ACCY 405 – Fall 2022

Examples of Prior Years’ Mid-term Exam Questions

Important notice regarding this document

The questions below illustrate only some of the types of questions that might be asked on the midterm
exam. Understand that in prior years our course content may have been slightly different.

Conceptual questions

Question: The Champaign County Public Health Department conducts restaurant inspections using a risk-
based approach. Specifically, while it inspects establishments assessed as having high relative risk of
causing foodborne illness 2-3 times per year, it inspects those assessed as having medium relative risk and
low relative risk, respectively, only once per year and once every-other-year. The PCAOB historically
also used a similar risk-based approach to conduct its inspections.

Question a: What does “risk-based” inspection mean in the context of PCAOB inspections?
What is the risk the PCAOB is trying to address through its inspection program?
A ”risk-based” approach means that the PCAOB is focusing on the audit firms that are inherently exposed
to a higher risk for not detecting material misstatements. The risk that the PCAOB is trying to address
through inspections is the risk that auditors are not detecting material misstatements in order to provide
comfort and confidence for shareholders when making investment decision
Question b: The PCAOB inspects auditors with 100 or more public company clients every year
and inspects auditors with fewer than 100 public company clients once every three years. Explain
two ways in which this method of determining inspection frequency is consistent with a risk-
based approach to inspections. Explain two ways in which this approach might not achieve the
goal of applying greater scrutiny to riskier settings. To receive full credit, your response must be
thoughtful and relate to the topics covered in class.
Consistent with a risk-based approach
 It targets the audit firms with the most public company clients, as those audits pose a higher risk
to investors and the public trust in the capital markets
 The PCAOB increases the inspection frequency for audit firms that have a history of audit
deficiencies or that operate in a higher-risk area of the market
 PCAOB inspects auditors with fewer than 100 public company clients once every three years,
which reflects the lower risk associated with smaller audit firms and less complex audits
(The requirement of PCAOB to inspect auditors with 100 firms more frequently is in line with the risk-
based approach since those firms may be subject to risker clients that exhibit the risk of material
misstatements. This is due to the fact that it would be more complex since they have a larger client base
that may not be similar in nature.
Not achieve the goal of applying greater scrutiny to riskier setting
 Audit quality is not solely a function of the number of public company clients an audit firm has,
and some smaller audit firms might pose a greater risk than larger ones
 The PCAOB’s inspection process may not adequately capture risks associated with emerging
audit areas, such audits of emerging technologies, as the PCAOB’s inspection process is
backward-looking and may not keep up with changing market dynamics
Question: There are different schools of thought when it comes to the importance of auditor
independence. Some see all of the independence rules as a “core value” of the audit profession whereas
others see it as a “burdensome constraint”.

Suppose the SEC is considering letting audit firms and their auditors invest in the common stock
of companies whose financial statements they audit, provided they meet the following
stipulations: 1. All audit firm and auditor holdings must be disclosed publicly on a quarterly
 basis. 2. Their holdings as of the date of the auditor’s report must be included as an addendum to
the auditor’s report in the company’s 10-K annual report.

Provide two potential benefits and two potential costs to this hypothetical new reform to the
investing public. Your reasons must specify benefits and costs to stakeholders other than the
auditor.
Two benefits in having a stake in the company
 Auditors are now concerned with the performance of the company so that they will be more
engaged with providing accurate assurance regarding the audit reports for the company they have
shares for.
 Since the auditors are shareholders of the company they audit for, they are essentially signaling
an inherent value of that company to the investors so that it can help them make informed
investment decisions
Two costs
 Auditors who are shareholders of the company they audit for may act upon their own self
interests when it comes to reporting/not reporting misstatements. This is called the moral hazard
problem
 It may potentially allow insider trading because now, the auditors have access to both the
financial statements of the company and insider information on the future performance. This
would allow them to buy and sell stocks based off the information. This is costly to the investors
since their information asymmetry is essentially increased.
Question: What benefits, if any, do private companies in the U.S., who are not required to have their
financial statements examined by an independent auditor, obtain when they have their financial statements
audited? Is there any evidence to back your response?
A study by Minnis showed that private companies actually received value from audits because they ended
up receiving lower interest rate for debt. This is due to the fact that the assurance services provided
signaling to the private lenders of the value of the private companies.

