Auditing and Assurance Services 14th Edition By Arens, Beasley and Elder– Exam and Quizzes

Auditing and Assurance Services 14th Edition By Arens, Beasley and Elder– Exam and Quizzes

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All 26 Chapters Quiz Answers

Auditing and Assurance Services, 14e (Arens)
Chapter 1 The Demand for Audit and Other Assurance Services

Learning Objective 1-1

1) The Sarbanes-Oxley Act applies to which of the following companies?
A) All companies.
B) Privately held companies.
C) Public companies.
D) All public companies and privately held companies with assets greater than $500 million.
Answer
Terms: Sarbanes-Oxley Act
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills
Topic: SOX

2) Which of the following is considered audit evidence?
A)
Oral statements
made by management Written
Communications Auditor
Observation
Y N N

B)
Oral statements
made by management Written
Communications Auditor
Observation
N Y Y

C)
Oral statements
made by management Written
Communications Auditor
Observation
Y Y Y

D)
Oral statements
made by management Written
Communications Auditor
Observation
N N Y

Answer
Terms: Audit evidence
Diff: Moderate
Objective: LO 1-1
AACSB: Reflective thinking skills

3) Evidence is paramount to audit and attestation engagements. List the four basic types of audit evidence.

4) The criteria by which an auditor evaluates the information under audit may vary with the information being audited.
A) True
B) False

Terms: Criteria which an auditor evaluates information
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills

5) The criteria used by an external auditor to evaluate published financial statements are known as generally accepted auditing standards.
A) True
B) False
Answer
Terms: Criteria used by external auditor to evaluate published financial statements
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills

6) The Sarbanes-Oxley Act establishes standards related to the audits of privately held companies.
A) True
B) False
Answer
Terms: Sarbanes-Oxley Act
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills
Topic: SOX

7) The Sarbanes-Oxley Act is widely viewed as having ushered in sweeping changes to auditing and financial reporting.
A) True
B) False

Terms: Sarbanes-Oxley Act
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills
Topic: SOX

8) Only companies that file annual statements with the Securities and Exchange Commission are required to have an annual external audit.
A) True
B) False
Answer
Terms: Required to have an annual external audit
Diff: Easy
Objective: LO 1-1
AACSB: Reflective thinking skills
Learning Objective 1-2

1) Recording, classifying, and summarizing economic events in a logical manner for the purpose of providing financial information for decision making is commonly called:
A) finance.
B) auditing.
C) accounting.
D) economics.
Answer
Terms: Recording, classifying, and summarizing economic events
Diff: Easy
Objective: LO 1-2
AACSB: Reflective thinking skills

2) Which department provides quantitative information in order for management and others to make decisions?
A) management information systems.
B) auditing.
C) finance.
D) accounting.
Answer
Terms: Department that provides quantitative information for management
Diff: Moderate
Objective: LO 1-2
AACSB: Reflective thinking skills

3) In “auditing” financial accounting data, the primary concern is with:
A) determining whether recorded information properly reflects the economic events that occurred during the accounting period.
B) determining if fraud has occurred.
C) determining if taxable income has been calculated correctly.
D) analyzing the financial information to be sure that it complies with government requirements.

Terms: Auditing financial accounting data primary concern
Diff: Moderate
Objective: LO 1-2
AACSB: Reflective thinking skills

4) The trait that distinguishes auditors from accountants is the:
A) auditor’s ability to interpret accounting principles generally accepted in the United States.
B) auditor’s education beyond the Bachelor’s degree.
C) auditor’s ability to interpret FASB Statements.
D) auditor’s accumulation and interpretation of evidence related to a company’s financial statements.
Answer
Terms: Distinguishes auditors from accountants
Diff: Challenging
Objective: LO 1-2
AACSB: Reflective thinking skills
5) Discuss the differences and similarities between the roles of accountants and auditors. What additional expertise must an auditor possess beyond that of an accountant?

Learning Objective 1-3

1) ________ risk reflects the possibility that the information upon which the business decision was made was inaccurate.
A) Client acceptance
B) Information
C) Business
D) Control
Answer
Terms: Risk that reflects the possibility that information upon which business risk decision was made
Diff: Moderate
Objective: LO 1-3
AACSB: Reflective thinking skills

2) The use of the Certified Public Accountant title is regulated by:
A) the federal government.
B) state law through a licensing department or agency of each state.
C) the American Institute of Certified Public Accountants through the licensing departments of the tax and auditing committees.
D) the Securities and Exchange Commission.
Answer
Terms: Certified Public Accountant title
Diff: Moderate
Objective: LO 1-3
AACSB: Reflective thinking skills
3) Financial statement users often receive unreliable financial information from companies. Which of the following is not a common reason for this?
A) Complex exchange transactions.
B) Voluminous data.
C) Remoteness of information.
D) Each of these choices is a common reason for unreliable financial information.
Answer
Terms: Common reason for financial statements users receiving unreliable financial information
Diff: Moderate
Objective: LO 1-3
AACSB: Reflective thinking skills

4) Explain what is meant by information risk, and list the four causes of this risk.

Learning Objective 1-4

1) An audit of historical financial statements is most often performed to determine whether the:
A) organization is operating efficiently and effectively.
B) entity is following specific procedures or rules set down by some higher authority.
C) management team is fulfilling its fiduciary responsibilities to shareholders.
D) none of these choices.
Answer
Terms: Audit of historical financial statements
Diff: Moderate
Objective: LO 1-4
AACSB: Reflective thinking skills

Learning Objective 1-5

1) In the audit of historical financial statements, what accounting criteria is most common?
A) Regulatory accounting principles.
B) International financial reporting standards.
C) Generally accepted accounting principles.
D) B and C
E) All of the above.
Answer
Terms: Most common accounting criteria
Diff: Easy
Objective: LO 1-5
AACSB: Reflective thinking skills
2) Any service that requires a CPA firm to issue a report about the reliability of an assertion that is made by another party is a(n):
A) accounting and bookkeeping service.
B) attestation service.
C) assurance service.
D) tax service.
Answer
Terms: Strengthen internal controls over accounting for materials used in production
Diff: Easy
Objective: LO 1-5
AACSB: Reflective thinking skills

3) Three common types of attestation services are:
A) audits, reviews, and attestations regarding internal controls.
B) audits, verifications, and attestations regarding internal controls.
C) reviews, verifications, and attestations regarding internal controls.
D) audits, reviews, and verifications.

Terms: Types of attestation services
Diff: Easy
Objective: LO 1-5
AACSB: Reflective thinking skills
4) Which of the following services provides the lowest level of assurance on a financial statement?
A) A review.
B) An audit.
C) Neither service provides assurance on financial statements.
D) Each service provides the same level of assurance on financial statements.

Terms: Service provides lowest level of assurance on a financial statement
Diff: Moderate
Objective: LO 1-5
AACSB: Reflective thinking skills

5) Which of the following is not a SysTrust Services principle as defined by the AICPA?
A) Online privacy.
B) Availability.
C) Processing integrity.
D) Operational integrity.
Answer
Terms: SysTrust Services principles defined by AICPA
Diff: Moderate
Objective: LO 1-5
AACSB: Reflective thinking skills
6) The Sarbanes-Oxley Act prohibits a CPA firm that audits a public company from providing which of the following types of services to that company?
A) Reviews of quarterly financial statements.
B) Preparation of corporate tax returns.
C) Most consulting services.
D) Tax services.
Answer
Terms: Sarbanes-Oxley Act
Diff: Challenging
Objective: LO 1-5
AACSB: Reflective thinking skills
Topic: SOX

7) Which of the following are required to have a written report regarding the assertion of another party?
A)
Financial Statement Audit Operational Audit Compliance Audit Attestation Engagement Assurance Engagement
Y Y Y Y Y

B)
Financial Statement Audit Operational Audit Compliance Audit Attestation Engagement Assurance Engagement
Y Y Y Y N

C)
Financial Statement Audit Operational Audit Compliance Audit Attestation Engagement Assurance Engagement
Y Y Y N N

D)
Financial Statement Audit Operational Audit Compliance Audit Attestation Engagement Assurance Engagement
N N N Y Y

Answer
Terms: Required to have a written report
Diff: Challenging
Objective: LO 1-5
AACSB: Reflective thinking skills
8) Attestation services on information technology include WebTrust services and SysTrust services. Which of the following statements most accurately describes SysTrust services?
A) SysTrust services provide assurance on business processes, transaction integrity and information processes.
B) SysTrust services provide assurance on system reliability in critical areas such as security and data integrity.
C) SysTrust services provide assurance on internal control over financial reporting.
D) SysTrust services provide assurance as to whether accounting personnel are following procedures prescribed by the company controller.
Answer
Terms: Attestation services on information technology; WebTrust and Systrust services
Diff: Challenging
Objective: LO 1-5
AACSB: Reflective thinking skills

9) Two types of attestation services provided by CPA firms are audits and reviews. Discuss the similarities and differences between these two types of attestation services. Which type provides the least assurance?

10) What is an engagement to attest on internal control over financial reporting?

11) What are the five categories of attestation services?

12) What is a WebTrust engagement? What is a SysTrust engagement? How do they differ?

13) CPA firms are never allowed to provide bookkeeping services for clients.
A) True
B) False
Answer
Terms: CPA services provided to clients
Diff: Moderate
Objective: LO 1-5
AACSB: Reflective thinking skills

14) Section 404 of the Sarbanes-Oxley Act requires public companies to have an external auditor attest to their internal control over financial reporting.
A) True
B) False

Terms: Section 404 of the Sarbanes-Oxley Act
Diff: Moderate
Objective: LO 1-5
AACSB: Reflective thinking skills
Topic: SOX
15) Most public companies’ audited financial statements are available on the SEC’s EDGAR database.
A) True
B) False

Terms: Public companies’ audited financial statements: SEC’s EDGAR database
Diff: Challenging
Objective: LO 1-5
AACSB: Reflective thinking skills

Learning Objective 1-6

1) One objective of an operational audit is to:
A) determine whether the financial statements fairly present the entity’s operations.
B) evaluate the feasibility of attaining the entity’s operational objectives.
C) make recommendations for improving performance.
D) report on the entity’s relative success in attaining profit maximization.
Answer
Terms: Objective of operational audit
Diff: Moderate
Objective: LO 1-6
AACSB: Reflective thinking skills

2) An examination of part of an organization’s procedures and methods for the purpose of evaluating efficiency and effectiveness is what type of audit?
A) Operational audit.
B) Compliance audit.
C) Financial statement audit.
D) Production audit.

Terms: Examination of part of an organization’s procedures and method to evaluate efficiency and effectiveness
Diff: Moderate
Objective: LO 1-6
AACSB: Reflective thinking skills

3) An audit to determine whether an entity is following specific procedures or rules set down by some higher authority is classified as a(n):
A) audit of financial statements.
B) compliance audit.
C) operational audit.
D) production audit.
Answer
Terms: Audit to determine whether entity followed specific procedures or rules
Diff: Moderate
Objective: LO 1-6
AACSB: Reflective thinking skills
4) Which one of the following is more difficult to evaluate objectively?
A) Presentation of financial statements in accordance with generally accepted accounting principles.
B) Compliance with government regulations.
C) Efficiency and effectiveness of operations.
D) All three of the above are equally difficult.
Answer
Terms: Most difficult to evaluate objectively
Diff: Challenging
Objective: LO 1-6
AACSB: Reflective thinking skills

5) Which of the following audits can be regarded as generally being a compliance audit?
A) IRS agents’ examinations of taxpayer returns.
B) GAO auditor’s evaluation of the computer operations of governmental units.
C) An internal auditor’s review of a company’s payroll authorization procedures.
D) A CPA firm’s audit of a public company.

Terms: Compliance audit
Diff: Challenging
Objective: LO 1-6
AACSB: Reflective thinking skills
6) Discuss the similarities and differences between financial statement audits, operational audits, and compliance audits. Give an example of each type.

7) To do an audit, it is necessary for information to be in a verifiable form and some criteria by which the auditor can evaluate the information. Detail the information and criteria that would be used for:
(A) an independent CPA firm audits a company’s historical financial statements.
(B) an Internal Revenue Service auditor who audits that same company’s tax return.
(C) an internal auditor use when performing an operational audit to evaluate whether the company’s computerized payroll processing system is operating efficiently and effectively.

8) The primary purpose of a compliance audit is to determine whether the financial statements are prepared in compliance with generally accepted accounting principles.
A) True
B) False

9) Results of compliance audits are typically reported to someone within the organizational unit being audited rather than to a broad spectrum of outside users.
A) True
B) False
Answer
Terms: Compliance audit
Diff: Moderate
Objective: LO 1-6
AACSB: Reflective thinking skills

Learning Objective 1-7

1) Match the engagement described to the (A) type of audit and (B) auditor that would perform the engagement. Each engagement will have an answer from List-A and List-B. An answer can be used once, more than once, or not at all.

List A – Type of Audit: List B – Type of Auditor:
a. Financial Statement
b. Compliance
c. Operational d. Internal
e. External
f. Government
g. IRS

Engagement:
1. Evaluate a company’s payroll processing for economy.
2. Evaluate/determine if bank covenants are being met.
3. Evaluate financial statements that are to be submitted to a bank.
4. Evaluate the promptness of materials inspection in a manufacturer’s receiving department.
5. Determine if Medicare reimbursements are in accordance with the Healthcare Financing Administration (HCFA).
6. Determine if the tax return of a multinational corporation is in accordance with the tax code.
7. Determine if a public school is properly applying their reimbursement for the payment-in-kind program.
8. Determine the effectiveness of the department of defense starwars project.

2) Discuss the similarities and differences between the roles of independent auditors, GAO auditors, internal revenue agents, and internal auditors.

3) The primary role of the United States General Accounting Office is the enforcement of the federal tax laws as defined by Congress and interpreted by the courts.
A) True
B) False
Answer
Terms: Primary role of United States General Accounting Office
Diff: Moderate
Objective: LO 1-7
AACSB: Reflective thinking skills

Learning Objective 1-8

1) The three requirements for becoming a CPA include all but which of the following?
A) Uniform CPA examination requirement.
B) Educational requirements.
C) Character requirements.
D) Experience requirement.
Answer
Terms: Requirements for becoming a CPA
Diff: Moderate
Objective: LO 1-8
AACSB: Reflective thinking skills

2) List and discuss the three primary requirements to become a CPA.
Auditing and Assurance Services, 14e (Arens)
Chapter 2 The CPA Profession

Learning Objective 2-1

1) The legal right to perform audits is granted to a CPA firm by regulation of:
A) each state.
B) the Financial Accounting Standards Board (FASB).
C) the American Institute of Certified Public Accountants (AICPA).
D) the Audit Standards Board.
Answer
Terms: Legal rights to perform audits
Diff: Moderate
Objective: LO 2-1
AACSB: Reflective thinking skills

2) The four categories for describing the size of audit firms include: the Big Four international firms; national firms; regional and local firms; and small firms. Which of the following is not a characteristic of a small firm?
A) Most have fewer than 25 professionals.
B) They perform audits on small and not-for-profit businesses.
C) Tax services are more important to their practice than auditing.
D) They do not audit publically traded companies.
Answer
Terms: Four categories for describing size of audit firms
Diff: Moderate
Objective: LO 2-1
AACSB: Reflective thinking skills

3) Sarbanes-Oxley and the Securities Exchange Commission restrict auditors from providing many consulting services to their publically traded audit clients. Which of the following is true for auditors of publically traded companies?
I. They are restricted from providing consulting services to privately held companies.
II. There is no restriction on providing consulting services to non-audit clients.
A) I only
B) II only
C) I and II
D) Neither I or II

Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions
Diff: Moderate
Objective: LO 2-1
AACSB: Reflective thinking skills
Topic: SOX

4) Which of the following statements is true as it relates to limited liability partnerships?
A) Only senior partners are liable for the partnership’s debts.
B) Partners have no liability in a limited liability partnership arrangement.
C) Partners are personally liable for the acts of those under their supervision.
D) All partners must be AICPA members.
Answer
Terms: Limited liability partnerships
Diff: Challenging
Objective: LO 2-1
AACSB: Reflective thinking skills

5) List and describe the three factors that influence the organizational structure of all CPA firms. What are the most common forms of CPA firm organization?

6) List and describe the six organizational structures available to CPA firms.
AnswerPA firms can take one of six organizational forms:
• Proprietorship. This form is limited to firms with only one owner.
• General partnership. This form is similar to a proprietorship, except that it applies to multiple owners.
• General corporation. Unlike a general partnership, shareholders in a general corporation are liable only to the extent of their investment in the corporation.
• Professional corporation. Professional corporations can have one or more shareholders. Personal liability protection for shareholders in professional corporations varies widely from state to state.
• Limited liability company. This form combines the most favorable attributes of a general corporation and a general partnership. LLCs are taxed like a general partnership, but its owners have limited personal liability like shareholders of a general corporation.
• Limited liability partnership. An LLP is structured and taxed like a general partnership. However, the personal liability protection of an LLP is less than that of a general corporation or an LLC, but it is greater than a general partnership. Many accounting firms now operate as LLPs.
Terms: Organizational structures available to CPA firms
Diff: Moderate
Objective: LO 2-1
AACSB: Reflective thinking skills

7) Many small/local accounting firms do not perform audits as their primary services to their clients include accounting and tax.
A) True
B) False
Answer
Terms: Small accounting firms do not perform audits
Diff: Easy
Objective: LO 2-1
AACSB: Reflective thinking skills

8) All of the Big Four and many of the smaller CPA firms now operate as Limited Liability Partnerships.
A) True
B) False
Answer
Terms: Limited liability partnerships
Diff: Easy
Objective: LO 2-1
AACSB: Reflective thinking skills

9) Sarbanes-Oxley and the Securities Exchange Commission restrict auditors from providing many consulting services to their publically traded audit clients.
A) True
B) False
Answer
Terms: Sarbanes-Oxley and Securities Exchange Commission restrict auditors
Diff: Easy
Objective: LO 2-1
AACSB: Reflective thinking skills
Topic: SOX

10) Limited liability companies are structured and taxed like a general partnership, but their owners have limited personal liability similar to that of a general corporation.
A) True
B) False
Answer
Terms: Limited liability companies
Diff: Moderate
Objective: LO 2-1
AACSB: Reflective thinking skills

Learning Objective 2-2

1) The organization that is responsible for providing oversight for auditors of public companies is called the ________.
A) Auditing Standards Board.
B) American Institute of Certified Public Accountants.
C) Public Oversight Board.
D) Public Company Accounting Oversight Board.
Answer
Terms: Organization responsible for providing oversight for auditors of public companies
Diff: Easy
Objective: LO 2-2
AACSB: Reflective thinking skills
Topic: SOX

2) Members of the Public Company Accounting Oversight Board are appointed and overseen by:
A) the U.S. Congress.
B) the American Institute of Certified Public Accountants.
C) the Auditing Standards Board.
D) the Securities and Exchange Commission.
Answer
Terms: Members of Public Company Accounting Oversight Board
Diff: Easy
Objective: LO 2-2
AACSB: Reflective thinking skills
Topic: SOX

3) The Public Company Accounting Oversight Board:
A) perform inspections of the quality controls at audit firms that audit public companies.
B) establish auditing standards that must be followed by CPAs on all audits.
C) oversee auditors of private companies.
D) perform any of the above functions.
Answer
Terms: Public Company Accounting Oversight Board
Diff: Moderate
Objective: LO 2-2
AACSB: Reflective thinking skills
Topic: SOX

4) Assume the Public Company Accounting Oversight Board (PCAOB) identifies a violation during its inspection of a registered accounting firm. The PCAOB:
A)
can enforce disciplinary action against the accounting firm report the matter to the Securities and Exchange Commission suspend the license to practice of the CPA guilty of the violation
Yes Yes Yes

B)
can enforce disciplinary action against the accounting firm report the matter to the Securities and Exchange Commission suspend the license to practice of the CPA guilty of the violation
Yes Yes No

C)
can enforce disciplinary action against the accounting firm report the matter to the Securities and Exchange Commission suspend the license to practice of the CPA guilty of the violation
Yes No No

D)
can enforce disciplinary action against the accounting firm report the matter to the Securities and Exchange Commission suspend the license to practice of the CPA guilty of the violation
No No No

Answer
Terms: Public Company Accounting Oversight Board inspection violations
Diff: Moderate
Objective: LO 2-2
AACSB: Reflective thinking skills
Topic: SOX

5) The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). What are the PCAOB’s primary functions? Who performed these functions prior to the PCAOB?

6) The Public Company Accounting Oversight Board (PCAOB) provides oversight to auditors of publically traded and private companies.
A) True
B) False
Answer
Terms: Public Company Accounting Oversight Board
Diff: Easy
Objective: LO 2-2
AACSB: Reflective thinking skills
7) All CPA firms registered with the PCAOB are required to undergo a peer review annually.
A) True
B) False
Answer
Terms: PCAOB requirement for peer review
Diff: Moderate
Objective: LO 2-2
AACSB: Reflective thinking skills
Topic: SOX

Learning Objective 2-3

1) The form that must be completed and filed with the Securities and Exchange Commission whenever a company experiences a significant event that is of interest to public investors is the:
A) Form S-1.
B) Form 8-K.
C) Form 10-K.
D) Form 10-Q.
Answer
Terms: Sec form 8-k, reporting significant events
Diff: Moderate
Objective: LO 2-3
AACSB: Reflective thinking skills

2) The form that must be filed with the Securities and Exchange Commission whenever a company plans to issue new securities to the public is the:
A) Form S-1.
B) Form 8-K.
C) Form 10-K.
D) Form 10-Q.
Answer
Terms: Form must be completed and filed with Securities and Exchange Commission when company plans to issue new securities
Diff: Moderate
Objective: LO 2-3
AACSB: Reflective thinking skills

3) The AICPA has authority to establish standards and rules in all but which of the following areas?
A) Auditing standards applicable to financial statements of private companies
B) Compilation and review standards
C) Professional conduct
D) Auditing standards applicable to financial statements of private and public companies
Answer
Terms: AICPA has authority to establish standards and rules
Diff: Challenging
Objective: LO 2-3
AACSB: Reflective thinking skills
4) Discuss the purpose of the Securities and Exchange Commission and its influence on setting generally accepted accounting principles.

