures.

20. Which of the following parties would normally attend a

planning meeting held before the beginning of an audit
engagement to discuss relevant client information and
the audit approach to be taken in performing the
engagement?
a. Engagement partner and the client’s chief financial
officer
b. Engagement partner and audit manager
c. Engagement partner, audit manager, and senior
auditor
d. Engagement partner, audit manager, senior
auditor, and junior audit staff members

- end of AT.3008 -

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