Question: An expression of the audit risk model is AR = RMM x DR, where AR = audit risk, RMM =
risk of material misstatement and DR = detection risk. In class we discussed how auditors use this model
during audit planning, with a focus on “planned” detection risk. We also discussed concepts of client
business risk and auditor business risk, even though these terms do not appear in the above expression.
Briefly define client business risk and auditor business risk and then describe the effect, if any, that these
have on various components of the audit risk model.

The Risk of Material Misstatement (RMM) is based on 2 things in a company/audit client:

1. IR(Inherent Risk-the inherent riskiness of an account and its assertions-for instance, revenue
recognition may be risker than fixed asset)
2. CR(Control Risk-the risk that the company’s internal controls will not prevent or detect an error
in the company’s financial risks)
So, if an account is inherently (naturally) riskier, then a way for the company/client to reduce risk is
to have more controls (reduce CR – the risk that controls will not prevent/detect an error). That would
prevent RMM increasing

Audit Risk is that RMM combined with detection Risk(DR). DR is the risk that the auditor will not
detect the material misstatement. The auditor controls this by doing more work (getting MORE audit
evidence) when the risk of material misstatement is higher. By getting more audit evidence, which
reduces DR, the auditor can make sure the Audit Risk is acceptable to the auditor.

So, AR=IR X CRX DR, Audit Risk is a factor of Inherent Risk, Control Risk and Detection Risk. The
auditor wants to keep the AR at an acceptable level, cannot let it get out of control. So the auditor can
adjust evidence gathering/detection risk to counteract increase in IR or CR.
 Client Business Risk (CBR) : The risk that the client will experience adverse outcome as a result of
economic conditions, events, circumstances, or management action/ inaction
EX) The risk that the client will remain viable (evaluating CBR comes down to assessment of client’s
viability)

Auditor’s Business Risk (ABR): The risk that the audit firm will be exposed to loss from events
arising in connection with financial statements it audited
EX) litigation, penalties, reputation loss, lack of profitability

Question: The PCAOB is considering expanding the auditor’s reporting model with changes that would
be similar to those seen in UK and IAASB standards. (Hint: Think about the KPMG audit report for Rolls
Royce) Discuss two ways in which investors could use expanded audit reports to reach better investing
decisions. Discuss two limitations or possible unintended consequences of using expanded audit reports to
help make investing decisions.
Positive standpoint: the expanded report with an added wording may result in greater transparency
which could improve confidence and trust in financial reporting. Requiring more disclosure by the audit
firm may encourage the auditors to do higher quality work on these areas that matter, increasing audit
quality and financial statements quality. The expanded report may help the user of the report
understand the complexity of the auditor’s judgment and methods, which helps users understand
the audit product better.

Negative standpoint: creating more complexity in reports may reduce trust rather than increase trust in
the auditors, the client and the underlying financial statements. If there are variances in practices and
standards in how to issue expanded reports that may result in greater confusions. If greater amounts of
work are required by auditors, perhaps there will be increased fees to clients, without obvious benefits to
users to reports.
Question: One argument as to why a financial statement audit can add value to investors is that they are
an efficient form of “insurance”. Briefly explain the difference between assurance and insurance. Then,
briefly explain how audits add value by providing assurance and by providing insurance.
Audits add value to investors by providing assurance and insurance. By providing assurance, audit
increase the level of confidence that investors can have in the financial statement of a company. This
helps investors to make more informed decision about whether to invest in a particular company or not.
Assurance provides insurance by being held liable for losses incurred by the investors since they can
turn around and sue them as well and essentially “recover” their damages from the auditors themselves.
Assurance is the independent professional services that improve the quality of information or its
contest, for decision makers. Insurance provides risk production, makes whole injured parties by
paying damages.