5) The difference between the Securities Act of 1933 and the Securities Act of 1934 is that only the 1934 act requires audited financial statements.
A) True
B) False
Answer
Terms: Securities Acts of 1933 and 1934
Diff: Easy
Objective: LO 2-3
AACSB: Reflective thinking skills

6) Form 10-K must be filed with the SEC whenever a public company experiences a significant event.
A) True
B) False
Answer
Terms: Form 10-K; SEC
Diff: Moderate
Objective: LO 2-3
AACSB: Reflective thinking skills

7) The overall purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions.
A) True
B) False
Answer
Terms: Securities and Exchange Commission
Diff: Moderate
Objective: LO 2-3
AACSB: Reflective thinking skills
Learning Objective 2-4

1) Statements on Standards for Accounting and Review Services are issued by the:
A) Accounting and Review Services Committee.
B) Professional Ethics Executive Committee.
C) Securities and Exchange Commission.
D) Financial Accounting Standards Board.
Answer
Terms: Statements on Standards for Accounting and Review Services (SSARS)
Diff: Moderate
Objective: LO 2-4
AACSB: Reflective thinking skills

2) Which of the following is not an essential component of quality control?
A) Policies and procedures to ensure that firm personnel are actively engaged in marketing strategies.
B) Policies and procedures to ensure that the work performed by firm personnel meet applicable professional standards.
C) Policies to ensure that personnel maintain their independence in fact and in appearance.
D) Policies that ensure that monitoring activities are effectively applied.
Answer
Terms: Component of quality control
Diff: Moderate
Objective: LO 2-4
AACSB: Reflective thinking skills

3) What are the major functions of the AICPA?

4) Membership in the AICPA is restricted to CPAs who are currently practicing as independent auditors.
A) True
B) False
Answer
Terms: Membership in AICPA
Diff: Easy
Objective: LO 2-4
AACSB: Reflective thinking skills

5) Membership in the AICPA is mandatory for all licensed practicing CPAs.
A) True
B) False
Answer
Terms: Membership in AICPA
Diff: Easy
Objective: LO 2-4
AACSB: Reflective thinking skills

6) Any public accounting firm can be a member of the AICPA if the firm meets the membership requirements.
A) True
B) False
Answer
Terms: Membership in AICPA
Diff: Easy
Objective: LO 2-4
AACSB: Reflective thinking skills

Learning Objective 2-5

1) Which of the following are audit standards used in professional practice by audit firms?
A)
International
Standards
on Auditing U.S. Generally Accepted Auditing Standards PCAOB Auditing Standards
Yes No No

B)
International
Standards
on Auditing U.S. Generally Accepted Auditing Standards PCAOB Auditing Standards
Yes Yes No

C)
International
Standards
on Auditing U.S. Generally Accepted Auditing Standards PCAOB Auditing Standards
Yes Yes Yes

D)
International
Standards
on Auditing U.S. Generally Accepted Auditing Standards PCAOB Auditing Standards
No Yes Yes

Answer
Terms: Standards used in professional practice
Diff: Easy
Objective: LO 2-5
AACSB: Reflective thinking skills

2) For privately held companies who of the following is responsible for establishing auditing standards?
A) Securities and Exchange Commission
B) Public Company Accounting Oversight Board
C) Auditing Standards Board
D) National Association of Accounting
Answer
Terms: Establishing auditing standards for privately held companies
Diff: Easy
Objective: LO 2-5
AACSB: Reflective thinking skills

3) Standards issued by the Public Company Accounting Oversight Board must be followed by CPAs who audit:
A) both private and public companies.
B) public companies only.
C) private companies, public companies, and nonprofit entities.
D) private companies only.
Answer
Terms: Public Company Accounting Oversight Board Standards
Diff: Moderate
Objective: LO 2-5
AACSB: Reflective thinking skills
Topic: SOX

4) The Audit Standards Board of the AICPA has undertaken the Clarity & Convergence Project to make GAAS easier to read understand and apply; as well as converge GAAS with the International Standards on Auditing (ISAs). Which of the following statements concerning the Clarity & Convergence Project is(are) true?
I. The “General” standards of GAAS will be termed “Responsibilities”.
II. The “Fieldwork” standards will be termed “Performance”.
III. The “Reporting” standards will be termed “Communications”.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Clarity and Convergence Project
Diff: Moderate
Objective: LO 2-5
AACSB: Reflective thinking skills

5) If an auditor of a public company cannot find guidance issued by the PCAOB on a particular audit matter, the auditor should generally seek guidance from which of the following sources?
A) Statements on Auditing Standards
B) Statements on Standards for Accounting and Review Services
C) Regulations issued by the Securities and Exchange Commission
D) The AICPA Code of Professional Conduct
Answer
Terms: Guidance issued by PCAOB
Diff: Challenging
Objective: LO 2-5
AACSB: Reflective thinking skills
Topic: SOX

6) The Auditing Standards Board of the AICPA has undertaken a Clarity and Convergence Project whose aim is to make GAAS easier to read, apply and converge with International Audit Standards. As a result the GAAS will become “Auditing Principles”. The principles will be consistent with the three categories of GAAS. Accordingly, which of the following is true?
I The General Standards will be termed Responsibilities Principles.
II. The Fieldwork Standards will be termed Performance Principles.
III. The Reporting Standards will be termed Communication Principles.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Clarity and Convergence Project
Diff: Challenging
Objective: LO 2-5
AACSB: Reflective thinking skills

7) Auditors of public companies should, in the absence of guidance issued by the PCAOB, follow auditing standards issued by the SEC.
A) True
B) False
Answer
Terms: Auditors of pubic companies; PCAOB and SEC
Diff: Easy
Objective: LO 2-5
AACSB: Reflective thinking skills
Topic: SOX

8) International Standards on Auditing are issued by the International Auditing Practices Committee.
A) True
B) False
Answer
Terms: International Standards on Auditing; International Auditing Practices Committee
Diff: Moderate
Objective: LO 2-5
AACSB: Reflective thinking skills

Learning Objective 2-6

1) Which one of the following is not one of the three General Standards?
A) Proper planning and supervision.
B) Independence of mental attitude.
C) Adequate training and proficiency.
D) Due professional care.
Answer
Terms: General standards
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills
2) Which one of the following is not a Field Work Standard?
A) Adequate planning and supervision.
B) Due professional care.
C) Understand the entity and its environment including internal control.
D) Sufficient appropriate audit evidence.
Answer
Terms: Field Work Standards
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills

3) The generally accepted auditing standard that requires “Adequate technical training and proficiency” is normally interpreted as requiring the auditor to have:
A) formal education in auditing and accounting.
B) worked for an entity similar to the entity being audited.
C) independence in mental attitude.
D) a graduate degree in a business field.
Answer
Terms: General accepted auditing standards; Adequate technical training and proficiency
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills

4) Which of the following statements most accurately captures the intent of the standards of field work?
A) Field work standards are primarily concerned with personal attributes necessary during the conduct of the audit.
B) Field work standards provide extensive guidance regarding the conduct of an audit.
C) Field work standards are primarily directed at the auditor’s planning, understanding of internal control, and evidence accumulation.
D) Field work standards are primarily concerned with the conduct of substantive testing as opposed to testing of internal controls.
Answer
Terms: Standards of field work
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills

5) The Statements on Auditing Standards issued by the Auditing Standards Board:
A) interpret generally accepted auditing standards.
B) are the equivalent of laws for audit practitioners.
C) must be followed in all situations.
D) are optional guidelines which an auditor may choose to follow or not follow when conducting an audit.
Answer
Terms: Statements on Auditing Standards
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills
6) An auditor need not abide by a particular auditing standard if the auditor believes that:
A) the issue in question is immaterial in amount.
B) more expertise is needed to fulfill the requirement.
C) the requirement of the standard has not been addressed by the PCAOB.
D) any of the above three are correct.
Answer
Terms: Auditor need not abide by a particular auditing standard
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills

7) Under GAAS, which of the following reflects a concept from the general group?
A) The confirmation of accounts receivable.
B) Completing an internal control questionnaire.
C) The initial planning of the audit with the audit partner, manager, senior, staff and client personnel.
D) The assignment of audit personnel to an engagement where they have no financial interest.
Answer
Terms: GAAS, general standards
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills

8) The third general standard states that due care is to be exercised in the performance of an audit. This standard is generally interpreted to require:
A) objective review of the adequacy of the technical training of firm personnel.
B) thorough review of the existing internal control structure.
C) critical review of work done at every level of supervision.
D) periodic review of a CPA firm’s quality control procedures.
Answer
Terms: Third general standard; Due care
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills

9) Which of the following statements best describes the primary purpose of Statements on Auditing Standards?
A) They are guides intended to set forth auditing procedures that are applicable to a variety of situations.
B) They are procedural outlines that are intended to narrow the areas of inconsistency and divergence of auditor opinion.
C) They are authoritative statements, enforced through the Code of Professional Conduct, and are intended to limit the degree of auditor judgment.
D) They are interpretations that are intended to clarify the meaning of “generally accepted auditing standards.”
Answer
Terms: Purpose of Statements on Auditing Standards
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills
10) Hansen Corporation’s stock is listed on a national stock exchange and registered with the Securities and Exchange Commission. Hansen’s management hires a CPA to perform an independent audit of Hansen’s financial statements. The primary objective of this audit is to provide assurance to the:
A) investors in Hansen Corporation’s stock.
B) stock exchange.
C) Securities and Exchange Commission.
D) management of Hansen Corporation.
Answer
Terms: Primary objective of audit to provide assurance
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills

11) Which of the following statements about Generally Accepted Audit Standards are true?
I. They serve as broad guidelines to auditors for conducting an audit engagement.
II. They are sufficiently specific to provide any meaningful guide to practitioners.
III. They represent a framework upon which the AICPA can provide interpretations..
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Generally Accepted Audit Standards
Diff: Challenging
Objective: LO 2-6
AACSB: Reflective thinking skills

12) Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) should be looked upon by practitioners as:
A) ideals to work towards, but which are not achievable.
B) maximum standards that denote excellent work.
C) minimum standards of performance that must be achieved on each audit engagement.
D) benchmarks to be used on all audits, reviews, and compilations.
Answer
Terms: Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS)
Diff: Challenging
Objective: LO 2-6
AACSB: Reflective thinking skills
13) Statements on Auditing Standards issued by the AICPA’s Auditing Standards Board are:
A) part of the generally accepted auditing standards under the AICPA Code of Professional Conduct.
B) interpretations of generally accepted auditing standards and departures from such statements must be justified.
C) interpretations of generally accepted auditing standards and such standards must be followed in every engagement.
D) generally accepted auditing procedures that are not covered by the AICPA Code of Professional Conduct.
Answer
Terms: Statements on Auditing Standards
Diff: Challenging
Objective: LO 2-6
AACSB: Reflective thinking skills

14) List the ten generally accepted auditing standards and divide them into their proper category.

15) Distinguish between generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP). What professional organization establishes GAAS? What professional organization establishes GAAP?

16) Statements on Auditing Standards are considered authoritative literature.
A) True
B) False
Answer
Terms: Statements on Auditing Standards
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills

17) Statements on Auditing Standards (SASs) are issued by the Public Company Accounting Oversight Board.
A) True
B) False
Answer
Terms: Statements on Auditing Standards (SAS); Public Company Accounting Oversight Board
Diff: Easy
Objective: LO 2-6
AACSB: Reflective thinking skills

18) Statements on Auditing Standards (SASs) are considered to be interpretations of the ten generally accepted auditing standards.
A) True
B) False
Answer
Terms: Statements on Auditing Standards (SAS); Generally accepted auditing standards
Diff: Moderate
Objective: LO 2-6
AACSB: Reflective thinking skills

Learning Objective 2-7

1) Which of the following is not true for audit firms who audit publically traded companies?
A) They must undergo a PCAOB inspection on an annual basis if they audit more than 100 issuers
B) They must have an AICPA peer review on all audit clients.
C) They must have an AICPA peer review on all non-publically traded clients.
D) The audit firm can choose which CPA firm they wish to conduct their AICPA peer review.
Answer
Terms: Audit firms who audit publically traded companies
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills

2) A basic objective of a CPA firm is to provide professional services to conform to professional standards. Reasonable assurance of achieving this basic objective is provided through:
A) continuing professional education.
B) compliance with generally accepted reporting standards.
C) a system of quality control.
D) a system of peer review.
Answer
Terms: Professional standards
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills

3) Within the context of quality control, the primary purpose of continuing professional education and training activities is to enable a CPA firm to provide its personnel with:
A) technical training that assures proficiency as a valuation expert.
B) professional education that is required in order to perform with due professional care.
C) knowledge required to fulfill assigned responsibilities.
D) knowledge required to perform a peer review.
Answer
Terms: Quality control; Continuing professional education and training activities
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills

4) The purpose of establishing quality control policies and procedures to accept or continue a client relationship is to:
A) provide reasonable assurance that personnel are adequately trained to fulfill their responsibilities.
B) monitor the risk factors concerning misstatements that arise from the misappropriation of assets.
C) document objective criteria for the CPA firm’s peer review.
D) minimize the likelihood of associating with client’s whose management may lack integrity.
Answer
Terms: Purpose of quality control policies and procedures to accept or continue client relationship
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills

5) Which of the following is an element of the CPA’s quality control system that should be considered in establishing it’s quality control policies and procedures?
A) Considering audit risk and materiality.
B) Using statistical sampling techniques.
C) Assigning personnel to engagements.
D) Complying with laws and regulations.
Answer
Terms: Quality control policies and procedures
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills

6) Which one of the following is not true regarding the American Institute of Certified Public Accountants peer review requirement?
A) A CPA firm must develop and adhere to quality control standards.
B) Peer reviews are mandatory.
C) A CPA firm will lose AICPA eligibility if a peer review is not performed.
D) Firms required to be registered with and inspected by the PCAOB are exempt.
Answer
Terms: AICPA peer review
Diff: Challenging
Objective: LO 2-7
AACSB: Reflective thinking skills

7) Discuss the relationship between quality control and generally accepted auditing standards.

8) List and describe the six elements of quality control. Who establishes the standards for quality control?

9) Listed below are policies or procedures that the Crystal Cove audit firm has in place. For each identified policy or procedure state if it is a Generally Accepted Audit Standard (GAAS) or a Quality Control Standard.
Audit firm Policy or Procedure
1. Independence in mental attitude.
2. A client evaluation form.
3. All personnel participate in continuing professional education.
4. Conducting the audit with professional skepticism.
5. Answering an independence questionnaire.
6. Understand the client industry.
7. Audit staff workpapers are reviewed by audit seniors, then managers.
8. Audit staff are supervised. Standards Category
a. GAAP Standards
b. Quality Control Standards

10) The following are definitions of terms that are listed on the right. Match the definition with its associated term. Each term can be used once, more than once or not at all.
Definition
1. An organizational structure where professional services are provided by one or more shareholders.
2. The grantor of the right to practice public accounting.
3. A report filed to indicate a significant event.
4. Sets professional standards and rules for auditors.
5. Oversees accounting firms who audit public companies.
6. An organizational structure where the owners are taxed like a partnership and have limited personal liability.
7. A report that is filed when a company wishes to issue new securities.
8. The methods used to ensure the firm meets its professional responsibilities to clients and others.
9. Assists in providing investors with reliable information.
10. Requires annual inspections of accounting firms auditing > 100 issuers.
11. Practice monitoring by a CPA firm for another CPA firm.
12. Fulfilling duties diligently and carefully.
13. Requires a registration statement. Audit Term
a. AICPA
b. PCAOB
c. Securities Exchange Commision
d. Form 10-k
e. IAASB
f. Form S-1
g. Due professional care
h. Limited Liability Partnership
i. Professional Corporation
j. Limited Liability Company
k. Peer review
l. 1933 Securities Act
m. 1934 Securities Act
n. Form 8-k
o. State Regulation
p. Code of Professional Conduct
q. Quality Control Standards
r. GAAS Standards

11) Quality controls are established for the entire CPA firm whereas GAAS are applicable to the individual engagement.
A) True
B) False
Answer
Terms: Quality controls and GAAS
Diff: Moderate
Objective: LO 2-7
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 3 Audit Reports

Learning Objective 3-1

1) An audit of historical financial statements most commonly includes the:
A) balance sheet, statement of retained earnings, and the statement of cash flows.
B) income statement, the statement of cash flows, and the statement of net working capital.
C) statement of cash flows, balance sheet, and the statement of retained earnings.
D) balance sheet, income statement, and the statement of cash flows.
Answer
Terms: Audit of historical financial statements
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills

2) Auditing standards require that the audit report must be titled and that the title must:
A) include the word “independent.”
B) indicate if the auditor is a CPA.
C) indicate if the auditor is a proprietorship, partnership, or incorporated.
D) indicate the type of audit opinion issued.
Answer
Terms: Auditing standards require audit report title
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

3) To emphasize the fact that the auditor is independent, a typical addressee of the audit report could be:
A)
Company Controller Shareholders Board of Directors
No Yes Yes

B)
Company Controller Shareholders Board of Directors
No No Yes

C)
Company Controller Shareholders Board of Directors
Yes Yes No

D)
Company Controller Shareholders Board of Directors
Yes No No

Answer
Terms: Audit report addressee
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
4) The scope paragraph of the standard unqualified audit report states that the audit is designed to:
A) discover all errors and/or irregularities.
B) discover material errors and/or irregularities.
C) conform to generally accepted accounting principles.
D) obtain reasonable assurance whether the statements are free of material misstatement.
Answer
Terms: Scope paragraph of standard unqualified audit report states
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

5) The audit report date on a standard unqualified report indicates:
A) the last day of the fiscal period.
B) the date on which the financial statements were filed with the Securities and Exchange Commission.
C) the last date on which users may institute a lawsuit against either client or auditor.
D) the last day of the auditor’s responsibility for the review of significant events that occurred subsequent to the date of the financial statements.
Answer
Terms: Audit report date on standard unqualified report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

6) The standard audit report refers to GAAS and GAAP in which paragraphs?
A)
GAAS GAAP
Scope only Opinion only

B)
GAAS GAAP
Intro only Scope and Opinion

C)
GAAS GAAP
Intro and Scope Opinion only

D)
GAAS GAAP
Intro only All paragraphs

Answer
Terms: Standard audit report; GAAS and GAAP
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
7) Which of the following is not explicitly stated in the standard unqualified audit report?
A) The financial statements are the responsibility of management.
B) The audit was conducted in accordance with generally accepted accounting principles.
C) The auditors believe that the audit provides a reasonable basis for their opinion.
D) An audit includes assessing the accounting estimates used.
Answer
Terms: Standard unqualified audit report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

8) If an auditor performs an audit of a public company, the scope paragraph should make reference to which standards?
A) GAAP.
B) GAAS.
C) Standards issued by the PCAOB (U.S.).
D) International Audit Standards.
Answer
Terms: Audit of public company, scope paragraph
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
Topic: Public

9) The introductory paragraph of the standard audit report states that the financial statements are:
A) the responsibility of the auditor.
B) the responsibility of management.
C) the joint responsibility of management and the auditor.
D) none of the above.
Answer
Terms: Introductory paragraph of standard audit report
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills

10) The introductory paragraph of the standard audit report performs which functions?
I. State the CPA has performed an audit.
II. Lists the financials being audited.
III. States the financials are the responsibility of the auditor.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Introductory paragraph of standard audit report
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills
11) Which of the following statements are true?
I. The introductory paragraph states that management is responsible for the preparation and content of the financial statements.
II. The scope paragraph states that the auditor evaluates the appropriateness of those accounting principles, estimates, and financial statement disclosures.
A) I only
B) II only
C) I and II
D) Neither I nor II
Answer
Terms: Introductory paragraph and scope paragraph
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills

12) The introductory paragraph of the standard audit report states that the auditor is:
A) responsible for the financial statements and the opinion on them.
B) responsible for the financial statements.
C) responsible for the opinion on the financial statements.
D) jointly responsible for the financial statements with management.
Answer
Terms: Introductory paragraph of standard audit report
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills
13) If the balance sheet of a company is dated December 31, 2011, the audit report is dated February 8, 2012, and both are released on February 15, 2012, this indicates that the auditor has searched for subsequent events that occurred up to:
A) December 31, 2011.
B) January 1, 2012.
C) February 8, 2012.
D) February 15, 2012.
Answer
Terms: Audit report subsequent event dating
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills
14) Which of the following is true concerning financial statements issued by a U.S. entity to the Securities and Exchange Commission?
A) Financial statements can be prepared using International Financial Reporting Standards.
B) The United States now allows an auditor to perform an audit of financial statements of a U.S. entity in accordance with both GAAS and International Audit Standards.
C) The United States only allows an auditor to perform an audit of financial statement of an entity in accordance with GAAS if they are using International Financial Reporting Standards.
D) An audit that uses both the GAAS and International Audit standards must modify the scope paragraph to include both sets of standards.
Answer
Terms: Financial statements issued by U.S. entity to Securities and Exchange Commission
Diff: Challenging
Objective: LO 3-1
AACSB: Reflective thinking skills

15) Most auditors believe that financial statements are “presented fairly” when the statements are in accordance with GAAP, and that it is also necessary to:
A) determine that they are not in violation of FASB statements.
B) examine the substance of transactions and balances for possible misinformation.
C) review the statements using the accounting principles promulgated by the SEC.
D) assure investors that net income reported this year will be exceeded in the future.
Answer
Terms: Financial statements are presented fairly in accordance with GAAP
Diff: Challenging
Objective: LO 3-1
AACSB: Reflective thinking skills

16) In which of the following situations would the auditor most likely issue an unqualified report?
A) The client valued ending inventory by using the replacement cost method.
B) The client valued ending inventory by using the Next-In-First-Out (NIFO) method.
C) The client valued ending inventory at selling price rather than historical cost.
D) The client valued ending inventory by using the First-In-First-Out (FIFO) method, but showed the replacement cost of inventory in the Notes to the Financial Statements.
Answer
Terms: Issuance of unqualified report
Diff: Challenging
Objective: LO 3-1
AACSB: Reflective thinking skills

17) Brown Co.’s financial statements adequately disclose uncertainties that concern future events, the outcome of which are not reasonably estimable. The auditor’s report should be a(n):
A) unqualified opinion.
B) disclaimer.
C) qualified opinion.
D) adverse opinion.
Answer
Terms: Adequately disclosed uncertainties
Diff: Challenging
Objective: LO 3-1
AACSB: Reflective thinking skills

18) An audit report prepared by Garrett and Brown, CPAs, is provided below. The audit for the year ended December 31, 2012 was completed on March 1, 2013, and the report was issued to Javlin Corporation, a private company, on March 13, 2013. List any deficiencies in this report. Do not rewrite the report.

We have examined the accompanying financial statements of Dalton Corporation as of December 31, 2012. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these statements based on our audit.

