CPA Risk Assessment & Underwriting 2 — Questions and Answers
Question 1: Under AU-C Section 315, which of the following is an example of an entity-level control relevant to risk assessment?
- Management's commitment to competence and ethical values (Correct answer)
- Daily reconciliation of petty cash
- Monthly inventory cycle counts
- Customer credit limit approvals
Correct answer: Management's commitment to competence and ethical values
Entity-level controls include the control environment elements such as management's commitment to competence and ethical values, which pervasively affect all other controls.
Question 2: Which risk assessment procedure involves the auditor making observations about whether reconciliations are actually being performed?
- Inquiry of management
- Analytical procedures
- Inspection of records
- Observation (Correct answer)
Correct answer: Observation
Observation involves the auditor watching a process or procedure being performed, such as observing staff performing reconciliations.
Question 3: In insurance underwriting, 'adverse selection' refers to:
- Choosing only the safest risks to insure
- Higher-risk individuals being more likely to seek insurance coverage (Correct answer)
- Selecting adverse policy terms for policyholders
- Declining all high-risk applicants
Correct answer: Higher-risk individuals being more likely to seek insurance coverage
Adverse selection occurs when people with higher risk are disproportionately likely to purchase insurance, leading to an imbalanced risk pool.
Question 4: A CPA auditing an insurance company's underwriting files would use 'loss ratio' primarily as:
- A measure of operating expenses relative to premiums
- A key performance metric comparing incurred losses to earned premiums (Correct answer)
- An indicator of reinsurance recoveries
- A benchmark for investment income
Correct answer: A key performance metric comparing incurred losses to earned premiums
The loss ratio equals incurred losses divided by earned premiums and is the primary metric for evaluating underwriting profitability.
Question 5: When assessing inherent risk at the assertion level, which factor is most relevant for a technology company's software revenue recognition?
- The company's debt-to-equity ratio
- Complexity of multi-element software arrangements (Correct answer)
- Number of employees in the sales department
- Age of accounts receivable balances
Correct answer: Complexity of multi-element software arrangements
Complex multi-element software arrangements create high inherent risk for revenue recognition because allocating transaction prices among performance obligations requires significant judgment.
Question 6: Which of the following best describes a 'significant risk' in auditing standards?
- Any risk with a high likelihood of material misstatement
- An identified and assessed risk of material misstatement requiring special audit consideration (Correct answer)
- A risk that exceeds the audit's materiality threshold
- Any control deficiency identified during the audit
Correct answer: An identified and assessed risk of material misstatement requiring special audit consideration
A significant risk is an identified and assessed risk of material misstatement that requires special audit consideration due to its nature or magnitude.
Question 7: In underwriting, the 'expense ratio' measures:
- Investment expenses as a percentage of assets
- Underwriting expenses as a percentage of net written premiums (Correct answer)
- Claims processing costs relative to total losses
- Reinsurance premiums relative to gross premiums
Correct answer: Underwriting expenses as a percentage of net written premiums
The expense ratio is calculated by dividing underwriting expenses (acquisition costs, administrative costs) by net written premiums.
CPA Risk Assessment & Underwriting 2
Under AU-C Section 315, which of the following is an example of an entity-level control relevant to risk assessment?