Scenario: An auditor is planning the audit of a nonissuer. The entity has a complex bonus structure for executives based on 'Adjusted EBITDA'. The auditor notes that 'Adjusted EBITDA' excludes 'non-recurring expenses', a definition that is subject to significant management judgment.<br/><br/>Which of the following is the MOST significant fraud risk associated with this scenario?

Answer options:

Management may understate revenue to lower tax liability.

Management may inappropriately classify recurring operating expenses as 'non-recurring' to inflate Adjusted EBITDA and maximize bonuses.

The auditor may not have the expertise to calculate EBITDA.

The entity may fail to disclose the bonus structure in the notes.

How to approach this question

Apply the Fraud Triangle. Incentive: Bonus. Opportunity: Subjective definition. What action achieves the goal? Moving expenses out of the calculation.

Full Answer

B.Management may inappropriately classify recurring operating expenses as 'non-recurring' to inflate Adjusted EBITDA and maximize bonuses.✓ Correct

Management may inappropriately classify recurring operating expenses as 'non-recurring' to inflate Adjusted EBITDA and maximize bonuses.

The risk is 'classification shifting'. By labeling normal operating expenses as 'non-recurring', management can artificially boost the Adjusted EBITDA metric to trigger bonus payouts. This is a classic management override/fraud scenario.

Common mistakes

Focusing on tax avoidance (understatement) when the incentive is for bonuses (overstatement).

Question 14 All questions Question 16

Practice the full CPA AUD Practice Exam 3

78 questions · hints · full answers · grading

More questions from this exam

Q01A CPA firm is performing an audit of a nonissuer in accordance with GAO Government Auditing Stand...Hard Q02During the audit of an issuer, the engagement partner learns that the firm's tax partner, who pro...Hard Q03An auditor is planning an audit of a nonissuer's financial statements. The auditor decides to use...Medium Q04An auditor is assessing control risk for a nonissuer's revenue cycle. The auditor identifies that...Hard Q05During the audit of a manufacturing company's inventory, the auditor utilizes a variables samplin...Hard

View all 78 questions →