We conducted our audit in accordance with generally accepted accounting principles. Those principles require that we plan and perform the audit to provide reasonable assurance about whether the financial statements are free of misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, except for the effects of not capitalizing certain lease obligations that should be capitalized in order to conform with generally accepted accounting principles, the financial statements referred to above present accurately the financial position of Jacob Corporation as of December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.

Garrett and Brown, CPAs

March, 2013

19) Describe the standard unqualified report to be issued for an audit of a private company. Begin by specifying the seven parts of the report, and then discuss the contents of each part.

20) Presented below is an independent auditor’s report for a private company prepared by the firm of Harrington and Perry, LLP.

Auditor’s Report

To the president and management of EPM, Inc.

We have examined the accompanying balance sheets and statements of income, retained earnings, and cash flows of EPM, Inc., as of December 31, 2012 and 2011. We performed our examination in accordance with auditing standards generally accepted in the United States of America and examined, on a test basis, evidence supporting the accounting principles used and estimates made by management.

In our opinion, the financial statements referred to above accurately present the financial position of EPM, Inc., in conformity with generally accepted accounting principles.

Harrington and Perry, LLP
December 31, 2012

Other information:

EPM, Inc., is a for-profit corporation and publishes comparative financial statements for distribution to shareholders, potential investors, and the general public. The client has a calendar year-end. For the most recent audit, the auditor completed all significant fieldwork on March 5, 2013 and issued the audit report on March 16, 2013. During 2012, EPM changed its method of depreciating long-term assets and properly reflected the effect of the change in the current year’s financial statements, restated the prior year’s financial statements, and properly discussed the change in a footnote (Note 4) to those statements. The auditors are satisfied that the change was preferable.

Required:

Consider all the facts given and rewrite the complete auditor’s report, including report title, address, body of report, name of firm, and audit report date.

21) The financial statements most commonly audited by external auditors are the balance sheet, the income statement, and the statement of changes in retained earnings.
A) True
B) False
Answer
Terms: Financial statements most commonly audited
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

22) AICPA professional standards provide uniform wording for the auditor’s report to enable users of the financial statements understand the audit report.
A) True
B) False
Answer
Terms: Uniform wording for auditor’s report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
23) Users of the financial statements rely on the auditor’s report because it provides absolute assurance the report provides.
A) True
B) False
Answer
Terms: Users of financial statements rely on auditor’s report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

24) The introductory paragraph of the auditor’s report states that the auditor is responsible for the preparation, presentation and opinion on financial statements.
A) True
B) False
Answer
Terms: Introductory paragraph of auditor’s report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

25) The audit report date is the date the auditor completed audit procedures in the field.
A) True
B) False
Answer
Terms: Audit report date
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
26) Audit reports issued for financial statements of a public company should refer to generally accepted auditing standards in the scope paragraph.
A) True
B) False
Answer
Terms: Audit reports issued for financial statements of public company; Scope paragraph
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills
Topic: Public

27) Audit reports issued for financial statements of a private company should refer to generally accepted auditing standards in the scope paragraph.
A) True
B) False
Answer
Terms: Audit reports issued for financial statements of private company; Scope paragraph; Generally accepted auditing standards
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

28) The audit report is normally addressed to the company’s president or chief executive officer.
A) True
B) False
Answer
Terms: Audit report normally addressed
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

29) The phrase “generally accepted accounting principles” can be found in the opinion paragraph of a standard unqualified report.
A) True
B) False
Answer
Terms: Generally accepted accounting principles; Opinion paragraph of standard unqualified report
Diff: Easy
Objective: LO 3-1
AACSB: Reflective thinking skills

30) The date of the auditor’s report is indicative of the last day of the auditor’s responsibility for the review of significant events occurring after the balance sheet date.
A) True
B) False
Answer
Terms: Date of auditor’s report indicates auditor’s responsibility
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills
31) The phrase “auditing standards generally accepted in the United States of America” can be found in the opinion paragraph of a standard, unqualified audit report for a public company.
A) True
B) False
Answer
Terms: Auditing standards generally accepted in the United States; Opinion paragraph in standard unqualified report for public company
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills
Topic: Public

32) The phrase “The audit is designed to obtain reasonable assurance about whether the statements are free of material misstatements” is included in the introductory paragraph of an audit report.
A) True
B) False
Answer
Terms: Introductory paragraph in audit report; Audit designed to obtain reasonable assurance
Diff: Moderate
Objective: LO 3-1
AACSB: Reflective thinking skills

Learning Objective 3-2

1) There are no questions for this Learning Objective.
Answer:

Learning Objective 3-3

1) Whenever an auditor issues an audit report for a public company, the auditor can choose to issue a report in which of the following forms?
I. A combined report on financial statements and internal control over financial reporting.
II. Separate reports on financial statements and internal control over financial reporting.
A) I only
B) II only
C) Either I or II.
D) Neither I nor II.
Answer
Terms: Audit report for public company
Diff: Easy
Objective: LO 3-3
AACSB: Reflective thinking skills
Topic: Public
2) PCAOB Auditing Standard No. 2 requires the audit of internal control over financial reporting to be integrated with:
A) the audit of the financial statements.
B) the quarterly review of financial information.
C) the review of annual financial statements.
D) None of the above.
Answer
Terms: PCAOB Auditing Standard No. 2; Audit of internal control over financial reporting
Diff: Moderate
Objective: LO 3-3
AACSB: Reflective thinking skills
Topic: Public

3) A combined report on financial statements and internal control over financial reporting includes all but which of the following types of paragraphs?
A) Inherent limitations paragraph
B) Description paragraph
C) Opinion paragraph
D) Each of the above paragraphs is included.
Answer
Terms: Combined report on financial statements and internal control over financial reporting
Diff: Moderate
Objective: LO 3-3
AACSB: Reflective thinking skills
Topic: Public

4) There are five conditions that must be met before an auditor can issue a standard unqualified report for the audit of a private company. Please discuss each of these five conditions.

5) Section 404(b) of the Sarbanes Oxley Act requires that the auditor of an issuer attest to management’s report on the efficiency of internal controls over financial reporting.
A) True
B) False
Answer
Terms: Section 404(b) of Sarbanes-Oxley Act; Internal controls over financial reporting
Diff: Moderate
Objective: LO 3-3
AACSB: Reflective thinking skills
Topic: Public

6) Auditors of public company financial statements must issue separate reports on internal control over financial reporting.
A) True
B) False
Answer
Terms: Auditors issue separate reports on internal control
Diff: Moderate
Objective: LO 3-3
AACSB: Reflective thinking skills
Topic: Public

Learning Objective 3-4

1) Examples of unqualified opinions which contain modified wording (without adding an explanatory paragraph) include:
A) the use of other auditors.
B) material uncertainties.
C) substantial doubt about the audited company (or the entity) continuing as a going concern.
D) lack of consistent application of GAAP.
Answer
Terms: Modified unqualified opinion
Diff: Easy
Objective: LO 3-4
AACSB: Reflective thinking skills

2) A CPA may wish to emphasize specific matters regarding the financial statements even though an unqualified opinion will be issued. Normally, such explanatory information is:
A) included in the scope paragraph.
B) included in the opinion paragraph.
C) included in a separate paragraph in the report.
D) included in the introductory paragraph.
Answer
Terms: Unqualified opinion with emphasis on specific matters regarding the financial statements
Diff: Easy
Objective: LO 3-4
AACSB: Reflective thinking skills
3) All of the following are conditions requiring a departure from a standard unqualified audit report except:
A) management refused to allow the auditor to confirm significant accounts receivable for which there were no alternative procedures performed.
B) Mmnagement decided not to allow the auditor to confirm significant accounts receivable, but the auditor obtained sufficient appropriate evidence by examining subsequent cash receipts.
C) part of the audit was performed by other auditors whose report was furnished to the principle auditor.
D) management has determined that fixed assets should be reported in the balance sheet at their replacement values rather than historical costs. The auditors do not concur.
Answer
Terms: Departure from unqualified audit report
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

4) Which of the following is not a cause for a modification of the format for a standard unqualified auditor’s report?
A) Substantial doubt about an entity’s ability to continue as a going concern.
B) Reports involving other auditors.
C) A departure from promulgated accounting principles.
D) Not consistently applying accounting principles.
Answer
Terms: Report modifications
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

5) Which of the following are changes that affect the comparability of financial statements but not the consistency and therefore, do not have to be included in the auditor’s report?
A) Error corrections not involving principles
B) Changes in accounting estimates
C) Variations in the format and presentation of financial information
D) All of the above.
Answer
Terms: Changes that affect the comparability of financial statements
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

6) Which of the following is least likely to cause uncertainty about the ability of an entity to continue as a going concern?
A) A potential lawasuit against the entity for a patent infringement.
B) Loss of major customers.
C) Significant recurring operating losses.
D) Working capital deficiencies.
Answer
Terms: Going concern
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills
7) When there is uncertainty about a company’s ability to continue as a going concern, the auditor’s concern is the possibility that the client may not be able to continue its operations or meet its obligations for a “reasonable period of time.” For this purpose, a reasonable period of time is considered not to exceed:
A) six months from the date of the financial statements.
B) one year from the date of the financial statements.
C) six months from the date of the audit report.
D) one year from the date of the audit report.
Answer
Terms: Going concern ; time period
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

8) When the auditor concludes that there is substantial doubt about the entity’s ability to continue as a going concern, the appropriate audit report could be:
I. an unqualified opinion with an explanatory paragraph.
II. a disclaimer of opinion.
A) I only
B) II only
C) I or II
D) Neither I nor II
Answer
Terms: Auditor concludes substantial doubt about entity’s ability to continue as going concern
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

9) When a company’s financial statements contain a departure from GAAP with which the auditor concurs, the departure should be explained in:
A) the scope paragraph.
B) an explanatory paragraph that appears before the opinion paragraph.
C) the opinion paragraph.
D) an explanatory paragraph after the opinion paragraph.
Answer
Terms: Justified Departure
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills
10) William Gregory, CPA, is the principal auditor for a multi-national corporation. Another CPA has examined and reported on the financial statements of a significant subsidiary of the corporation. Gregory is satisfied with the independence and professional reputation of the other auditor, as well as the quality of the other auditor’s examination. With respect to his report on the consolidated financial statements, taken as a whole, Gregory:
A) must not refer to the examination of the other auditor.
B) must refer to the examination of the other auditor.
C) may refer to the examination of the other auditor.
D) must refer to the examination of the other auditors along with the percentage off consolidated assets and revenue that they audited.
Answer
Terms: Reports involving other auditors
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

11) A company has changed its method of inventory valuation from an unacceptable one to one in conformity with generally accepted accounting principles. The auditor’s report on the financial statements of the year of the change should include:
A) no reference to consistency.
B) a reference to a prior period adjustment in the opinion paragraph.
C) an explanatory paragraph that justifies the change and explains the impact of the change on reported net income.
D) an explanatory paragraph explaining the change.
Answer
Terms: Consistency modifications
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

12) Which of the following modifications of the auditor’s report does not include an explanatory paragraph?
A) A qualified report due to a GAAP departure.
B) The report includes an emphasis of a matter.
C) There is a very material scope limitation.
D) A principle auditor accepts the work of an other auditor.
Answer
Terms: Shared opinions
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills
13) No reference is made in the auditor’s report to other auditors who perform a portion of the audit when:
I. The other auditor audited an immaterial portion of the audit.
II. The other auditor is well known or closely supervised by the principle auditor.
III. The principle auditor has thoroughly reviewed the work of the other auditor.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Shared opinions
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

14) Readers of financial statements often interpret that the number of paragraphs in the independent auditor’s report is a “signal” of the entity’s financial fairness. Which of the following is not true regarding the number of paragraphs in an independent auditor’s report?
A) More than three paragraphs indicates either a qualification or report modification.
B) An additional paragraph is added before the opinion for a qualified, adverse or disclaimer of opinion.
C) An additional paragraph is added after the opinion when there is required information the auditor must report when the opinion is unqualified.
D) No explanatory paragraph is required for an unqualified shared report involving other auditors, however, explanatory language is added in the introductory paragraph.
Answer
Terms: Number of paragraphs in independent auditor’s report
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

15) Which of the following circumstances would not require more than one report modification in from the standard unqualified independent auditor’s report?
A) There is a GAAP departure and accounting principles were not consistently applied with that of the preceding year.
B) There is a scope limitation and the auditor’s are not independent.
C) There is a scope limitation and there is substantial doubt about the entity’s ability to continue as a going concern.
D) There is substantial doubt about the entity’s ability to continue as a going concern and the causes of these uncertainties are not adequately disclosed in a footnote.
Answer
Terms: Multiple report modifications from standard unqualified report
Diff: Challenging
Objective: LO 3-4
AACSB: Analytic skills
16) Which of the following is not an unqualified opinion with modified wording?
A) Emphasis of a matter.
B) Reports involving other auditors.
C) Auditor disagrees with client’s departure from GAAP.
D) Lack of consistent application of GAAP.
Answer
Terms: Unqualified opinion with modified wording
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

17) Which of the following is false concerning the principal CPA firm’s alternatives when issuing a report when another CPA firm performs part of the audit?
A) Issue a joint report signed by both CPA firms.
B) Make no reference to the other CPA firm in the audit report, and issue the standard unqualified opinion.
C) Make reference to the other auditor in the report by using modified wording (a shared opinion or report).
D) A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor.
Answer
Terms: Shared opinions
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

18) Which of the following requires recognition in the auditor’s opinion as to consistency?
A) The correction of an error in the prior year’s financial statements resulting from a mathematical mistake in capitalizing interest.
B) A change in the estimate of provisions for warranty costs.
C) The change from the cost method to the equity method of accounting for investments in common stock.
D) A change in depreciation method which has no effect on current year’s financial statements but is certain to affect future years.
Answer
Terms: Consistency
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

19) Indicate which changes would require an explanatory paragraph in the audit report.
A)
Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Change from LIFO to FIFO
Yes Yes

B)
Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Change from LIFO to FIFO
No No

C)
Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Change from LIFO to FIFO
Yes No

D)
Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Change from LIFO to FIFO
No Yes

Answer
Terms: Changes that require explanatory paragraph in audit report
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

20) Indicate which changes would require an explanatory paragraph in the audit report.
A)
Change in the estimated life of an asset Variation in the format of the financial statements
Yes Yes

B)
Change in the estimated life of an asset Variation in the format of the financial statements
No No

C)
Change in the estimated life of an asset Variation in the format of the financial statements
Yes No

D)
Change in the estimated life of an asset Variation in the format of the financial statements
No Yes

Answer
Terms: Changes that require explanatory paragraph in audit report
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

21) Indicate which changes would require an explanatory paragraph in the audit report.
A)
The CPA concludes there is substantial doubt about the entity’s ability to continue as a going concern Change from FIFO to LIFO
Yes Yes

B)
The CPA concludes there is substantial doubt about the entity’s ability to continue as a going concern Change from FIFO to LIFO
No No

C)
The CPA concludes there is substantial doubt about the entity’s ability to continue as a going concern Change from FIFO to LIFO
Yes No

D)
The CPA concludes there is substantial doubt about the entity’s ability to continue as a going concern Change from FIFO to LIFO
No Yes

Answer
Terms: Changes that would require an explanatory paragraph in audit report
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

22) Indicate which changes would require an explanatory paragraph in the audit report.
A)
A departure from GAAP which, due to unusual circumstances, does not require a qualified or adverse opinion. The CPA makes reference to the work of another auditor to indicate shared responsibility in an unqualified opinion.
Yes Yes

B)
A departure from GAAP which, due to unusual circumstances, does not require a qualified or adverse opinion. The CPA makes reference to the work of another auditor to indicate shared responsibility in an unqualified opinion.
No No

C)
A departure from GAAP which, due to unusual circumstances, does not require a qualified or adverse opinion. The CPA makes reference to the work of another auditor to indicate shared responsibility in an unqualified opinion.
Yes No

D)
A departure from GAAP which, due to unusual circumstances, does not require a qualified or adverse opinion. The CPA makes reference to the work of another auditor to indicate shared responsibility in an unqualified opinion.
No Yes

Answer
Terms: Changes that would require an explanatory paragraph in audit report
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

23) In certain circumstances, an auditor will issue modified unqualified report. Discuss each of the five circumstances when an auditor would issue an unqualified report with an explanatory paragraph or modified wording.
Answern unqualified report with an explanatory paragraph or modified wording is appropriate in the following circumstances:
• Lack of consistent application of GAAP. When the client has not followed generally accepted accounting principles consistently in the current period in relation to the preceding period, an unqualified opinion with an explanatory paragraph following the opinion paragraph is appropriate.
• Substantial doubt about continuing as a going concern. When an auditor concludes there is substantial doubt about the client’s ability to continue as a going concern, an unqualified opinion with an explanatory paragraph following the opinion paragraph is appropriate. The auditor also has the option of issuing a disclaimer of opinion.
• A departure from GAAP with which the auditor concurs. If adherence to GAAP would result in misleading financial statements, an unqualified opinion with an explanatory paragraph is appropriate.
• Emphasis of a matter. If the auditor wants to emphasize specific matters in the audit report, an explanatory paragraph discussing those matters may be added to an unqualified report.
• Reports involving other auditors. When an auditor relies upon a different CPA firm to perform part of the audit, the auditor can indicate that responsibility for the audit is shared with another CPA firm by modifying the wording of an unqualified report.
Terms: Circumstances where an auditor will issue modified unqualified report with explanatory paragraph or modified wording
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

24) A modified unqualified auditor report arises when the auditor believes the financials are fairly stated but also believes additional information should be provided.
A) True
B) False
Answer
Terms: Modified unqualified audit report
Diff: Easy
Objective: LO 3-4
AACSB: Reflective thinking skills

25) Changes of an accounting estimate requires the auditor to issue a modified unqualified audit report with a consistency paragraph is inserted after the opinion paragraph.
A) True
B) False
Answer
Terms: Changes of accounting estimates; Modified unqualified audit report
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

26) The only modified unqualified opinion that does not include an explanatory paragraph is when other auditors are involved. In this case only the introductory paragraph is modified.
A) True
B) False
Answer
Terms: Modified unqualified opinion
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

27) Items that materially affect the comparability of the financial statements generally require disclosure in the footnotes.
A) True
B) False
Answer
Terms: Items that materially affect comparability of financial statements
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

28) Changes in an estimate, such as a change in the estimated useful life of an asset for depreciation purposes, affect consistency but not comparability, and therefore require an explanatory paragraph in the audit report.
A) True
B) False
Answer
Terms: Comparability vs. consistency
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills

29) Changes in reporting entities, such as the inclusion of an additional company in combined financial statements, affect comparability but not consistency, and therefore do not require an explanatory paragraph in the audit report.
A) True
B) False
Answer
Terms: Comparability and consistency
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

30) When an auditor relies upon a different CPA firm to perform part of the audit and chooses to issue a shared opinion, the wording of the report should be modified in all three paragraphs.
A) True
B) False
Answer
Terms: Auditor reliance on different CPA firm to perform part of audit; Shared opinion
Diff: Moderate
Objective: LO 3-4
AACSB: Reflective thinking skills
31) When other auditors are involved in the audit and they qualify their portion of the audit, the principle auditor must decide if the amount in question is material to the financial statements as a whole.
A) True
B) False
Answer
Terms: Shared responsibiltiy
Diff: Challenging
Objective: LO 3-4
AACSB: Reflective thinking skills

Learning Objective 3-5

1) As a result of management’s refusal to permit the auditor to physically examine inventory. The auditor must depart from the unqualified audit report because:
A) the financial statements have not been prepared in accordance with GAAP.
B) the scope of the audit has been restricted by circumstances beyond either the client’s or auditor’s control.
C) the financial statements have not been audited in accordance with GAAS.
D) the scope of the audit has been restricted.
Answer
Terms: Auditor must depart from unqualified audit report; Management refusal to permit the auditor to physically examine inventory
Diff: Easy
Objective: LO 3-5
AACSB: Reflective thinking skills

2) An adverse opinion is issued when the auditor believes:
A) some parts of the financial statements are materially misstated or misleading.
d the financial statements would be found to be materially misstated if an investigation were performed.
B) the financial statements would be found to be materially misstated if an investigation were performed.
C) the auditor is not independent.
D) the overall financial statements are so materially misstated that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP.
Answer
Terms: Adverse opinion
Diff: Easy
Objective: LO 3-5
AACSB: Reflective thinking skills

3) An auditor can express a qualified opinion due to a:
A)
Departure from GAAP Lack of Consistency Lack of Sufficient Evidence
Yes No No

B)
Departure from GAAP Lack of Consistency Lack of Sufficient Evidence
No Yes No

C)
Departure from GAAP Lack of Consistency Lack of Sufficient Evidence
Yes No Yes

D)
Departure from GAAP Lack of Consistency Lack of Sufficient Evidence
Yes Yes Yes

Answer
Terms: Qualified opinions
Diff: Easy
Objective: LO 3-5
AACSB: Reflective thinking skills

4) An auditor determines the financial statements include at least a material departure from GAAP. Which type of opinion may be issued?
A)
Disclaimer Qualified Adverse
Yes No No

B)
Disclaimer Qualified Adverse
No Yes No

C)
Disclaimer Qualified Adverse
Yes No Yes

D)
Disclaimer Qualified Adverse
No Yes Yes

Answer
Terms: Opinion , GAAP departure
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills
5) A qualified opinion can be issued for which of the following?
I. When a limitation on the scope of the audit has occurred.
II. When the auditor lacks independence.
III. When generally accepted accounting principles have not been used.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Qualified opinion
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

6) In which situation would the auditor be choosing between “except for” qualified opinion and an adverse opinion?
A) The auditor lacks independence.
B) A client-imposed scope limitation.
C) A circumstance imposed scope limitation.
D) Lack of full disclosure within the footnotes.
Answer
Terms: Qualified opinion and adverse opinion
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills
7) When the auditor determines the financial statements are fairly stated and then determines that the auditor lacks independence, the auditor should issue:
A) an adverse opinion.
B) a disclaimer of opinion.
C) either a qualified opinion or an adverse opinion.
D) either a qualified opinion or an unqualified opinion with modified wording.
Answer
Terms: Audit report when auditor not independent
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

8) If the auditor lacks independence, a disclaimer of opinion must be issued:
A) if the client requests it.
B) only if it is highly material.
C) only if it is material but not pervasive.
D) in all cases.
Answer
Terms: Disclaimer when auditor lacks independence
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills
9) When a disclaimer is issued because the auditor lacks independence:
A) no report title is included on the report.
B) a one-paragraph audit report is issued.
C) the only reason cited for issuing the disclaimer is the lack of independence.
D) all of the above are correct.
Answer
Terms: Disclaimer issued if auditor lacks independence
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

10) When a client has changed their method of valuing inventory from FIFO to LIFO and the change has a material effect on the financial statements. If the auditor does not concur with the appropriateness of the change, the auditor should issue a(n):
A) disclaimer.
B) adverse opinion.
C) unqualified opinion.
D) qualified opinion.
Answer
Terms: Change in valuing inventory and auditor does not concur with change
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

11) Items that materially affect the comparability of financial statements generally require disclosure in the footnotes. If the client refuses to properly disclose the item, the auditor will most likely issue:
A) a disclaimer.
B) an unqualified opinion.
C) a qualified opinion.
D) an adverse opinion.
Answer
Terms: Disclosure and comparability
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

12) Which of the following scenarios does not result in a qualified opinion?
A) A scope limitation prevents the auditor from completing an important audit procedure.
B) The auditor’s report refers to the work of a specialist.
C) The auditor lacks independence with respect to the audited entity.
D) An accounting principle at variance with GAAP is used.
Answer
Terms: Qualified opinion
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills
13) Whenever the client imposes restrictions on the scope of the audit, the auditor should be concerned that management may be trying to prevent discovery of misstatements. In such cases, the auditor will likely issue a:
A) disclaimer of opinion in all cases.
B) qualification of both scope and opinion in all cases.
C) disclaimer of opinion whenever materiality is in question.
D) qualification of both scope and opinion whenever materiality is in question.
Answer
Terms: Client imposed restrictions on scope of audit
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

14) In which of the following circumstances would an auditor most likely express an adverse opinion?
A) The CEO refuses to let the auditor have access to the board of director meeting minutes.
B) The financial statements are not in conformity with the FASB statement on loss contingencies.
C) Information comes to the auditor’s attention that raises substantial doubt about the ability for the client to continue as a going concern.
D) Tests of controls show that the internal control structure is so poor that the auditor has to assess control risk at the maximum.
Answer
Terms: Adverse opinion circumstances
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

15) Which of the following statements is true?
I. The auditor is required to issue a disclaimer of opinion in the event of a material uncertainty.
II. The auditor is required to issue a disclaimer of opinion in the event of a going concern problem.
A) I only
B) II only
C) I and II
D) Neither I nor II
Answer
Terms: Disclaimer of opinion
Diff: Challenging
Objective: LO 3-5
AACSB: Reflective thinking skills
16) The most common case in which conditions beyond the client’s and auditor’s control cause a scope restriction is an engagement:
A) agreed upon after the client’s balance sheet date.
B) where the client won’t allow the auditor to confirm receivables for fear of offending its customers.
C) where the auditor doesn’t have enough staff to satisfactorily audit all of the client’s foreign subsidiaries.
D) where the client is going through Chapter 11 bankruptcy.
Answer
Terms: Scope restriction beyond client and auditor control
Diff: Challenging
Objective: LO 3-5
AACSB: Reflective thinking skills

17) When the client fails to make adequate disclosure in the body of the statements or in the related footnotes, it is the responsibility of the auditor to:
A) inform the reader that disclosure is not adequate, and to issue an adverse opinion.
B) inform the reader that disclosure is not adequate, and to issue a qualified opinion.
C) present the information in the audit report and issue an unqualified or qualified opinion.
D) present the information in the audit report and to issue a qualified or an adverse opinion.
Answer
Terms: Inadequate disclosure
Diff: Challenging
Objective: LO 3-5
AACSB: Reflective thinking skills

18) There are three conditions necessitating a departure from an unqualified audit report. Name, discuss and state the appropriate audit report for each of these three conditions.

19) A qualified report is issued when all auditing conditions have been met, no significant misstatements have been discovered, and it is the auditor’s opinion that the financial statements are fairly stated in accordance with GAAP.
A) True
B) False
Answer
Terms: Qualified report
Diff: Easy
Objective: LO 3-5
AACSB: Reflective thinking skills

20) Auditors should issue a disclaimer of opinion when there is a highly material client-imposed scope restriction.
A) True
B) False
Answer
Terms: Disclaimer of opinion; Client-imposed scope restriction
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

21) Whenever an auditor issues a qualified report, he or she must use the term “except for” in the opinion paragraph.
A) True
B) False
Answer
Terms: Qualified report; Except for in opinion paragraph
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

22) Whenever an auditor issues a qualified report due to a scope limitation, he/she must use the term “except for” in both the scope and opinion paragraph.
A) True
B) False
Answer
Terms: Qualified report; Scope limitation
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

23) When an auditor discovers a highly material GAAP violation in the financial statements and the client refuses to correct it, the auditor should issue a disclaimer of opinion.
A) True
B) False
Answer
Terms: Disclaimer of opinion; Highly material GAAP violation in the financial statements and client refuses to correct it
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills
24) Client imposed restrictions on the audit always require a disclaimer of opinion.
A) True
B) False
Answer
Terms: Disclaimer of opinion; Client imposed restrictions on audit
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

25) An auditor should issue a qualified opinion with an explanatory paragraph whenever there is a material uncertainty affecting the financial statements.
A) True
B) False
Answer
Terms: Qualified opinion with explanatory paragraph
Diff: Moderate
Objective: LO 3-5
AACSB: Reflective thinking skills

Learning Objective 3-6

1) When the auditor evaluates the effect of a change in accounting principle, the materiality of the change should be evaluated based on:
A) the prior years presented.
B) the current year.
C) guidelines included in GAAS.
D) the effect on total assets.
Answer
Terms: Effect of change of accounting principle; Materiality of change
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills

2) Misstatements must be compared with some measurement base before a decision can be made about materiality. A commonly accepted measurement base includes:
A) net income.
B) total assets.
C) working capital.
D) all of the above.
Answer
Terms: Misstatements and materiality
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills
3) When comparing misstatements with a measurement base, the auditor must consider the pervasiveness of the misstatement. Of the following examples, the most pervasive misstatement is a(n):
A) understatement of inventory.
B) understatement of retained earnings caused by a miscalculation of dividends payable.
C) misclassification of notes payable as a long-term liability when it should be current.
D) misclassification of salary expense as a selling expense.
Answer
Terms: Pervasive misstatements
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills

4) The dollar amount of some misstatements cannot be accurately measured. For example, if the client were unwilling to disclose an existing lawsuit, the auditor must estimate the likely effect on:
A) net income.
B) users of the financial statements.
C) the auditor’s exposure to lawsuits.
D) management’s future decisions.
Answer
Terms: Misstatements accurately measured
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills

5) Materiality is an essential consideration in determining the appropriate type of report under a given set of circumstances. Which of the following is not considered an immaterial instance that would not cause the financials to become qualified?
A) Immediately expensing office supplies rather than inventorying them.
B) Recording prepaid insurance as an asset in the prior year and expensing it in the current year.
C) A misstatement in property, plant and equipment affects a user’s decision.
D) All of the above are immaterial.
Answer
Terms: Materialityquailifications
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills

6) When a client fails to follow GAAP, the audit can be unqualified, qualified, or adverse depending on the materiality. What factors affect materiality that an auditor should consider?
A) The dollar amount in comparison to a base.
B) If the misstatement can be measured.
C) The nature of the item.
D) All the above are factors an auditor should consider regarding materiality.
Answer
Terms: Client fails to follow GAAP; Materiality
Diff: Moderate
Objective: LO 3-6
AACSB: Reflective thinking skills
7) When the auditor cannot perform procedures and the amounts are so material that a disclaimer of opinion is required, the:
A) opinion paragraph will state “does not present fairly.”
B) opinion paragraph will state “presents fairly.”
C) scope paragraph will be unchanged from the standard unqualified opinion.
D) scope paragraph will be deleted.
Answer
Terms: Disclaimer of opinion
Diff: Challenging
Objective: LO 3-6
AACSB: Reflective thinking skills

8) Discuss how materiality affects audit reporting decisions.

9) Materiality is essential when an auditor considers his/her determination of the appropriate report for a given set of circumstances.
A) True
B) False
Answer
Terms: Materiality; Appropriate report
Diff: Easy
Objective: LO 3-6
AACSB: Reflective thinking skills

10) A pervasive exception is one that affects different parts of the financial statements.
A) True
B) False
Answer
Terms: Pervasive exception
Diff: Easy
Objective: LO 3-6
AACSB: Reflective thinking skills
11) An item with a “psychic” effect (e.g., where the item maintains an increasing earnings trend) is a qualitative factor that may affect the auditors decision regarding materiality.
A) True
B) False
Answer
Terms: Psychic effect; Materiality
Diff: Challenging
Objective: LO 3-6
AACSB: Reflective thinking skills

Learning Objective 3-7

1) The explanatory paragraph for a qualified opinion would:
A) easy precede the scope paragraph.
B) follow the scope paragraph.
C) follow the opinion paragraph.
D) either precede or follow the opinion paragraph depending on the materiality.
Answer
Terms: Explanatory paragraph for qualified opinion
Diff: Easy
Objective: LO 3-7
AACSB: Reflective thinking skills

2) An auditor who issues a qualified opinion because sufficient appropriate evidence was not obtained should describe the limitations in an explanatory paragraph. The auditor should also modify the:
A)
Scope paragraph Opinion paragraph Notes to the financial statements
Yes No Yes

B)
Scope paragraph Opinion paragraph Notes to the financial statements
No Yes Yes

C)
Scope paragraph Opinion paragraph Notes to the financial statements
No Yes No

D)
Scope paragraph Opinion paragraph Notes to the financial statements
Yes Yes No

Answer
Terms: Qualified opinion insufficient evidence
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills

3) When an auditor issues a qualified report due to a scope limitation an explanatory paragraph is normally added. Which, if any, of the following paragraphs are also modified?
A)
Introductory Scope Opinion
Yes Yes Yes

B)
Introductory Scope Opinion
Yes Yes No

C)
Introductory Scope Opinion
No Yes No

D)
Introductory Scope Opinion
No Yes Yes

Answer
Terms: Qualified report due to scope restriction; Paragraphs modified
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

4) When a qualified or adverse opinion is issued, the qualifying paragraph is inserted:
A) between the introductory and scope paragraphs.
B) between the scope and opinion paragraphs.
C) after the opinion paragraph, as a fourth paragraph.
D) immediately after the address, as the first paragraph.
Answer
Terms: Qualified or adverse opinion paragraph placement
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

5) The independent auditor must issue a qualified opinion when which of the financial(s) are missing?
I. Balance Sheet
II. Income Statement
III. Statement of Cash Flows
A) I only
B) II only
C) III only
D) I, II, and III
Answer
Terms: Qualified opinion issued when which financial statement is missing
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills
6) If the financial statements include an income statement and a balance sheet but exclude the statement of cash flows, the auditors:
A) can issue an unqualified report.
B) should issue a qualified opinion due to the departure from GAAP.
C) should issue a qualified opinion because the missing statement of cash flows constitutes a scope limitation.
D) should include the statement of cash flows, modify the report and issue an unqualified opinion.
Answer
Terms: Report when financial statements exclude statement of cash flows
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

7) Which of the following is incorrect concerning scope limitations?
A) If client imposed the auditor should be concerned about client trying to prevent discovery of a material misstatement.
B) An unqualified opinion can result if auditors can perform alternative procedures and are satisfied that the information is fairly stated.
C) The most common circumstance imposed scope restriction is due to the client changing their auditors.
D) The most common circumstance imposed scope limitation is when the auditor is appointed after the balance sheet date.
Answer
Terms: Scope limitation
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

8) When a scope limitation exists in an audit which type of report modification can result?
A)
Qualified Opinion Paragraph Only Qualified Scope Paragraph Only Disclaimer Opinion No Scope Paragraph
Yes No Yes

B)
Qualified Opinion Paragraph Only Qualified Scope Paragraph Only Disclaimer Opinion No Scope Paragraph
No No Yes

C)
Qualified Opinion Paragraph Only Qualified Scope Paragraph Only Disclaimer Opinion No Scope Paragraph
Yes Yes No

D)
Qualified Opinion Paragraph Only Qualified Scope Paragraph Only Disclaimer Opinion No Scope Paragraph
No No No

Answer
Terms: Scope limitation
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

9) When a pervasive scope limitation exists which paragraphs will be included in the independent auditors report?
A)
Introductory Scope Opinion Explanatory
Yes Yes Yes Yes

B)
Introductory Scope Opinion Explanatory
Yes No Yes Yes

C)
Introductory Scope Opinion Explanatory
Yes No Yes No

D)
Introductory Scope Opinion Explanatory
No No Yes No

Answer
Terms: Pervasive scope limitation
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

10) What type of audit opinion does the independent auditor issue when the following financial statements are not presented?
A)
Balance Sheet Income Statement Statement of Cash Flows
Qualified Qualified Qualified

B)
Balance Sheet Income Statement Statement of Cash Flows
Disclaimer Disclaimer Qualified

C)
Balance Sheet Income Statement Statement of Cash Flows
Adverse Adverse Adverse

D)
Balance Sheet Income Statement Statement of Cash Flows
Adverse Adverse Qualified

Answer
Terms: Audit opinion issued when financial statements are not presented
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills
11) Subsequent to the close of Spacely Sprockets fiscal year ending October 31, 2012, a major debtor has declared bankruptcy due to a series of events. The receivable is significantly material in relation to the financial statements, and recovery is doubtful. The debtor had confirmed the full amount due to Spacely Sprocket at the balance sheet date. Because the account was confirmed at the balance sheet date, Spacely refuses to disclose any information in relation to this subsequent event. The CPA believes that all other accounts were stated fairly at the balance sheet date. In addition, Spacely changed their method of inventory valuation from FIFO to LIFO. This change was disclosed in Note X to the financial statements. Accordingly, what type of opinion should be expressed?
A) Unqualified with an explanatory paragraph.
B) Qualified due to a GAAP departure.
C) Qualified due to a scope limitation.
D) A combination of B and C.
Answer
Terms: Audit report when client has subsequent event and change in inventory valuation
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills

12) For the report containing a disclaimer for lack of independence, the disclaimer is in the:
A) third or opinion paragraph.
B) second or scope paragraph.
C) first and only paragraph.
D) fourth or explanatory paragraph.
Answer
Terms: Disclaimer in which report paragraph
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills

13) When an adverse opinion is issued, a scope paragraph would be:
A) qualified.
B) unchanged.
C) deleted.
D) expanded to identify the additional procedures which the auditor performed.
Answer
Terms: Adverse opinion and scope paragraph
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills
14) After the balance sheet date but prior to issuance of the auditor’s report the auditor learns that the client’s facility in a foreign country has been expropriated. Management refuses to disclose this information in a financial statement footnote or present pro-forma data as to the effect of the event. The auditor should:
A) add a footnote to the financial statements
B) disclaim an opinion due to the client imposed scope limitation.
C) provide the information in the report and modify the opinion.
D) issue an unqualified opinion but provide the information in the auditor report.
Answer
Terms: Material subsequent event management refusal to disclose
Diff: Challenging
Objective: LO 3-1 and LO 3-7
AACSB: Reflective thinking skills

15) The following is a portion of an adverse audit report issued for a public company. (Note: A separate report was issued on the effectiveness of internal control over financial reporting.)

Independent Auditor’s Report

To the shareholders of Wallace Corporation

We have audited the accompanying balance sheet of Wallace Corporation as of December 31, 2012, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

The company has excluded from property and debt in the accompanying balance sheet certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $14,500,000, long-term debt by $13,200,000, and retained earnings by $1,300,000 as of December 31, 2012, and net income and earnings per share would be increased by $1,300,000 and $2.25, respectively, for the year then ended.

Required:

Complete the above adverse audit report by preparing the opinion paragraph. Do not date or sign the report.

16) The following is a portion of a qualified scope and opinion report due to a scope restriction. (Note: A separate report was issued on the effectiveness of internal control over financial reporting.)

Independent Auditor’s Report

To the shareholders of Fast Times Corporation

We have audited the accompanying balance sheet of Fast Times Corporation as of September 30, 2012, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

Except as discussed in the following paragraph, we conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

We were unable to obtain audited financial statements supporting the company’s investment in a foreign affiliate stated at $1,040,000, or its equity in earnings of that affiliate of $501,000, which is included in net income, as described in Note 14 to the financial statements. Because of the nature of the company’s records, we were unable to satisfy ourselves as to the carrying value of the investment or the equity in its earnings by means of other auditing procedures.

Required:

Complete the above report by preparing the opinion paragraph. Do not date or sign the report.

17) Your CPA firm has completed the fieldwork for the 2012 audit of Sharp Corporation, a private company with an October year-end. You were preparing to draft a standard, unqualified audit report when you discovered that the audit manager on the Sharp engagement owns 10 shares of Sharp’s common stock. Prepare the appropriate report.

18) Assume you are the partner in charge of the 2007 audit of Becker Corporation, a private company. The audit report has not yet been prepared. In each independent situation following (1-8), indicate the appropriate action (a-g) to be taken. The possible actions are as follows:

a. Issue a standard unqualified report.
b. Qualify both the scope and opinion paragraphs.
c. Qualify the opinion paragraph.
d. Issue an unqualified opinion with an explanatory paragraph.
e. Issue an unqualified opinion with modified wording (no explanatory paragraph).
f. Issue an adverse opinion.
g. Disclaim an opinion.

The situations are as follows:
________ 1. Becker Corporation carries its property, plant, and equipment accounts at current market values. Current market values exceed historical cost by a highly material amount, and the effects are pervasive throughout the financial statements.

________ 2. Management of Becker Corporation refuses to allow you to observe, or make, any counts of inventory. The recorded book value of inventory is highly material.

________ 3. You were unable to confirm accounts receivable with Becker’s customers. However, because of detailed sales and cash receipts records, you were able to perform reliable alternative audit procedures.

________ 4. One week before the end of fieldwork, you discover that the audit manager on the Becker engagement owns a material amount of Becker’s common stock.

________ 5. You relied upon another CPA firm to perform part of the audit. Although you were the principal auditor, the other firm audited a material portion of the financial statements. You wish to refer to (but not name) the other firm in your report.

________ 6. You have substantial doubt about Becker’s ability to continue as a going concern.

________ 7. Becker Corporation changed its method of computing depreciation in 2007. You concur with the change and the change is properly disclosed in the financial statement footnotes.

________ 8. Ten days after the balance sheet date, one of Becker’s buildings was destroyed by a fire. Becker refuses to disclose this information in a footnote to the financial statements, but you believe disclosure is required to conform with GAAP. The amount of the uninsured loss was material, but not highly material.

19) Smith and Jones, CPAs, audited the consolidated financial statements of Concord Inc. and all but one of its subsidiaries for the year ended September 30, 2012 and are expressing an unqualified opinion on the financials presented as a whole.

Smith, the engagement partner, instructed Mary, an assistant on the engagement, to draft the auditor’s report on November 4, 2012, the date of fieldwork completion. In drafting the report Mary considered the following:

• In preparing its financial statements, Concord changed its method of accounting for research and development costs and properly expensed these amounts. Management described the change in principle in Note 10 to the consolidated financial statements.
• Ball & Brown, CPAs, audited the financial statements of Biotherm, Inc., a consolidated subsidiary of Concord for the year ended September 30, 2012. The subsidiary’s financial statements reflect total assets of 22% and total revenues of 20% of the consolidated totals. Ball & Brown expressed an unqualified opinion and furnished to Smith & Jones a copy of their auditor report. Smith & Jones have decided not to assume responsibility for the work of Ball & Brown insofar as it relates to the expression of an opinion on the consolidated financial statements taken as a whole because of the materiality of Biotherm’s financial statements to the consolidated whole. Ball & Brown’s report will not be presented together with that of Smith & Jones.
• Concord is the subject of a grand jury investigation into possible violations of federal antitrust laws and possible related crimes. Related civil class actions are pending. Concord’s management has adequately disclosed in Note 12 to their consolidated financial statements. Because of the early stage of the investigation, the ultimate outcome of these matters cannot be determined at this time. Therefore, no provision for any liability that may result has been recorded.
• Concord experienced a net loss in 2012 and is currently in default under substantially all of its debt agreements. Management’s plans in regard to these matters are adequately disclosed in Note 14 to Concord’s consolidated financial statements. The financials do not include any adjustments that might result from the outcome of this uncertainty. These matters rase substantial doubt about Concord’s ability to continue as a going concern.

Ball reviewed Mary’s draft and indicated in his review notes that there were many deficiencies in Mary’s Draft. The audit report that Mary drafted follows.

Independent Auditor’s Report

We have audited the consolidated financial statements of Concord, Inc., and subsidiaries as of September 30, 2012, and the related consolidated statements of income, changes in stockholders equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Biotherm, Inc., a wholly-owned subsidiary, which statements reflect total assets and revenues constituting 22% and 20% respectively at September 30, 2011 of the consolidated totals. Those statements were audited by Ball & Brown, CPAs, whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included for Biotherm, Inc. is based solely on their report.

We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used, as well as assessing control risk. We believe our audits provide a reasonable basis for our opinion.

In our opinion, based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Concord Inc., as of September 30, 2012 in conformity with generally accepted accounting principles, except for the uncertainty, which is discussed in Note 12 to the consolidated financials.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue in existence for a reasonable period of time. As discussed in Note 14 to the consolidated financial statements, the Company suffered a net loss and is currently in default under substantially all of its debt agreements. Management’s plans in regard to these matters are also described in Note 14. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Smith & Jones, CPAs
November 4, 2012

Required:
The following items present deficiencies in the drafted audit report noted by Smith. For each deficiency, indicate whether:

S. Smith’s review note is correct
M. Mary’s draft is correct
B. Both Smith’s review note and Mary’s draft are incorrect

Smith’s Review Notes

1. An explanatory paragraph is required between the scope and opinion paragraphs is required for the change in accounting principles referring the reader to Note 10.

2. The names of the other auditors do not need to be explicitly stated in the introductory paragraph. Only that “other auditors” performed the audit and provided their report.

3. The opinion paragraph should extend the auditor’s opinion beyond financial position to include the results of Concord’s operations and flows.

4. The reference to the uncertainty in the opinion paragraph is incomplete. It should describe the nature of the uncertainty as pertaining to the grand jury investigation into possible violations of federal antitrust laws.

5. The explanatory paragraph following the opinion paragraph does not include the terms “substantial doubt” and “going concern”. These terms are required to be used in this paragraph.

6. The explanatory paragraph following the opinion paragraph includes an inappropriate statement that “the consolidated financial statement6s do not include any adjustments that might result from the outcome of this uncertainty.” This statement is misleading and should be omitted.

20) In auditing the long-term investments account, Arens, CPA, is unable to obtain audited financial statements for an investee located in a foreign country. Levine concludes sufficient appropriate audit evidence regarding this investment cannot be obtained.

For each of the following situations below, identify the appropriate opinion type and report modification by selecting a choice from the appropriate tables below.

Situation Opinion
Type Intro
Scope
Opinion
Exp1

1. Assume the potential effect on the financial statements is immaterial.
2. Assume the potential effect on the financial statements is moderate.
3. Assume the potential effect on the financial statements is high.

Opinion Type Standard Paragraph Choice Explanatory Paragraph
U Unqualified O Omit 0 None required
Q Qualified N No change + Insert before opinion
A Adverse M Modify – Insert after opinion
D Disclaimer

21) Audit situations 1 through 10 present various independent factual situations an auditor might encounter in conducting an audit. List A represents the types of opinions the auditor ordinarily would issue, and List B represents the report modifications (if any) that would be necessary. For each situation, select one response from List A and one from List B. Select, as the best answer for each item, the action the auditor normally would take. Items from either list may be selected once, more than once, or not at all.

Assume the following:
• The auditor is independent
• The auditor previously expressed an unqualified opinion on the prior-year financial statements unless otherwise noted
• Only single-year (not comparative) statements are presented for the current year (unless otherwise stated)
• The conditions for an unqualified opinion exist unless contradicted in the factual scenario
• The conditions stated in the factual scenario are material
• No report modifications are to be made except in response to the factual scenario

Factual Scenario
1. The financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with GAAP.
2. In auditing the Long-Term Investments account, an auditor is unable to obtain audited F/S for an investee located in a foreign country. The auditor concludes that sufficient competent evidential matter regarding this investment cannot be obtained but it is not pervasive to the financials as a whole.
3. Due to recurring operating losses and working capital deficiencies the auditor has substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. However, the F/S disclosures are adequate.
4. The principal auditor decides to refer to the work of another auditor, who audited a wholly owned subsidiary of the entity and issued an unqualified opinion.
5. An entity issues F/S that present financial position and results of operations but omits the related statement of cash flows. Management discloses in the notes to the F/S that it does not believe the statement of cash flows to be useful.
6. An entity changes its depreciation method for production equipment from SL to units of production based on hours of utilization. The auditor concurs with the change, although it has a material effect on the comparability of the entity’s F/S.
7. An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, management. cannot reasonably estimate the ultimate outcome of the litigation. The auditor believes that there is a reasonable possibility of a significant material loss, but the lawsuit is adequately disclosed in the notes to the F/S.
8. An entity discloses certain lease obligations in the notes to the F/S. The auditor believes that the failure to capitalize these leases is a departure from GAAP.
9. The entity wishes to show comparative F/S and include the prior year. However, the prior year F/S contained a qualification due to an inappropriate method of GAAP. Accordingly, management. corrected the prior year GAAP deficiency and included the updated numbers in the comparative financials for the current year.

10. The entity wishes to show comparative F/S and include the prior year. However, the prior year F/S were audited by another auditor who refuses to reissue his opinion.

List A
Opinion Choices List B
Report Modification Choices
A Qualified H Describe the circumstances in an explanatory paragraph preceding the opinion paragraph w/o modifying the three standard paragraphs.
B Unqualified I Describe the circumstances in the opinion paragraph w/o adding an explanatory paragraph.
C Adverse J Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the opinion paragraph.
D Disclaimer K Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the opinion paragraph.
E Either Qualified or Adverse L Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the scope & opinion paragraph.
F Either Disclaimer or Adverse M Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the scope & opinion paragraph.
G Either Qualified or Disclaimer N Describe the circumstances in the scope paragraph w/o adding an explanatory paragraph.
O Describe the circumstances in an explanatory paragraph following the opinion paragraph w/o modifying the three standard paragraphs.
P Describe the circumstances in the introductory paragraph w/o adding an explanatory paragraph.
. Q Describe the circumstances in the introductory paragraph w/o adding an explanatory paragraph, and modify the scope & opinion paragraphs.
R Issue the standard auditor’s report w/o modification.
S None of the above.

22) Financial statement users are typically more concerned with an unqualified report with explanatory paragraphs than they are with a disclaimer of opinion.
A) True
B) False
Answer
Terms: Financial statement users; Unqualified report with explanatory paragraphs; Disclaimer of opinion
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills
23) A lack of independence will override any other scope limitations and requires a disclaimer of opinion.
A) True
B) False
Answer
Terms: Lack of independence; Disclaimer of opinion
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

24) When a qualified opinion is issued, an explanatory paragraph is added immediately after the opinion paragraph to explain the nature of the qualification that affects the opinion.
A) True
B) False
Answer
Terms: Qualified opinion explanatory paragraph and opinion paragraph
Diff: Moderate
Objective: LO 3-7
AACSB: Reflective thinking skills

25) If an auditor is not independent and the auditor knows that the company has not followed GAAP, the auditor should immediately disclaim an opinion and not mention the departure from GAAP in the audit report.
A) True
B) False
Answer
Terms: Auditor not independent, GAAP violations; Disclaim opinion
Diff: Challenging
Objective: LO 3-7
AACSB: Reflective thinking skills

Learning Objective 3-8

1) When a pervasive scope limitation exists, which paragraphs of the independent auditor’s report will differ from the standard unqualified audit report?
A)
Introductory Scope Opinion Explanatory
Yes Yes Yes Yes

B)
Introductory Scope Opinion Explanatory
No Yes Yes Yes

C)
Introductory Scope Opinion Explanatory
No No Yes Yes

D)
Introductory Scope Opinion Explanatory
No No Yes No

Answer
Terms: Pervasive scope limitation
Diff: Challenging
Objective: LO 3-8
AACSB: Analytic skills
2) Which of the following statements is not true?
A) A one-paragraph report is generally used when the auditor is not independent.
B) A three-paragraph report ordinarily indicates there are no exceptions in the audit.
C) More than three paragraphs in the report indicates there must be some type of qualification in the audit.
D) An unqualified opinion with an explanation or modified wording would require more than three paragraphs.
Answer
Terms: Number of paragraphs in the audit report
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills
3) Which auditor report would require only one paragraph?
A)
Disclaimer due to scope restriction Qualified opinion due to scope restriction
Yes Yes

B)
Disclaimer due to scope restriction Qualified opinion due to scope restriction
No No

C)
Disclaimer due to scope restriction Qualified opinion due to scope restriction
Yes No

D)
Disclaimer due to scope restriction Qualified opinion due to scope restriction
No Yes

Answer
Terms: Auditor report with one paragraph
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills

4) A four paragraph auditor opinion is required when:
A)
Unqualified opinion indicating shared responsibility with another auditor Unqualified opinion expressing substantial doubt that the company is a going concern
Yes Yes

B)
Unqualified opinion indicating shared responsibility with another auditor Unqualified opinion expressing substantial doubt that the company is a going concern
No No

C)
Unqualified opinion indicating shared responsibility with another auditor Unqualified opinion expressing substantial doubt that the company is a going concern
Yes No

D)
Unqualified opinion indicating shared responsibility with another auditor Unqualified opinion expressing substantial doubt that the company is a going concern
No Yes

Answer
Terms: Four paragraph auditor opinion
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills

5) A four paragraph auditor opinion is required when:
A)
Qualified opinion due to scope restriction Disclaimer due to a scope restriction
Yes Yes

B)
Qualified opinion due to scope restriction Disclaimer due to a scope restriction
No No

C)
Qualified opinion due to scope restriction Disclaimer due to a scope restriction
Yes No

D)
Qualified opinion due to scope restriction Disclaimer due to a scope restriction
No Yes

Answer
Terms: Four paragraph auditor opinion
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills

6) A four paragraph auditor opinion is required when:
A)
Qualified opinion due to departure from GAAP Adverse opinion due to departure from GAAP
Yes Yes

B)
Qualified opinion due to departure from GAAP Adverse opinion due to departure from GAAP
No No

C)
Qualified opinion due to departure from GAAP Adverse opinion due to departure from GAAP
Yes No

D)
Qualified opinion due to departure from GAAP Adverse opinion due to departure from GAAP
No Yes

Answer
Terms: Four paragraph auditor opinion
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills

7) A four paragraph auditor opinion is required for:
A)
An unjustified accounting change A justified accounting change, properly accounted for
Yes Yes

B)
An unjustified accounting change A justified accounting change, properly accounted for
No No

C)
An unjustified accounting change A justified accounting change, properly accounted for
Yes No

D)
An unjustified accounting change A justified accounting change, properly accounted for
No Yes

Answer
Terms: Four paragraph auditor opinion
Diff: Challenging
Objective: LO 3-8
AACSB: Reflective thinking skills
8) Any audit report that contains more than three paragraphs means there is either a qualified opinion or required explanation.
A) True
B) False
Answer
Terms: Audit report with more than three paragraphs; Qualified opinion or required explanation
Diff: Moderate
Objective: LO 3-8
AACSB: Reflective thinking skills

9) All audit reports with three paragraphs mean the auditor has issued an unqualified opinion.
A) True
B) False
Answer
Terms: Audit reports with three paragraphs; Unqualified opinion
Diff: Moderate
Objective: LO 3-8
AACSB: Reflective thinking skills

Learning Objective 3-9

1) Auditing standards of the United States allow auditors to perform an audit in accordance with International Standards on Auditing (ISAs).
A) True
B) False
Answer
Terms: Auditing standards of United States and International Standards of Auditing
Diff: Moderate
Objective: LO 3-9
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 4 Professional Ethics

Learning Objective 4-1

1) There are no questions for this Learning Objective.

Learning Objective 4-2

1) Describe an ethical dilemma that an auditor or an accountant might face in his or her business career, then illustrate how the auditor or accountant might use the six-step approach presented in the text to resolve that dilemma. Be specific.

Learning Objective 4-3

1) The underlying reason for a code of professional conduct for any profession is:
A) the need for public confidence in the quality of service of the profession.
B) that it provides a safeguard to keep unscrupulous people out.
C) that it is required by federal legislation.
D) that it allows licensing agencies to have a yardstick to measure deficient behavior.
Answer
Terms: Reason for code of professional conduct
Diff: Easy
Objective: LO 4-3
AACSB: Reflective thinking skills

2) Which of the following statements is true when the CPA has been engaged to perform an audit of financial statements?
A) The CPA firm is engaged and paid by the client; therefore, the firm has primary responsibility to be an advocate for the client.
B) The CPA firm is engaged and paid by the client, but the primary beneficiaries of the audit are those who rely on the financial statements.
C) Should a situation arise where there is no convincing authoritative standard available, and there is a choice of actions which could impact a client’s financial statements, the CPA is free to endorse the choice which is in the investors’ interests.
D) The CPA firm has primary responsibility to the FASB.
Answer
Terms: CPA engaged to perform audit of financial statements
Diff: Moderate
Objective: LO 4-3
AACSB: Reflective thinking skills

3) Explain why there is a special need for ethical conduct in the auditing profession.

Learning Objective 4-4

1) Which of the following is(are) true concerning the Ethical Principles of the Code of Professional Conduct?
I. They identify ideal conduct.
II. They are general ideals and difficult to enforce.
A) I only
B) II only
C) I and II
D) Neither I nor II
Answer
Terms: Ethical principles of the Code of Professional Conduct
Diff: Easy
Objective: LO 4-4
AACSB: Reflective thinking skills

2) Which of the following is not one of the four parts of the AICPA’s Code of Professional Conduct?
A) Principles
B) Rules of Conduct
C) Interpretations
D) Definitions
Answer
Terms: AICPA Code of Professional Conduct
Diff: Easy
Objective: LO 4-4
AACSB: Reflective thinking skills

3) One of the AICPA’s Ethical Principles deals with the public interest. It states that members should accept the obligation to act in a way that will:
A)
Honor the public trust Serve the client’s interest
Yes Yes

B)
Honor the public trust Serve the client’s interest
No No

C)
Honor the public trust Serve the client’s interest
Yes No

D)
Honor the public trust Serve the client’s interest
No Yes

Answer
Terms: Ethical Principles; Public interest; Obligations
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

4) According to the Principles section of the Code of Professional Conduct, all members:
A) should be independent in fact and in appearance at all times.
B) in public practice should be independent in fact and in appearance at all times.
C) in public practice should be independent in fact and in appearance when providing auditing and other attestations services.
D) in public practice should be independent in fact and in appearance when providing auditing, tax, and other attestation services.
Answer
Terms: Principles section of the Code of Professional Conduct
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

5) Which of the following statements best describes the enforceability of the Interpretations of the Rules of Conduct?
A) The Interpretations are not enforceable.
B) The Interpretations are enforceable.
C) The Interpretations may be enforceable if they have been reviewed and approved by the AICPA’s Division of Professional Ethics.
D) The Interpretations are not enforceable, but a practitioner must justify departure from them.
Answer
Terms: Enforceability of Interpretations of the Rules of Conduct
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

6) Of the four parts of the AICPA’s Code of Professional Conduct, which part is enforceable?
A) Ethical Rulings
B) Rules of Conduct
C) Principles
D) Interpretations
Answer
Terms: AICPA Code of Professional Conduct; Enforceable
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

7) Ethical Rulings are:
I. Explanations relating to broad hypothetical circumstances.
II. Not enforceable, but one must justify departure.
III. Explanations relating to specific factual circumstances.
A) I and II
B) I and III
C) II and III
D) I, II, and III
Answer
Terms: Ethical Rulings
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

8) The AICPA’s Code of Professional Conduct requires independence for all:
A) attestation engagements.
B) services performed by accountants in public practice.
C) accounting and auditing services performed.
D) professional work performed by CPAs.
Answer
Terms: Independence
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

9) A member firm of the AICPA is not only responsible for its compliance with the Rules of Conduct, but it is also responsible for compliance by its:
A)
Employees Shareholders
Yes Yes

B)
Employees Shareholders
Yes Yes

C)
Employees Shareholders
Yes Yes

D)
Employees Shareholders
Yes Yes

Answer
Terms: AICPA; Compliance with Rules of Conduct; Responsible
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

10) Four of the six Ethical Principles in the AICPA’s Code of Professional Conduct are equally applicable to all members of the AICPA. Which of the following principles applies only to members in public practice?
A) Scope and Nature of Services
B) Integrity
C) Due Care
D) The Public Interest
Answer
Terms: Ethical Principles apply only to members in public practice
Diff: Challenging
Objective: LO 4-4
AACSB: Reflective thinking skills

11) The Code of Professional Conduct is established by the membership of the AICPA, and the Interpretations of the Rules of Conduct are prepared by the:
A) Financial Accounting Standards Board.
B) Securities and Exchange Commission.
C) CPA licensing agencies within each state.
D) Professional Ethics Executive Committee of the AICPA.
Answer
Terms: Code of Professional Conduct; Interpretations of Rules of Conduct
Diff: Challenging
Objective: LO 4-4
AACSB: Reflective thinking skills

12) Identify and describe each of the four parts to the AICPA’s Code of Professional Conduct. Also discuss which parts are officially enforceable and which are not.

13) Briefly describe the advantages and disadvantages of a code of conduct based on general statements of ideal conduct as opposed to specific rules that define unacceptable behavior.

14) What are the six Ethical Principles stated in the Code of Professional Conduct? Briefly discuss each principle. Are these principles enforceable?

15) An advantage of specific rules in the Code of Professional Conduct is the enforceability of minimum behavior and performance standards.
A) True
B) False
Answer
Terms: Code of Professional Conduct
Diff: Easy
Objective: LO 4-4
AACSB: Reflective thinking skills

16) The Sarbanes-Oxley Act permits the auditor to perform a wide variety of non-audit services for audit clients.
A) True
B) False
Answer
Terms: Code of Professional Conduct
Diff: Easy
Objective: LO 4-4
AACSB: Reflective thinking skills
Topic: SOX

17) An advantage of the principles of professional conduct in the Code of Professional Conduct is that they are more easily enforced than are the specific rules of conduct.
A) True
B) False
Answer
Terms: Code of Professional Conduct
Diff: Easy
Objective: LO 4-4
AACSB: Reflective thinking skills
18) In the AICPA Code of Professional Conduct, ethical rulings are less specific than rules of conduct.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Ethical rulings
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

19) Interpretations of rules of conduct in the Code of Professional Conduct are not officially enforceable and practitioners need not justify departure from them.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Interpretation of rules
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

20) In the AICPA Code of Professional Conduct, interpretations of rules are more specific than ethical rulings.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Ethical rulings; Interpretations of rules
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

21) In the AICPA Code of Professional Conduct, the second principle of professional conduct, entitled “The Public Interest,” applies only to members of the AICPA in public practice and not to members who work as accountants in business, government, or education.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Public Interest principle
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

22) In the AICPA Code of Professional Conduct, the sixth principle of professional conduct, entitled “Scope and Nature of Services,” applies to members of the AICPA who work in public practice, business, government, or education.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Scope and nature of services principle
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills
23) The Independence Standards Board was formed to provide a conceptual framework for independence issues related to audits of public companies.
A) True
B) False
Answer
Terms: Independence Standards Board
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

24) Non-CPA members of a firm with AICPA membership are not eligible for membership within the AICPA and therefore do not have to follow the AIPCA Code of Professional Conduct.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Non-CPA members
Diff: Moderate
Objective: LO 4-4
AACSB: Reflective thinking skills

Learning Objective 4-5

1) For which of the following professional services must CPAs be independent?
A) Management advisory services.
B) Audits of financial statements.
C) Preparation of tax returns.
D) All three of the above.
Answer
Terms: Independence
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills

2) “Independence” in auditing means:
A) maintaining an indirect financial interest.
B) not being financially dependent on a client.
C) taking an unbiased and objective viewpoint.
D) being an advocate for a client.
Answer
Terms: Independence
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills

3) When CPAs are able to maintain their actual independence, it is referred to as independence in:
A) conduct.
B) appearance.
C) fact.
D) total.
Answer
Terms: Independence
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills

4) Which of the following statements is true? The CPA firm will lose its independence if:
A) a staff auditor providing audit services to the client acquires stock in that client.
B) a staff tax preparer who provides 15 hours of non-audit services to the client acquires stock in that client.
C) an audit manager in an office different than the office providing audit services has a direct, immaterial financial interest in the audit client.
D) a covered member has an indirect, immaterial financial interest in an audit client.
Answer
Terms: Independence
Diff: Moderate
Objective: LO 4-5
AACSB: Analytic skills

5) The AICPA’s Code of Professional Conduct ________ a CPA firm from doing both bookkeeping and auditing services for the same public company client?
A) encourages
B) prohibits
C) allows
D) allows on a case-by-case basis
Answer
Terms: AICPA Code of Professional Conduct
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills

6) The Sarbanes-Oxley Act requires which employees of an accounting firm to rotate off the engagement every five years?
A)
In-Charge Auditor Partner responsible for concurring review
Yes Yes

B)
In-Charge Auditor Partner responsible for concurring review
No No

C)
In-Charge Auditor Partner responsible for concurring review
Yes No

D)
In-Charge Auditor Partner responsible for concurring review
No Yes

Answer
Terms: Sarbanes-Oxley Act; Partner rotation
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills
Topic: SOX

7) Which of the following statements are true with respect to audit committees?
I. One member has to be a financial expert.
II. Audit committees are required for all companies.
III. Outside member of the board of directors should comprise the audit committee.
A) I and II
B) I and III
C) II and III
D) I, II, and III
Answer
Terms: Audit committee
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

8) The provisions of the Sarbanes-Oxley Act of 2002 are most likely to allow which of the following non-audit services for audit clients?
A) appraisal or valuation services (e.g., pension, post-employment benefit liabilities).
B) financial information systems design and implementation
C) internal audit outsourcing.
D) tax consulting.
Answer
Terms: Sarbanes-Oxley Act of 2002; Allowed non-audit services
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills
9) Interpretations to the Rules of Conduct permit a CPA firm to do both bookkeeping and auditing for the same client if three criteria are met. Which of the following is not one of those criteria?
A) The client must accept full responsibility for the financial statements.
B) The client is required to file an annual report, including audited financial statements, with the Securities and Exchange Commission.
C) The CPA must not assume the role of employee or of manager.
D) The CPA must follow applicable auditing standards.
Answer
Terms: Services allowed by SEC when CPA audits company
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

10) Which of the following services are allowed by the SEC whenever a CPA also audits the company?
A) Internal audit outsourcing.
B) Legal services unrelated to the audit.
C) Appraisal or valuation services.
D) Services related to assessing the effectiveness of internal control over financial reporting.
Answer
Terms: Services allowed by SEC when CPA audits company
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

11) Which of the following services is not prohibited by the SEC whenever a CPA also audits the company?
A) actuarial services
B) assisting the company in preparing certain SEC registration statements (e.g., 10-Q, 10-K)
C) investment banker services
D) bookkeeping services
Answer
Terms: Services allowed by SEC when CPA audits company
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

12) The members of a client’s “audit committee” should be:
A) members of management.
B) directors who are not a part of company management.
C) non-directors and non-managers.
D) directors and managers.
Answer
Terms: Members of audit committee
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills
13) The Sarbanes-Oxley Act requires a cooling off period of ________ before a member of an audit team can work for a client in a key management position?
A) one year
B) eighteen months
C) three years
D) five years
Answer
Terms: Sarbanes-Oxley Act; Cooling off period
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills
Topic: SOX

14) In determining independence with respect to any audit engagement, the ultimate decision as to whether or not the auditor is independent must be made by the:
A) auditor.
B) client.
C) audit committee.
D) public.
Answer
Terms: Auditor independence
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

15) A CPA firm should decline an offer to perform consulting services engagement if:
A) the proposed engagement is not accounting-related.
B) recommendations made by the CPA firm are to be subject to review by the client.
C) acceptance would require the CPA firm to make management decisions for an audit client.
D) any of the above is true.
Answer
Terms: CPA firm should decline to perform consulting services
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills

16) Companies are required to disclose in their proxy statement or annual filings with the SEC the total amount of audit and non-audit fees paid to the audit firm for the two most recent years. Which of the following is not one of the categories of fees that must be disclosed?
A) tax fees
B) consulting fees
C) audit-related fees
D) all other fees
Answer
Terms: Annual SEC filings; Audit and non-audit fees
Diff: Challenging
Objective: LO 4-5
AACSB: Reflective thinking skills
17) Interpretations of the AICPA Code of Professional Conduct are dominated by the concept of:
A) independence.
B) compliance with standards.
C) accounting.
D) acts discreditable to the profession.
Answer
Terms: Interpretations of AICPA Code of Professional Conduct dominated by
Diff: Challenging
Objective: LO 4-5
AACSB: Reflective thinking skills

18) Each of the following situations involves a possible violation of the rule on independence. For each situation, (1) decide whether the Code of Professional Conduct has been violated, and (2) briefly explain how the situation violates (or does not violate) the Code of Professional Conduct.

a. Harry Brown is a partner in the Topeka office of Hedley & Co., CPAs. Harry’s brother is employed in an audit-sensitive position by Jensen Appliances, a publicly held company in Kansas. Jensen Appliances is one of Hedley & Co.’s audit clients. Neither Harry nor personnel from the Topeka office is involved in the audit of Jensen.

Violation? Yes No
Explanation:

b. John Woods is an audit manager with Calden & Co., CPAs, a one-office CPA firm. John owns 100 shares of common stock in one of the firm’s audit clients, but he does not provide any audit or non-audit services to the company.

Violation? Yes No
Explanation:

c. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Fine & Herman also performs the annual audit of Henderson Corporation.

Violation? Yes No
Explanation:

d. Bob Shelton CPA, is the auditor of Cafe Ecko. A couple of weeks ago, Cafe Ecko’s management commenced litigation against Bob, alleging he was negligent in last year’s audit.

Violation? Yes No
Explanation:

e. Hamilton Appliance has not paid Karen Linwood, CPA, her audit fee for the past two years. Karen is starting work on the current year’s audit of Hamilton.

Violation? Yes No
Explanation:
Answer. No violation. Although partners in a CPA firm are not allowed to have close relatives employed in a position of significant influence by a client, it is acceptable to have a close relative employed in an audit-sensitive position (with no significant influence), as long as the partner does not participate in the engagement and is not in an office that participates on the engagement.

b. No violation. John is not a covered member with respect to the audit client as he has no responsibility for the engagement and is not in a position to influence the engagement.

c. No violation. The AICPA does not prohibit CPA firms from providing bookkeeping, tax, and audit services to the same non-public client.

d. Violation. When there is a lawsuit or intent to start a lawsuit between a CPA and an audit client’s management related to audit services, independence is impaired.

e. Violation. Independence is impaired if fees remain unpaid for services provided more than one year prior to the date of the report.
Terms: Violation of rule on independence; AICPA Code of Professional Conduct
Diff: Challenging
Objective: LO 4-5
AACSB: Analytic skills

19) A public company may purchase internal audit services from their financial statement auditor if they are approved by the company’s audit committee.
A) True
B) False
Answer
Terms: Public company; Non-audit services purchased
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills
Topic: SOX

20) The audit committee of a private company need not approve all non-audit services provided by the company’s financial statement auditor.
A) True
B) False
Answer
Terms: Private company; Non-audit services purchased
Diff: Easy
Objective: LO 4-5
AACSB: Reflective thinking skills
21) The Sarbanes-Oxley Act does not require audit committee approval of all non-audit services prior to their performance by the company’s external auditor.
A) True
B) False
Answer
Terms: Sarbanes-Oxley Act; Audit committee
Diff: Moderate
Objective: LO 4-5
AACSB: Reflective thinking skills
Topic: SOX

Learning Objective 4-6

1) Interpretations of Independence Rule 101 prohibit covered members from owning any stock or other direct investment in audit clients. Covered members would include which of the following?
A)
All partners in the engagement office even if they have no engagement responsibility Individuals on the attest engagement The firm and its employee benefit plans
Yes Yes Yes

B)
All partners in the engagement office even if they have no engagement responsibility Individuals on the attest engagement The firm and its employee benefit plans
Yes No No

C)
All partners in the engagement office even if they have no engagement responsibility Individuals on the attest engagement The firm and its employee benefit plans
No Yes Yes

D)
All partners in the engagement office even if they have no engagement responsibility Individuals on the attest engagement The firm and its employee benefit plans
No No No

Answer
Terms: Independence Rule 101; Direct investment; Covered members
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills

2) In some situations, the interpretations of the Rules of Conduct permit former partners to have relationships with a client of the firm without affecting the firm’s independence. Which of the following situations would cause a loss of independence?
I. The former partner uses the CPA firm’s office space and has significant influence over a client.
II. The former partner severs relations with the firm and accepts employment with the firm’s client after having been retired for 18 months.
III. The former partner is held out as an associate of the firm and takes part in the firm’s business activities.
A) I and II
B) I and III
C) II and III
D) I, II and III
Answer
Terms: Rules of conduct; Independence relationships
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills

3) Financial interests family members of a CPA can affect the CPA’s independence. Which of the following parties would not be included as a “direct financial interest” of the CPA?
A) Spouse
B) Dependent child
C) Relative supported by the CPA
D) Sibling living in the same city as the CPA
Answer
Terms: Independence; Direct financial interest
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills

4) Interpretations of the rules regarding independence allow an auditor to serve as:
A) a director or officer of an audit client.
B) an underwriter for the sale of a client’s securities.
C) a trustee of a client’s pension fund.
D) an honorary director for a not-for-profit charitable or religious organization.
Answer
Terms: Independence
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills

5) Independence is required of a CPA when performing:
A) external audits.
B) all attestation services.
C) all attestation and tax services.
D) all professional services.
Answer
Terms: Independence
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills
6) Which of the following activities is allowed for a CPA firm’s attestation clients?
A) Contingent fees based on savings due to implementation of an information system.
B) Commissions for referring a review client to an insurance agency for insurance coverage.
C) Preparation of tax returns for which fees are based upon client refunds.
D) Each of the above is allowed.
Answer
Terms: Activities allowed for CPA firm’s attestation clients
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

7) CPAs may provide bookkeeping services to their non-public audit clients, but there are a number of conditions that must be met if the auditor is to maintain independence. Which of the following conditions is not necessary?
A) The CPA must not assume a management role or function.
B) The client must hire an external CPA to approve all of the journal entries prepared by the auditor.
C) The auditor must comply with GAAS when auditing work prepared by his/her firm.
D) The client must accept responsibility for the financial statements.
Answer
Terms: Independence
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

8) An example of an “indirect ownership interest in a client” would be ownership of a client’s stock by a member’s:
A) dependent child.
B) spouse.
C) non-dependent grandfather.
D) All of the above are examples of indirect ownership.
Answer
Terms: Indirect ownership interest in a client
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

9) When determining whether independence is impaired because of an ownership interest in a client company, materiality will affect ownership:
A) in all circumstances.
B) only for direct ownership.
C) only for indirect ownership.
D) under no circumstances.
Answer
Terms: Independence; Materiality
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills
10) A direct financial interest violates independence in which of the following circumstances?
A) When close relatives such as nondependent children, brothers, and sisters have a significant financial interest in the client.
B) When close relatives such as nondependent children, brothers, and sisters have any financial interest in the client.
C) When the CPA owns shares in a mutual fund that has an ownership interest in the client.
D) When close relatives such as brother, sister, or in-laws are employed by the client.
Answer
Terms: Direct financial interest, independence
Diff: Moderate
Objective: LO 4-6
AACSB: Analytic skills

11) A CPA sole practitioner purchased stock in a client corporation and placed it in a trust as an educational fund for the CPA’s minor child. The trust securities were not material to the CPA but were material to the child’s personal net worth. Would the independence of the CPA be considered to be impaired with respect to the client?
A) Yes, because the stock is a direct financial interest.
B) Yes, because the stock is an indirect financial interest that is material to the CPA’s child.
C) No, because the CPA does not have a direct financial interest in the client.
D) No, because the CPA does not have a material indirect financial interest in the client.
Answer
Terms: Financial interest and independence
Diff: Moderate
Objective: LO 4-6
AACSB: Analytic skills

12) Julie and Lisa are sisters. Julie is a CPA auditing the company where Lisa works. Julie’s independence is impaired if:
A) Lisa is the controller.
B) Lisa owns 25% of the company.
C) Lisa is the marketing manager.
D) All of the above.
Answer
Terms: Financial interest and independence
Diff: Moderate
Objective: LO 4-6
AACSB: Analytic skills
13) Oehlers, CPA, is a staff auditor participating in the engagement of Capital Trust, Inc. Which of the following circumstances impairs Oehlers independence?
A) Oehlers sister is an internal auditor employed part-time by Capital Trust.
B) Oehlers friend, and employee of another local accounting firm, prepares the tax return of Capital Trust’s CEO.
C) Oehlers and Capital Trust’s 401K plan own stock with the same corporation.
D) During the period of professional engagement, Capital Trust gave Oehlers tickets to a football game worth $75.
Answer
Terms: Financial interest and independence
Diff: Moderate
Objective: LO 4-6
AACSB: Analytic skills
14) An auditor’s independence is considered impaired if the auditor has:
A) an immaterial, indirect financial interest in a client.
B) an outstanding $8,000 balance on a credit card issued by a client.
C) an automobile loan from a client bank, collateralized by the automobile.
D) a joint, closely held business investment with the client that is material to the auditor’s net worth.
Answer
Terms: Financial interest and independence
Diff: Moderate
Objective: LO 4-6
AACSB: Analytic skills

15) According to the profession’s ethical standards, an auditor would be considered independent in which of the following instances?
A) The auditor’s checking account, which is fully insured by a federal agency, is held at a client financial institution.
B) The auditor is also an attorney who advises the client as its general counsel.
C) An employee of the auditor serves as treasurer of a charitable organization that is a client.
D) The client owes the auditor fees for two consecutive annual audits.
Answer
Terms: iIndependence
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

16) Generally, loans between a CPA firm or its members and an audit client are prohibited because they create a financial relationship. However, there are exceptions. Which of the following loans is not an exception to this rule?
A) automobile loans
B) loans fully collateralized by cash deposits at the same financial institution
C) home mortgages
D) unpaid credit card balances not exceeding $15,000
Answer
Terms: Independence; Loan exceptions
Diff: Challenging
Objective: LO 4-6
AACSB: Reflective thinking skills
17) Generally, loans between a CPA firm or its members and an audit client are prohibited because it is a financial relationship. Which of the following, made under normal lending procedures, is not an exception to this rule?
A) immaterial loans
B) home mortgages
C) material loans
D) secured loans
Answer
Terms: Loans between CPA firm and audit client prohibited; Normal lending procedures
Diff: Challenging
Objective: LO 4-6
AACSB: Reflective thinking skills
18) The Code of Conduct rule on independence indicates that materiality must be considered when:
A)
Evaluating direct investments made by the CPA Evaluating indirect ownership investments
Yes Yes

B)
Evaluating direct investments made by the CPA Evaluating indirect ownership investments
No No

C)
Evaluating direct investments made by the CPA Evaluating indirect ownership investments
Yes No

D)
Evaluating direct investments made by the CPA Evaluating indirect ownership investments
No Yes

Answer
Terms: Independence; Direct and indirect ownership investments
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

19) In which of the following instances would impair a CPA’s independence when they have been retained as the auditor?
I. A charitable organization where the CPA serves as treasurer.
II. A municipality where the CPA owns $250,000 of the $25 million outstanding bonds of the municipality.
III. A company that the CPA’s investment club has a one-tenth investment interest.
A) I and II
B) I and III
C) II and III
D) I, II, and III
Answer
Terms: Impair independence
Diff: Challenging
Objective: LO 4-6
AACSB: Analytic skills

20) Which of the following statements is correct regarding non-audit services that are not prohibited by Sarbanes-Oxley or SEC?
A) They must be approved by management of the client.
B) They must be approved by staff of the PCAOB.
C) They must be approved by staff of the PCAOB and the SEC.
D) They must be approved by the company’s audit committee.
Answer
Terms: Sarbanes-Oxley; non-audit services
Diff: Challenging
Objective: LO 4-6
AACSB: Reflective thinking skills
Topic: SOX
21) Which of the following is least likely to impair a CPA firm’s independence with respect to an audit client in the Oklahoma City office of a national CPA firm?
A) A partner in the Oklahoma City office owns an immaterial amount of stock in the client.
B) A partner in the Jersey City office owns 25% of the client’s stock.
C) A partner in the Oklahoma City office, who does not work on the audit engagement, previously served as controller for the audit client.
D) A partner in the Chicago office previously served as vice president of finance for the audit client.
Answer
Terms: Independence
Diff: Challenging
Objective: LO 4-6
AACSB: Analytic skills

22) A CPA’s financial interests in nonclients may have an effect on independence if the nonclients are investors in or investees of the client. Which situation would not impair a CPA’s independence?
A) The client has an immaterial investment in a nonclient investee in which the CPA has an immaterial investment.
B) The CPA has a material indirect financial interest in a nonclient in which the client has a material investment.
C) The client investor has a nonmaterial investment in the nonclient investee in which the CPA has a material investment.
D) The CPA has a joint closely held investment with the client in a nonclient that is material to the client as well as the CPA.
Answer
Terms: Impair CPA independence
Diff: Challenging
Objective: LO 4-6
AACSB: Analytic skills

23) Don Crosby, a partner in a national CPA firm, has just learned that his self sufficient daughter has accepted a position as the CFO of Sunglasses, Inc., a current client within the office with which he is employed. Explain the independence ramifications on 1) Don’s independence, 2) his office, and 3) the firm’s independence.

24) The following situations involve a possible violation of the AICPA’s Code of Professional Conduct. For each situation, (1) determine the applicable rule from the Code, (2) decide whether or not the Code has been violated, and (3) briefly explain how the situation violates (or does not violate) the Code.

a. In 20×4, Freeman and Johnson, both CPAs, decided to form a CPA practice. In 20×7, Freeman and Johnson approached Bill Delaney, a physician and medical expert, and asked him to assist them with their growing medical consulting practice. Delaney agreed, but only after he was given an ownership interest in the firm. Delaney does not intend to quit his private medical practice.

Rule: ________ Violation? Yes No
Explanation:

b. Brian DePalie has a successful dentistry practice in Charleston. Brian has recommended one of his patients to Katie Walton, CPA. To show gratitude for the referral, Katie has agreed to pay Brian a token gift of $50. Katie discloses the payment arrangement to her new clients.

Rule: ________ Violation? Yes No
Explanation:

c. The accounting firm of Bayer & Peng, CPAs, is negotiating a fee with a new audit client. They agree the client will pay $50,000 if Bayer & Peng issues a clean, unqualified opinion, $40,000 if a qualified opinion is issued, and only $20,000 if an adverse opinion is issued.

Rule: ________ Violation? Yes No
Explanation:

d. Don Smith, CPA, is a member of the engagement team that performs the audit of Shaw Corporation. Don’s five-year-old daughter, Precious, received ten shares of Shaw Corporation’s common stock for her fifth birthday. The stock was a gift from Precious’s grandmother.

Rule: ________ Violation? Yes No
Explanation:

e. Jennifer Harris, CPA, is a partner in the CPA firm that audits Alltech, Inc., a closely held corporation. Jennifer’s sister-in-law is the chief financial officer at Alltech, Inc.

Rule: ________ Violation? Yes No
Explanation:
Answer. Violation of the rule on Form of Organization and Name. Non-CPA ownership of firms is allowable, however, non-CPA owners must actively provide services to the firm’s clients as their principal occupation.

b. No violation of the Commissions and Referral Fees rule. A CPA may pay a referral fee to a non-CPA as long as the payment is disclosed to the client.

c. Violation of the Contingent Fees rule. This is a contingent fee agreement and is prohibited by Rule 302.

d. Violation of the Independence rule. Don is a covered member for purposes of Rule 101. Because his daughter is a dependent, her ownership interest in Shaw is treated as a direct financial interest of her father.

e. No violation of the Independence rule. According to the Code a close relative is defined as a parent, sibling, or nondependent child. Thus, a sister-in-law is not considered to be a close relative.
Terms: Violations of Rules of AICPA Code of Professional Conduct
Diff: Challenging
Objective: LO 4-5 and LO 4-6
AACSB: Analytic skills

25) The following situations involve a possible violation of the AICPA’s Code of Professional Conduct. For each situation, (1) determine the applicable rule from the Code, (2) decide whether or not the Code has been violated, and (3) briefly explain how the situation violates (or does not violate) the Code.

a. Howard Cunningham & Co., CPAs, designates its firm as “Members of the American Institute of Certified Public Accountants.” All of the partners of the firm are CPAs. However, one of the partners has recently chosen to allow her membership to lapse because of personal reasons.

Rule: ________ Violation? Yes No
Explanation:

b. Brad Long, CPA, was traveling from Orlando to Miami, Florida when he was pulled over by a police officer on suspicion of driving under the influence. He was convicted in court of driving while under the influence of alcohol. Because of past convictions, Brad was sentenced to 5 years in prison.

Rule: ________ Violation? Yes No
Explanation:

c. Kelley Brent, CPA, is a partner in a one-office CPA firm that audits Dane, Inc., a closely held corporation. Kelley’s sister was recently appointed as the chief financial officer for Dane, Inc.

Rule: ________ Violation? Yes No
Explanation:

d. Sarah Matrin, CPA, is a senior auditor in the San Francisco office of Cooper & Howell, CPAs. Sarah’s father is employed as the controller of Line Electronics, a public company in Detroit, Michigan. Line Electronics is one of the firm’s audit clients. Neither Sarah nor the San Francisco office is involved in the audit of Line Electronics.

Rule: ________ Violation? Yes No
Explanation:

e. On August 20, 20×6, Hank Anderson, CPA and partner, was offered and accepted the engagement to audit the annual financial statements of Jernigan Corporation for the year ended December 31, 20×6. Preliminary work began on the audit on September 15, 20×6 and the engagement ended on March 7, 20×7. Jernigan is regulated by the SEC. Hank served as controller of Jernigan Corporation from December 1, 20×2, until April 10, 20×6, at which time he terminated his employment with Jernigan.

Rule: ________ Violation? Yes No
Explanation:
Answer. Violation of the Form of Organization and Name rule. A firm may not designate itself as “Members of the American Institute of Certified Public Accountants” unless all of its owners are members of the Institute.

b. Violation of the Acts Discreditable rule. Felonies are considered acts discreditable.

c. Violation of the Independence rule. According to the Code, Kelly’s sister is a “close relative” and she occupies a key position at an audit client. Because Kelly is a partner in the office that provides the audit services to Dane, the firm is not independent.

d. No violation of the Independence rule. While Sarah’s father occupies a key position with an audit client of the firm, there is no independence violation as long as Sarah is not a member of the engagement team. The firm may provide the audit services.

e. Violation of the Independence rule. Since Hank had an employment relationship with the client during part of the period covered by the financial statements, his independence is impaired.
Terms: Violations of Rules of AICPA Code of Professional Conduct
Diff: Challenging
Objective: LO 4-5 and LO 4-6
AACSB: Analytic skills

26) The scenarios below all involve a possible violation of the AICPA’s Code of Professional Conduct. For each scenario select:
1. Which rule of the Code the scenario falls under and
2. If the scenario is a violation of the Code for the CPA Firm.

Violation Code of Conduct Rule:
a. Yes
b. No
c. 101: Independence
d. 102: Integrity and Objectivity
e. 302: Contingent Fees
f. 501: Acts Discredible
g. 503: Commission and Referal Fees
h. 505: Form of Organization & Name

Scenario
1. Margaret Henry is a partner in the Tupelo office of Jenkins & Thorn, CPAs. Margaret’s father is the controller at Markrich Sporting Supplies, Inc., a publicly held company in Tupelo. Markrich is one of Jenkins & Thorn’s audit clients. Margaret is not involved in the audit of Markrich.

2. Jason Alexander is an audit manager with Reese & Co., CPAs. Jason owns 100 shares of common stock in one of the firm’s audit clients, but he does not provide any audit or non-audit services to the company.

3. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Mr. Herman also performs the annual audit of Henderson Corporation.

4. Elaine Cooper CPA, is the auditor of Paula’s Pizza. Towards the end of the audit, Paula gave Elaine her estimate of receivable collectability and Elaine accepted it without further cooperation.

5. Charley Ray, CPA, is a member of the engagement team that performs the audit of Desiree Corporation. Charley’s five-year-old daughter, Becky, received ten shares of Desiree common stock for her fifth birthday in a trust fund established by Becky’s grandmother.

6. Freeman and Johnson formed a successful CPA practice ten years ago. In 20×4, they approached Adam Sawtooth, a surgeon and medical expert, and asked him to assist them with their growing medical consulting practice. Sawtooth agreed, but only after he was given an ownership interest in the firm. Sawtooth does intend to reduce his private practice hours and spend 40% of his working hours devoted to the Freeman & Johnson practice.

7. Salley Preen has a successful computer network consulting business. Sally has recommended one of her clients to Sam Walton, CPA. To show gratitude for the referral, Sam has agreed to pay Sally a token gift of $50. Sam has not disclosed the payment arrangement to his new clients.

8. The accounting firm of Swift & Taylor, CPAs, is negotiating a fee with a new audit client where the client will pay $50,000 if the client obtains the line of credit needed for working capital purposes otherwise, the fee will be $40,000.

9. Brad Long, CPA, was traveling from Orlando to Miami, Florida when he was pulled over by a police officer on suspicion of driving under the influence. He was convicted in court of driving while under the influence of alcohol and received six months probation.

10. Sammy Bryant, CPA, is a senior in a one-office CPA firm that audits Childress, Inc., a closely held corporation. Sammy’s sister was recently appointed as the assistant controller for Childress, Inc.

27) Rule 101, Independence, prohibits a CPA from performing both audit services and bookkeeping services for the same public company in the same year.
A) True
B) False
Answer
Terms: Rule 101, Independence
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills
28) Under Rule 101, Independence, independence is considered to be impaired if fees remain unpaid for professional services provided more than six months before the date of the current year’s report.
A) True
B) False
Answer
Terms: Rule 101, Independence
Diff: Easy
Objective: LO 4-6
AACSB: Reflective thinking skills

29) Auditors are allowed to have an indirect financial interest in an audit client, such as ownership of stock in a client’s company by the auditor’s brother, as long as the amount of the financial interest is immaterial to the brother.
A) True
B) False
Answer
Terms: Indirect financial interest; Immaterial
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills
30) Rule 101, Independence, applies to members of the AICPA when performing any professional service.
A) True
B) False
Answer
Terms: Rule 101, Independence
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

31) Rule 101, Independence, applies to covered members in a position to influence an attest engagement.
A) True
B) False
Answer
Terms: Rule 101, Independence
Diff: Moderate
Objective: LO 4-6
AACSB: Reflective thinking skills

Learning Objective 4-7

1) The CPA must not subordinate his or her professional judgment to that of others in any:
A) engagement.
B) audit engagement.
C) engagement excluding tax services.
Answer
Terms: CPA subordinate professional judgment
Diff: Easy
Objective: LO 4-7
AACSB: Reflective thinking skills
2) Which of the following would be a violation of the rule requiring “objectivity” by the CPA?
I. The auditor accepts management’s opinion regarding the collection of accounts receivable without an independent evaluation.
II. In preparing a client’s tax return, the CPA encourages a client to take a deduction which the CPA believes is risky.
A) I only
B) II only
C) I and II
D) Neither I nor II
Answer
Terms: Violation of rule requiring CPA objectivity
Diff: Moderate
Objective: LO 4-7
AACSB: Analytic skills

3) Several months after an unqualified audit report was issued, the auditor discovers the financial statements were materially misstated. The client’s CEO agrees that there are misstatements, but refuses to correct them. She claims that “confidentiality” prevents the CPA from informing anyone.
A) The CEO is correct and the auditor must maintain confidentiality.
B) The CEO is incorrect, but because the audit report has been issued it is too late.
C) The CEO is correct, but to be ethically correct the auditor should violate the confidentiality rule and disclose the error.
D) The CEO is incorrect, and the auditor has an obligation to issue a revised audit report, even if the CEO will not correct the financial statements.
Answer
Terms: Confidentiality on audit
Diff: Easy
Objective: LO 4-7
AACSB: Reflective thinking skills

4) A member in public practice may perform for a contingent fee any professional services for a client for whom the member or member’s firm performs:
A) an audit.
B) consulting services.
C) preparation of an original tax return.
D) preparation of an amended tax return.
Answer
Terms: Contingent fees
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

5) A member in public practice shall neither receive from, nor pay to, a client a commission when the member or member’s firm also performs certain services for that client. Are commissions allowed if the CPA performs:
A)
A compilation that will be used by a third party An audit of prospective financial information
Yes Yes

B)
A compilation that will be used by a third party An audit of prospective financial information
No No

C)
A compilation that will be used by a third party An audit of prospective financial information
Yes No

D)
A compilation that will be used by a third party An audit of prospective financial information
No Yes

Answer
Terms: Commissions
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

6) The AICPA’s Code of Professional Conduct states that a CPA should maintain integrity and objectivity. The term “objectivity” in the Code refers to a CPA’s ability to:
A) choose independently between alternate accounting principles and auditing standards.
B) distinguish between accounting practices that are acceptable and those that are not.
C) be unyielding in all matters dealing with auditing procedures.
D) maintain an impartial attitude on matters that come under the CPA’s review.
Answer
Terms: AICPA Code of Professional Conduct; Objectivity
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

7) Which of the following is required for a firm to designate itself “Member of the American Institute of Certified Public Accountants” on its letterhead?
A) At least one of the partners must be a member of the AICPA.
B) All partners must be members of the AICPA.
C) The partners whose names appear in the firm name must be members of the AICPA.
D) A majority of the partners must be members of the AICPA.
Answer
Terms: Members of the AICPA requirements
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills
8) CPAs are prohibited from which of the following forms of advertising?
A) Self-laudatory advertising.
B) Celebrity endorsement advertising.
C) Use of trade names, such as “Awesome Auditors.”
D) Use of phrases, such as “Guaranteed largest tax refunds in town!”
Answer
Terms: Prohibited forms of advertising
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

9) According to the Code of Professional Conduct which of the following is true with respect to records in a CPA’s possession?
A) Extensive analyses of inventory prepared by the client at the auditor’s request are working papers that belong to the auditor and need not be furnished to the client upon request.
B) The auditor who returns client records must comply with any subsequent requests to again provide such information.
C) A corporation’s consolidating worksheets of their multinational conglomerate belong to the auditor and need not be furnished to the client upon request.
D) An auditor may retain client records if fees due with respect to a completed engagement have not been paid.
Answer
Terms: Code of Profession Conduct; Records in CPA’s possession
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

10) Rule 301 of the AICPA’s Code of Professional Conduct requires CPAs to maintain the confidentiality of client information. This rule would be violated if a CPA disclosed information without a client’s consent as a result of a:
A) subpoena or summons.
B) peer review.
C) complaint filed with the trial board of the Institute.
D) request by a client’s largest stockholder.
Answer
Terms: Confidentiality
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills
11) Which one of the following statements is false?
A) Confidentiality is broken when an auditor is presented with a subpoena concerning an audit client.
B) Information that a CPA obtains from a client is generally not privileged.
C) When a CPA firm conducts an AICPA-authorized peer review of the quality controls of another CPA firm, permission of the client is not needed to examine audit documentation.
D) A CPA firm which observes substandard audit documentation of another firm during a peer review can initiate a complaint to the AICPA.
Answer
Terms: Confidentiality
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

12) A CPA is allowed to accept a referral fee for recommending a client to another CPA if:
A)
The client pre-approves the transaction Payment of the referral fee is disclosed to the client
Yes Yes

B)
The client pre-approves the transaction Payment of the referral fee is disclosed to the client
Yes Yes

C)
The client pre-approves the transaction Payment of the referral fee is disclosed to the client
Yes Yes

D)
The client pre-approves the transaction Payment of the referral fee is disclosed to the client
Yes Yes

Answer
Terms: Referral fee allowed
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

13) Rule 505 of the AICPA’s Code of Professional Conduct permits CPA firms to organize as:
A) proprietorships or partnerships only.
B) proprietorships, partnerships, or professional corporations.
C) proprietorships, general partnerships, general corporations, professional corporations, limited liability companies, and limited liability partnerships if permitted by state law.
D) single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations.
Answer
Terms: Rule 505, AICPA Code of Professional Conduct; CPA firm form of organization
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

14) If a nonpublic company asks an accountant to perform a review engagement, and the accountant has an immaterial direct financial interest in the company, the accountant is:
A) independent because the financial interest is immaterial and, therefore, may issue a review report.
B) not independent and, therefore, may not issue a review report.
C) not independent and, therefore, may not be associated with the financial statements.
D) not independent and, therefore, may issue a review report, but may not issue an auditor’s opinion.
Answer
Terms: Review engagement and accountant has immaterial direct financial interest
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

15) In which of the following circumstances would a CPA be ethically bound to refrain from disclosing any confidential client information?
A) The CPA is issued a summons enforceable by a court order which orders the CPA to present confidential information.
B) A major stockholder of a client company seeks accounting information from the CPA after management declined to disclose the requested information.
C) Confidential client information is made available as part of a quality review of the CPA’s practice by a peer review team authorized by the AICPA.
D) An inquiry by a disciplinary body of a state CPA society requests confidential client information.
Answer
Terms: Confidential client information
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

16) Which of the following fee arrangements is not a violation of the AICPA’s Code of Professional Conduct?
A) Basing fees as an expert witness on the amount awarded to the plaintiff, even though the CPA performs a compilation for client use.
B) Basing consulting fees on a percentage of a bond issue, even though the CPA performs a review of the client’s financial statements.
C) Basing fees for a tax service on the amount of the refund that the client will receive.
D) Basing consulting fees on a percentage of a bond issue, even though the CPA performs an audit of the client’s financial statements.
Answer
Terms: Fee arrangements not a violation of AICPA Code of Professional Conduct
Diff: Challenging
Objective: LO 4-7
AACSB: Reflective thinking skills

17) Which of the following is not defined as an act discreditable in either the Rules or the Interpretations of the AICPA’s Code of Professional Conduct?
A) The CPA firm’s partner in charge failed to file his tax return for the past year.
B) The CPA firm discriminates in its hiring practices based on the age of the applicant.
C) The CPA retains the client’s books and records to enforce past-due payment of the CPA’s bill, even after the client has demanded they be returned.
D) The CPA firm’s partner-in-charge was arrested recently on his way home from the firm’s holiday party. He was a passenger in a car driven by his wife and she was charged with “driving while intoxicated.”
Answer
Terms: Act discreditable
Diff: Challenging
Objective: LO 4-7
AACSB: Reflective thinking skills

18) There are a number of offenses that may expel a CPA from membership in the AICPA. Which of the following is not one of these offenses?
A) The willful failure to file any income tax return that the CPA, as an individual taxpayer, is required by law to file.
B) The willful filing of a fraudulent income tax return on a client’s behalf.
C) Conviction of a crime punishable resulting in 6 months in incarceration.
D) The willful aiding in the preparation of a false and fraudulent income tax return.
Answer
Terms: Offenses to expel CPA
Diff: Challenging
Objective: LO 4-7
AACSB: Analytic skills

19) Rule 201 – General Standards requires members to comply with certain standards and interpretations. Which of the following is not a standard specifically addressed in Rule 201?
A) professional integrity
B) due professional care
C) planning and supervision
D) sufficient relevant data
Answer
Terms: Rule 201, General Standards
Diff: Challenging
Objective: LO 4-7
AACSB: Reflective thinking skills

20) Which of the following circumstances impairs an auditor’s independence?
I. Litigation by a client against an audit firm claiming a deficiency in the previous audit.
II. Litigation by a client against an audit firm related to tax services.
III. Litigation by an audit firm against a client claiming management fraud or deceit.
A) I and II
B) I and III
C) II and III
D) I, II, and III
Answer
Terms: Impair auditor independence
Diff: Challenging
Objective: LO 4-7
AACSB: Reflective thinking skills
21) Discuss Rule 301–Confidential Client Information, including the four exceptions to the rule.

22) Imprisonment for a period of six months or longer will result in automatic expulsion from the AICPA.
A) True
B) False
Answer
Terms: Imprisonment; Expulsion
Diff: Easy
Objective: LO 4-7
AACSB: Reflective thinking skills

23) Rule 505, Form of Organization and Name, prohibits CPA firms from practicing as limited liability partnerships.
A) True
B) False
Answer
Terms: Rule 505, Form of Organization and Name
Diff: Easy
Objective: LO 4-7
AACSB: Reflective thinking skills

24) Under Rule 505, Form of Organization and Name, a CPA firm may use any name as long as it is not misleading.
A) True
B) False
Answer
Terms: Rule 505, Form of Organization and Name
Diff: Easy
Objective: LO 4-7
AACSB: Reflective thinking skills
25) A CPA firm may practice public accounting only in a form of organization permitted by federal law or regulation.
A) True
B) False
Answer
Terms: Form of Organization
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

26) Under Rule 301, Confidential Client Information, permission is not required from the client to use the audit documentation relating to that client during an AICPA-authorized peer review program with another CPA firm.
A) True
B) False
Answer
Terms: Rule 301, Confidential Client Information
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

27) Information obtained by a CPA from a client is legally privileged in federal court.
A) True
B) False
Answer
Terms: Legally privileged information
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

28) Rule 502, Advertising and Other Forms of Solicitation, prohibits members of the AICPA in public practice from performing comparative advertising.
A) True
B) False
Answer
Terms: Rule 502, Advertising and Other Forms of Solicitation
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

29) Under Rule 505, Form of Organization and Name, a CPA firm may not designate itself as “Members of the American Institute of Certified Public Accountants” unless a majority of its owners are members of the Institute.
A) True
B) False
Answer
Terms: Rule 505, Form of Organization and Name
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills
30) Under the AICPA’s Code of Professional Conduct, CPAs are prohibited from offering audit clients a discount for referring a prospective client even if they are disclosed.
A) True
B) False
Answer
Terms: AICPA Code of Professional Conduct; Offer audit clients a discount
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

31) All owners of a CPA firm must be CPAs who are qualified to practice.
A) True
B) False
Answer
Terms: CPA qualified to practice
Diff: Moderate
Objective: LO 4-7
AACSB: Reflective thinking skills

Learning Objective 4-8

1) If the board of accountancy in the state in which a CPA firm is licensed has rules that are different than the AICPA’s rules, the CPA firm must follow:
A) whichever rules are less restrictive.
B) whichever rules are more restrictive.
C) the rules of the AICPA.
D) the rules of the state’s board of accountancy.
Answer
Terms: State rules which differ from AICPA rules
Diff: Moderate
Objective: LO 4-8
AACSB: Reflective thinking skills

2) Describe the methods used by the AICPA and State Boards of Accountancy to enforce the rules of conduct.
3) Expulsion from the AICPA for failing to follow the rules of conduct is, by itself, sufficient to prevent a CPA from practicing public accounting.
A) True
B) False
Answer
Terms: Expulsion from AICPA for failing to follow rules of conduct
Diff: Moderate
Objective: LO 4-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 5 Legal Liability

Learning Objective 5-1

1) Discuss three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs.

Learning Objective 5-2

1) A(n) ________ failure occurs when an auditor issues an erroneous opinion because it failed to comply with requirements of auditing standards.
A) business
B) audit
C) ethics
D) process
Answer
Terms: Failure which occurs when an auditor issues an erroneous opinion
Diff: Easy
Objective: LO 5-2
AACSB: Reflective thinking skills

2) Distinguish between what is meant by business failure and audit failure.
Answerusiness failure occurs when a business is unable to repay its lenders or meet expectations of its investors because of economic or business conditions, such as recession, poor management decisions, or unexpected competition in the industry. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.
Terms: Business failure and audit failure
Diff: Easy
Objective: LO 5-2
AACSB: Reflective thinking skills
3) Audit risk is the risk there will be an audit failure for a given audit engagement.
A) True
B) False
Answer
Terms: Audit risk
Diff: Moderate
Objective: LO 5-2
AACSB: Reflective thinking skills

4) The term “audit failure” refers to the situation when the auditor has followed auditing standards yet still fails to discover that the client’s financial statements are materially misstated.
A) True
B) False
Answer
Terms: Audit failure; Followed audit standards and fail to discover material misstatement
Diff: Moderate
Objective: LO 5-2
AACSB: Reflective thinking skills

Learning Objective 5-3

1) In the performance of an audit, a CPA:
A) is legally liable for not detecting client fraud.
B) must strictly follow GAAS for privately held clients.
C) must strictly follow PCAOB auditing standards for publicly held clients.
D) must exercise due professional care in the performance of their audit responsibilities.
Answer
Terms: Performance of an audit
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

2) Auditors who fail to exercise due care in their performance of professional services may be liable for:
A) punitive liability.
B) breach of contract.
C) excess liability.
D) criminal charges.
Answer
Terms: Liability when auditors fail to exercise due care
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

3) Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intent to deceive financial statement users. This description is the legal term for:
A) ordinary negligence.
B) gross negligence.
C) constructive fraud.
D) fraud.
Answer
Terms: Legal term for reckless in an audit with not intent to deceive
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

4) The standard of due care to which the auditor is expected to adhere to in the performance of the audit is referred to as the:
A) prudent person concept.
B) common law doctrine.
C) due care concept.
D) vigilant person concept.
Answer
Terms: Standard of due care
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

5) Auditors may be liable to their clients for:
A)
Punitive damages Compensatory damages
Yes Yes

B)
Punitive damages Compensatory damages
No No

C)
Punitive damages Compensatory damages
Yes No

D)
Punitive damages Compensatory damages
No Yes

Answer
Terms: Auditor liability to clients
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

6) Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include:
A) employees of the CPA firm.
B) employees of the audit client.
C) other CPA firms engaged to do part of the audit work.
D) specialists employed by the CPA firm to provide technical advice on the audit.
Answer
Terms: Laws of agency. Partners of CPA firm liable for work of others on whom they rely
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

7) “Absence of reasonable care that can be expected of a person in a set of circumstances” defines:
A) pecuniary negligence.
B) gross negligence.
C) extreme negligence.
D) ordinary negligence.
Answer
Terms: Absence of reasonable care
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

8) An example of a breach of contract would likely include:
A) an auditor’s refusal to return the client’s general ledger book until the client paid last year’s audit fees.
B) a bank’s claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan.
C) a CPA firm’s failure to complete an audit on the agreed-upon date because the firm had a backlog of other work which was more lucrative.
D) an auditor’s claim that the client staff is unqualified.
Answer
Terms: Breach of contract
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

9) Privity of contract exists between:
A) auditor and the federal government.
B) auditor and third parties.
C) auditor and client.
D) auditor and client attorney.
Answer
Terms: Privity of contract
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

10) An individual who is not party to the contract between a CPA and the client, but who is known by both and is intended to receive certain benefits from the contract is known as:
A) a third party.
B) a common law inheritor.
C) a tort.
D) a third-party beneficiary.
Answer
Terms: Individual who is not a party to the contract between a CPA and client, but who is known
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

11) Laws that have been passed by the U.S. Congress and other governmental units are:
A) statutory laws.
B) judicial laws.
C) federal laws.
D) common laws.
Answer
Terms: Laws passed through state legislatures
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

12) The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing is called:
A) separate and proportionate liability.
B) shared liability.
C) unitary liability.
D) joint and several liability.
Answer
Terms: Assessment against a defendant of the full loss suffered by a plaintiff
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

13) The assessment against a defendant of that portion of the damage caused by the defendant’s negligence is called:
A) separate and proportionate liability.
B) joint and several liability.
C) shared liability.
D) unitary liability.
Answer
Terms: Assessment against a defendant of that portion of the damages
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

14) Audit fraud occurs when:
A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive.
B) a misstatement is made and there is knowledge of its falsity but no intent to deceive.
C) the auditor lacks even slight care in the performance in performing the audit.
D) the auditor has an absence of reasonable care in the performance of the audit.
Answer
Terms: Audit fraud
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

15) Which of the following most accurately describes constructive fraud?
A) Absence of reasonable care
B) Lack of slight care
C) Knowledge and intent to deceive
D) Extreme or unusual negligence without the intent to deceive
Answer
Terms: Describes constructive fraud
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

16) Which of the following most accurately describes fraud?
A) Absence of reasonable care
B) Lack of slight care
C) Knowledge and intent to deceive
D) Extreme or unusual negligence without the intent to deceive
Answer
Terms: Describes fraud
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

17) A third-party beneficiary is one which:
A) has failed to establish legal standing before the court.
B) does not have privity of contract and is unknown to the contracting parties.
C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract.
D) may establish legal standing before the court after a contract has been consummated.
Answer
Terms: Third-party beneficiary
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

18) If the CPA negligently failed to properly prepare and file a client’s tax return, the CPA may be liable for:
A) the penalties the client owes the IRS.
B) the penalties and interest the client owes.
C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged.
D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid.
Answer
Terms: Liability when a CPA negligently failed to properly prepare and file tax return
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

19) Which of the following, if present, would most likely support a finding of constructive fraud on the part of a CPA?
A) Gross negligence in applying GAAS
B) Ordinary negligence in applying GAAS
C) Lack of duty to perform
D) Contributory negligence
Answer
Terms: Support a finding of constructive fraud
Diff: Moderate
Objective: LO 5-3
AACSB: Analytic skills

20) Which of the following statements is true?
A)
Gross negligence may constitute constructive fraud Fraud requires the intent to deceive All fraud should be detected during audit
Yes Yes No

B)
Gross negligence may constitute constructive fraud Fraud requires the intent to deceive All fraud should be detected during audit
No Yes No

C)
Gross negligence may constitute constructive fraud Fraud requires the intent to deceive All fraud should be detected during audit
Yes No Yes

D)
Gross negligence may constitute constructive fraud Fraud requires the intent to deceive All fraud should be detected during audit
No No No

Answer
Terms: Gross negligence, fraud, and constructive fraud
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills
21) When performing an audit the CPA is required to:
A) exercise the level of care of a reasonably prudent CPA.
B) strictly adhere of GAAS.
C) strictly be liable for detection of material misstatements in the financial statements.
D) avoid gross negligence in the performance of their duties.
Answer
Terms: Performing an audit CPA required to
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

22) Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant. Elise was negligent while auditing several of the firm’s clients. Under these circumstances, which of the following statements is true?
A) Elise would have no personal liability for negligence.
B) Gregory & Hedrick is not liable for Elise’s negligence because CPAs are generally considered to be independent contractors.
C) Gregory & Hedrick would not be liable for Elise’s negligence if Winters disobeyed specific instructions in the performance of the audits.
D) Gregory & Hedrick can recover against its insurer on its malpractice policy even if one of the partners was also negligent in reviewing Elise’s work.
Answer
Terms: Auditor negligent while auditing
Diff: Challenging
Objective: LO 5-3
AACSB: Reflective thinking skills

23) Define ordinary negligence, gross negligence, and constructive fraud.

24) An important concept in contract law for accountants to understand is the “third-party beneficiary doctrine”. Explain and give an example.
Answer third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement.
Terms: Contract law; Third-party beneficiary doctrine
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills
25) Distinguish between constructive fraud and fraud.
Answeronstructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive.
Terms: Constructive fraud and fraud
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

26) Distinguish between “joint and several liability” and “separate and proportionate liability.”

27) Match seven of the legal terms (a-j) with the definitions provided below (1-7):

a. Common law
b. Constructive fraud
c. Breach of contract
d. Joint and several liability
e. Ordinary negligence
f. Third-party beneficiary
g. Gross negligence
h. Statutory law
i. Fraud
j. Separate and proportionate liability

________ 1. Laws that have been passed by the U.S. Congress and other governmental units.

________ 2. Absence of reasonable care that can be expected of a person in a set of circumstances.

________ 3. Lack of even slight care, tantamount to reckless behavior that can be expected of a person.

________ 4. The assessment against a defendant of that portion of the damage caused by the defendant’s negligence.

________ 5. Failure of one or both parties in a contract to fulfill the requirements of the contract.

________ 6. The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing.

________ 7. Existence of extreme or unusual negligence even though there was no intent to deceive or do harm; also termed recklessness.

28) The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept.
A) True
B) False
Answer
Terms: Standard of due care; Prudent person concept
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

29) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s actions does not extend to another partner’s personal assets.
A) True
B) False
Answer
Terms: CPA firm operating as a limited liability partnership
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

30) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner’s actions does extend to the firm’s assets.
A) True
B) False
Answer
Terms: CPA firm operating as a limited liability partnership
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills

31) Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units.
A) True
B) False
Answer
Terms: Statutory laws
Diff: Easy
Objective: LO 5-3
AACSB: Reflective thinking skills
32) The doctrine of joint and several liability is one factor that has contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs.
A) True
B) False
Answer
Terms: Doctrine of joint and several liability; Contributed to increase in lawsuits
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

33) Several states have statutes that permit privileged communication between the client and auditor, allowing a CPA to refuse to testify in state and federal courts.
A) True
B) False
Answer
Terms: CPA and privileged communication
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

34) Gross negligence is the existence of extreme or unusual negligence with the intent to deceive.
A) True
B) False
Answer
Terms: Gross negligence; Extreme or unusual negligence; Intent to deceive
Diff: Moderate
Objective: LO 5-3
AACSB: Reflective thinking skills

Learning Objective 5-4

1) Audit contracts (engagement letters):
A) may be either oral or written.
B) must be written.
C) must be written and notarized.
D) must be written if the client is regulated by the Securities and Exchange Commission.
Answer
Terms: Audit contracts; Engagement letters
Diff: Easy
Objective: LO 5-4
AACSB: Reflective thinking skills

2) In third-party suits, which of the auditor’s defenses contends lack of privity of contract?
A) Lack of duty
B) Non-negligent performance
C) Contributory negligence
D) Absence of causal connections
Answer
Terms: Third-party suits; Auditor defenses contends lack of privity contract
Diff: Easy
Objective: LO 5-4
AACSB: Reflective thinking skills

3) In connection with the audit of financial statements, an independent auditor could be responsible for failure to detect a material fraud if:
A) statistical sampling techniques were not used on the audit engagement.
B) the auditor planned the audit in a negligent manner.
C) accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier.
D) the fraud was perpetrated by one employee who circumvented the existing internal controls.
Answer
Terms: Independent auditor could be responsible for failure to detect material fraud
Diff: Easy
Objective: LO 5-4
AACSB: Reflective thinking skills

4) Which of the following is an illustration of liability to clients under common law?
A) Client sues auditor for not discovering a theft of assets by an employee.
B) Bank sues auditor for not discovering that borrower’s financial statements are misstated.
C) Combined group of stockholders sue auditor for not discovering materially misstated financial statements.
D) Federal government prosecutes auditor for knowingly issuing an incorrect audit report.
Answer
Terms: Liability to clients under common law
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

5) Which of the following is an illustration of liability under the federal securities acts?
A) Client sues auditor for not discovering a theft of assets by an employee.
B) Bank sues auditor for not discovering that borrower’s financial statements are misstated.
C) Combined group of stockholders sue auditor for not discovering materially misstated financial statements.
D) auditor sues client for not cooperating during engagement.
Answer
Terms: Liability under federal securities acts
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

6) A CPA firm normally uses one or a combination of four defenses when there are legal claims by clients. Which one of the following is generally not a defense?
A) Lack of duty
B) Non-negligent performance
C) Contributory negligence
D) Foreseeable users
Answer
Terms: Defenses when there are legal claims
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills
7) The legal term for when an auditor issues an opinion of an audit, knowing that an adequate audit was not performed is called?
A) breach of contract
B) tort action for negligence
C) constructive fraud
D) fraud
Answer
Terms: Failure of party to meet its obligations, causing injury to another party
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

8) Tort actions against CPAs are more common than breach of contract actions because:
A) there are more torts than contracts.
B) the burden of proof is on the auditor rather than on the person suing.
C) the person suing need prove only negligence.
D) the amounts recoverable are normally larger.
Answer
Terms: Tort actions against CPAs are more common than breach of contract
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

9) The principal issue to be resolved in cases involving alleged negligence is usually:
A) the amount of the damages suffered by plaintiff.
B) whether to impose punitive damages on defendant.
C) the level of care exercised by the CPA.
D) whether defendant was involved in fraud.
Answer
Terms: Principal issue to be resolved in cases involving alleged negligence
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

10) In the auditing environment, failure to meet auditing standards is often:
A) an accepted practice.
B) a suggestion of negligence.
C) conclusive evidence of negligence.
D) tantamount to criminal behavior.
Answer
Terms: Failure to meet auditing standards
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

11) A common way for a CPA firm to demonstrate its lack of duty to perform is by use of a(n):
A) expert witness’ testimony.
B) audit contract, or engagement letter.
C) management representation letter.
D) confirmation letter.
Answer
Terms: Common way to demonstrate lack of duty to perform
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

12) To succeed in an action against the auditor, the client must be able to show that:
A) the auditor was fraudulent.
B) the auditor was grossly negligent.
C) there was a written contract.
D) there is a close causal connection between the auditor’s behavior and the damages suffered by the client.
Answer
Terms: To succeed in an action against the auditor, client must show that
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

13) Matthews & Co., CPAs, issued an unqualified opinion on Dodgers Corporation. Millennium Bank, which relied on the audited financial statements, granted a loan of $200,00,000 to Dodgers Corporation. Dodgers subsequently defaulted on the loan. To succeed in an action against Matthews & Co., Millennium Bank must prove that the bank was:
A) in privity of contract with Dodgers.
B) in privity of contract with Millennium.
C) free from contributory negligence.
D) justified in relying on the financial statements in granting the loan.
Answer
Terms: Legal action where bank relied audited financial statements, granted loan on which customer defaulted
Diff: Challenging
Objective: LO 5-4
AACSB: Analytic skills

14) The preferred defense in third-party suits is:
A) lack of duty to perform.
B) non-negligent performance.
C) absence of causal connection.
D) client fraud.
Answer
Terms: Preferred defense in third-party suits
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

15) One of the changes in auditing procedure which was brought about as a result of the 1136 Tenants case was that auditors were encouraged to begin using:
A) letters of representation.
B) confirmation letters.
C) engagement letters.
D) billet doux letters.
Answer
Terms: Audit procedure brought about by 1136 Tenants case
Diff: Challenging
Objective: LO 5-4
AACSB: Reflective thinking skills

16) The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson’s auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt’s best defense?
A) King is not in privity of contract.
B) The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards.
C) Lynch & Merritt were not guilty either of gross negligence or fraud.
D) Lynch & Merritt were not aware of the King-Wilson surety relationship.
Answer
Terms: Defense in recovery against auditors with employee theft
Diff: Challenging
Objective: LO 5-4
AACSB: Analytic skills

17) There are four major sources of an auditor’s legal liability. One source is liability to the audit client. List the other three sources.

18) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Which of these defenses is ordinarily not available against third-party suits?

19) An example of auditor legal liability to third parties under common law would be the federal government prosecuting an auditor for knowingly issuing an incorrect audit report.
A) True
B) False
Answer
Terms: Legal liability to third parties under common law
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

20) The 1136 Tenants case was a criminal case concerning a CPA’s failure to uncover fraud during a financial statement audit.
A) True
B) False
Answer
Terms: 1136 Tenants case
Diff: Moderate
Objective: LO 5-4
AACSB: Reflective thinking skills

21) The preferred defense in third-party suits is absence of causal connection.
A) True
B) False
Answer
Terms: Preferred defense in third-party suits; Absence of causal connection
Diff: Challenging
Objective: LO 5-4
AACSB: Reflective thinking skills

Learning Objective 5-5

1) A financial institution sues the audit firm for failure to discover that a borrower’s financial statements are materially misstated. This is an example of which of the following legal liability concepts?
A) Liability to clients
B) Liability to 3rd parties under common law
C) Civil liability under federal securities law
D) Criminal liability
Answer
Terms: Legal liability in audit of financial statements that are materially misstated
Diff: Easy
Objective: LO 5-5
AACSB: Reflective thinking skills

2) Which of the following auditor’s defenses usually means non-reliance on the financial statements by the user?
A) Lack of duty
B) Non-negligent performance
C) Absence of causal connections
D) Contributory negligence
Answer
Terms: Auditor defenses which means non-reliance on the financial statements
Diff: Easy
Objective: LO 5-5
AACSB: Analytic skills

3) A group typically included as “third parties” in common law is:
A)
Actual and potential stockholders Employees of client
Yes Yes

B)
Actual and potential stockholders Employees of client
No No

C)
Actual and potential stockholders Employees of client
Yes No

D)
Actual and potential stockholders Employees of client
No Yes

Answer
Terms: Third-parties in common law
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills
4) The major conclusion of the 1931 Ultramares case was that:
A) ordinary negligence is insufficient for liability to third parties.
B) ordinary negligence is sufficient for liability to third-party beneficiaries.
C) fraud or gross negligence is sufficient for liability to third parties.
D) auditors have no liabilities to third parties.
Answer
Terms: Major conclusion of 1931 Ultramares case
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

5) Under common law, a foreseen user would be treated the same as:
A)
A primary beneficiary A known third party
Yes Yes

B)
A primary beneficiary A known third party
No No

C)
A primary beneficiary A known third party
Yes No

D)
A primary beneficiary A known third party
No Yes

Answer
Terms: Foreseen user under common law treated the same as
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

6) A broad interpretation of the rights of third-party beneficiaries holds that users that the auditor should have been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. This is known as the concept of:
A) foreseen users.
B) foreseeable users.
C) expected users.
D) four-party contracts.
Answer
Terms: Rights of third-party beneficiaries; Privity of contract
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

7) Which of the auditor’s defenses is ordinarily not available when lawsuits are filed by a third party?
A) Absence of causal connections
B) Contributory negligence
C) Non-negligent performance
D) Lack of duty
Answer
Terms: Auditor defenses not available when lawsuits filed by a third party
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

8) According to the principle established by the Restatement of Torts case, foreseen users must be members of:
A) any potential user group.
B) a legally protected class.
C) a reasonably limited and identifiable user group.
D) a reasonably limited and established user group.
Answer
Terms: Principle established by Restatement of Torts; Foreseen users must be members
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

9) In an action against a CPA in a jurisdiction that follows the Ultramares doctrine, lack of privity is a viable defense provided the plaintiff:
A) is the client’s creditor who sued the CPA for negligence.
B) can prove gross negligence.
C) violated the Securities Act of 1933.
D) violated the Securities Act of 1934.
Answer
Terms: Ultramares doctrine; Lack of privity is viable defense
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

10) Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor’s report to make decisions about the client company has:
A) no rights unless an auditor is grossly negligent.
B) no rights unless an auditor is fraudulent.
C) no rights against an auditor.
D) the same rights against an auditor as a client.
Answer
Terms: Common law third-party rights
Diff: Challenging
Objective: LO 5-5
AACSB: Analytic skills

11) The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was that:
A) the auditor’s defense of privity of contract is still valid against third parties.
B) the auditor is liable for ordinary negligence to specifically foreseen third parties.
C) the auditor is liable for ordinary negligence to reasonably foreseeable third parties.
D) the auditor’s defense of contributory negligence is no longer valid.
Answer
Terms: Basic legal concept affirmed in 1985 case, Credit Alliance
Diff: Challenging
Objective: LO 5-5
AACSB: Analytic skills

12) The partnership of Booth & Haynes, CPAs, has been engaged to examine the financial statements of Paul, Inc., in connection with the registration of Paul’s securities with the Securities and Exchange Commission. Under these circumstances, which of the following statements is true?
A) Booth & Haynes is assuming much greater third-party liability than it assumes on engagements under common law.
B) If its examination is not fraudulent, Booth & Haynes may issue an appropriate disclaimer to the financial statements and thereby avoid liability.
C) Booth & Haynes must incorporate if they wish to practice before the SEC.
D) Booth & Haynes must be a large interstate firm if they wish to practice before the SEC.
Answer
Terms: CPAs engaged to examine financial statements in connection with registration of securities with the Securities and Exchange Commission
Diff: Challenging
Objective: LO 5-5
AACSB: Analytic skills

13) As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company’s controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft?
A) He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees.
B) He would have no liability because privity of contract is lacking.
C) He would be liable for losses attributable to his negligence.
D) He would be liable only if it could be proven that he was grossly negligent.
Answer
Terms: Under common law, extent of liability where auditor failed to adhere to generally accepted auditing standards in examination of client and failed to detect employee embezzlement
Diff: Challenging
Objective: LO 5-5
AACSB: Analytic skills

14) Three approaches to the application of the foreseen users’ concept are (1) the Credit Alliance approach, (2) the restatement of torts approach, and (3) the foreseeable user approach. Summarize each of these three approaches.

15) Of the three approaches to applying the concept of foreseen users (Credit Alliance approach, restatement of torts approach, and foreseeable user approach), the approach followed by the most states is the Credit Alliance approach.
A) True
B) False
Answer
Terms: Credit Alliance approach; Restatement of torts approach; Foreseeable user approach
Diff: Moderate
Objective: LO 5-5
AACSB: Reflective thinking skills

16) The restatement of torts approach to the concept of foreseen users states that any users that the auditor should have reasonably been able to foresee as being likely users of financial statements have the same rights as those with privity of contract.
A) True
B) False
Answer
Terms: Restatement of torts approach; Foreseen users; Privity of contract
Diff: Challenging
Objective: LO 5-5
AACSB: Reflective thinking skills

17) The Credit Alliance approach to the concept of foreseen users states that to be liable to third parties, an auditor (1) must know and intend that the work product would be used by the third-party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor’s conduct.
A) True
B) False
Answer
Terms: Credit Alliance approach; Foreseen users; Liability to third parties
Diff: Challenging
Objective: LO 5-5
AACSB: Reflective thinking skills

Learning Objective 5-6

1) Which of the following required an adequate system of internal control for SEC registrants?
A) Sarbanes-Oxley Act of 2002
B) Securities Act of 1933
C) Foreign Corrupt Practices Act of 1977
D) Securities Act of 1934
Answer
Terms: Required an adequate system of internal control for SEC registrants
Diff: Easy
Objective: LO 5-6
AACSB: Reflective thinking skills

2) The increased litigation under the federal securities laws has resulted from:
A)
The availability of class-action litigation The strict liability standards imposed on CPAs by the securities laws An excess of attorneys
Yes Yes Yes

B)
The availability of class-action litigation The strict liability standards imposed on CPAs by the securities laws An excess of attorneys
Yes No No

C)
The availability of class-action litigation The strict liability standards imposed on CPAs by the securities laws An excess of attorneys
Yes Yes No

D)
The availability of class-action litigation The strict liability standards imposed on CPAs by the securities laws An excess of attorneys
No No No

Answer
Terms: Increased litigation under federal securities law resulted from
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills
3) Under the Securities Act of 1933, the auditor’s responsibility for making sure the financial statements were fairly stated extends to:
A) the date of the financial statements.
B) the date the registration statement becomes effective.
C) the date of the audit report.
D) one year beyond the date of the financial statements.
Answer
Terms: Securities Act of 1933; Auditor responsibility for making sure financial statements were fairly stated extends
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

4) Under the Securities Exchange Act of 1934, which type of organization is required to submit audited financial statements to the SEC?
A) Every company with securities traded on national and over-the-counter exchanges.
B) Every corporation.
C) Every company issuing new securities.
D) Every corporation which is chartered by a state government.
Answer
Terms: Securities Act of 1934; Organizations required to submit audited financial statements
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

5) The Securities and Exchange Commission can impose all but which of the following sanctions?
A) Suspend a CPA from auditing SEC clients.
B) Prohibit a CPA from accepting new SEC clients for a period of time.
C) Require a CPA to participate in continuing-education programs and make changes in their practice.
D) Revoke a CPA license.
Answer
Terms: Securities and Exchange Commission can impose sanctions
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

6) The Foreign Corrupt Practices Act (FCPA) of 1977:
A) requires auditors to review and evaluate systems of internal control as a part of an audit.
B) requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control.
C) requires auditors to review client’s internal control system in a manner which is thorough enough to judge whether client meets the requirements of the FCPA.
D) requires auditors to file a report with the SEC if client’s internal control system is inadequate.
Answer
Terms: Foreign Corrupt Practices Act of 1977
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills
7) While the Foreign Corrupt Practices Act of 1977 remains in effect, its internal control provisions have been largely superseded by which of the following?
A) The Sarbanes-Oxley Act of 2002
B) The Racketeer Influenced and Corrupt Organization Act
C) The Federal False Statements Statute
D) The Federal Mail Fraud Statute
Answer
Terms: Foreign Corrupt Practices Act of 1977; Internal control provisions
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills
Topic: SOX

8) Which of the following is not likely a factor in the increase in the number of lawsuits and sizes of awards to plaintiffs related to auditor behavior?
A) Increased awareness of auditor responsibilities by users of financial statements.
B) CPA firms are more willing to settle lawsuits.
C) Difficulty judges and jurors have in understanding legal matters.
D) Increased consciousness on the part of the SEC for its responsibility to protect investors.
Answer
Terms: Factor in increase in number of lawsuits and sizes of awards
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

9) A major purpose of federal securities regulations is to:
A) provide sufficient reliable information to the investing public who purchase securities in the marketplace.
B) establish the qualifications for accountants who are members of the profession.
C) eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public.
D) provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission.
Answer
Terms: Major purpose of federal securities regulations
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

10) The leading precedent-setting auditing case in third-party liability is:
A) Escott et al. v. Bar Chris Construction Corp.
B) Hochfelder v. Ernst & Ernst.
C) Ultramares Corporation v. Touche.
D) United States v. Simon.
Answer
Terms: Leading precedent-setting auditing case in third-party liability
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills
11) Which of the following statements about the Securities Act of 1933 is not true?
A) A third-party that purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in the audited financial statements.
B) A third-party user does not have the burden of proof that he/she relied on the financial statements.
C) A third-party user has the burden of proof that the auditor was either negligent or fraudulent in doing the audit.
D) A third-party user does not have the burden of proof that the loss was caused by the misleading statements.
Answer
Terms: Securities Act of 1933
Diff: Challenging
Objective: LO 5-6
AACSB: Analytic skills
12) The most significant audit issue that came as a result of the court decision in the Escott et al. v. Bar Chris Construction Corporation case in 1968 was:
A) the court’s reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent.
B) the affirmation of the increased auditor’s responsibility when performing an S-1 review, a review of events subsequent to the balance sheet, for registration statements.
C) the increased auditor responsibility when associated with unaudited financial statements.
D) the court’s refusal to allow the percentage-of-completion method of accounting for revenues.
Answer
Terms: Significant audit issue from Escott et al v. Bar Chris Construction Corporation case in 1968
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills

13) Under the federal securities acts, one significant result occurring directly due to the Escott et al. v. Bar Chris Construction Corporation case was that SAS was changed to require:
A) greater emphasis on subsequent events procedures.
B) new standards for unaudited statements.
C) a broader definition of third-party beneficiaries.
D) more companies to file annual reports with the SEC.
Answer
Terms: Significant result from Escott et al v. Bar Chris Construction Corporation case
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills
14) Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor’s involvement with the:
A) 8-K form.
B) 10-K form.
C) 10-Q form.
D) S-1 form.
Answer
Terms: Securities Exchange Act of 1934
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills

15) Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as:
A) the antifraud provisions.
B) the new issues provisions.
C) the full-employment act for accountants.
D) the RICO provisions.
Answer
Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills

16) In a leading securities law and CPA liabilities case, the U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, what would be required to be shown to the court was the auditor’s:
A) ordinary negligence.
B) gross negligence.
C) knowledge and intent to deceive.
D) financial gain at the expense of the plaintiff.
Answer
Terms: Securities Exchange Act of 1934 Rule 10b-5; U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills

17) The Sarbanes-Oxley Act of 2002 makes it felony to destroy or create documents to impede or obstruct a federal investigation. Those provisions were adopted following which of the following legal cases?
A) United States v. Natelli
B) United States v. Andersen
C) ESM Government Securities v. Alexander Grant & Co.
D) United States v. Simon
Answer
Terms: Similarity between United States v. Natelli case (i.e., the National Student Marketing case of 1975), and the ESM Government Securities v. Alexander Grant & Co. case of 1986
Diff: Challenging
Objective: LO 5-6
AACSB: Analytic skills
18) The Securities and Exchange Commission has authority to:
A) prescribe specific auditing procedures to detect fraud concerning inventories and accounts receivable of companies engaged in interstate commerce.
B) deny lack of privity as a defense in third-party actions for gross negligence against the auditors of public companies.
C) determine accounting principles for the purpose of financial reporting by companies offering securities to the public.
D) require a change of auditors of governmental entities after a given period of years as a means of ensuring auditor independence.
Answer
Terms: Securities and Exchange Commission authority
Diff: Challenging
Objective: LO 5-6
AACSB: Reflective thinking skills

19) Discuss the sanctions the Securities and Exchange Commission can impose on auditors.

20) One result from the Escott et al. v. Bar Chris case was a greater emphasis being placed on audit staff understanding the client’s business and industry.
A) True
B) False
Answer
Terms: Result from Escott et al. v. Bar Chris
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

21) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities.
A) True
B) False
Answer
Terms: Securities Act of 1933
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills
22) Under the Securities Act of 1933, a third-party plaintiff does not have the burden of proof that he or she relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Rather, the plaintiff need only prove that the audited financial statements contained a material misrepresentation or omission.
A) True
B) False
Answer
Terms: Securities Act of 1933; Burden of proof
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

23) Companies with securities traded on national and over-the-counter exchanges are required to submit audited financial statements once every three years to the Securities and Exchange Commission.
A) True
B) False
Answer
Terms: Securities Act Commission; Securities traded on national exchanges
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

24) The same three defenses available to auditors in common lawsuits by third parties-non-negligent performance, lack of duty, and absence of causal connection–are also available for suits under the Securities Exchange Act of 1934.
A) True
B) False
Answer
Terms: Securities Act of 1934; Defenses available to auditors in common law suits by third parties
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

25) The United States Supreme Court has ruled that outside professionals such as accountants who don’t help run corrupt businesses cannot be sued under the provisions of the Foreign Corrupt Practices Act.
A) True
B) False
Answer
Terms: United States Supreme Court; Foreign Corrupt Practices Act
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills
26) The Foreign Corrupt Practices Act of 1977 allows an injured party to seek treble (triple) damages and recovery of legal fees in cases where it can be demonstrated that the defendant was engaged in a pattern of fraudulent activity.
A) True
B) False
Answer
Terms: Foreign Corrupt Practices Act of 1977
Diff: Moderate
Objective: LO 5-6
AACSB: Reflective thinking skills

Learning Objective 5-7

1) In which case were auditors prosecuted for filing false financial statements for a client with the government?
A) 1136 Tenants case
B) United States v. Simon case
C) Escott et al. v. Bar Chris case, aka Bar Chris
D) Ultramares Corporation v. Touche case
Answer
Terms: Case where auditors were prosecuted for filing false financial statements
Diff: Moderate
Objective: LO 5-7
AACSB: Reflective thinking skills

2) A CPA is subject to criminal liability if the CPA:
A) refuses to turn over requested audit documentation to a client.
B) performs an audit in a negligent manner.
C) willfully omits a material fact from a set of financial statements.
D) willfully breaches a contract with a client.
Answer
Terms: CPA subject to criminal liability
Diff: Moderate
Objective: LO 5-7
AACSB: Reflective thinking skills

3) Which of the following best describes a trend in litigation involving CPAs?
A) A CPA cannot render an opinion unless the CPA has audited all affiliates of a company.
B) A CPA may not successfully assert that the CPA had no motive to be part of a fraud.
C) A CPA may be exposed to criminal as well as civil liability.
D) A CPA is primarily responsible for a client’s footnotes filed with the SEC.
Answer
Terms: Trend in litigation involving CPAs
Diff: Moderate
Objective: LO 5-7
AACSB: Reflective thinking skills

4) CPAs can be held liable for criminal activity under both state and federal laws. Infamous cases have involved United States vs. Natelli and ESM Government Securities v. Alexander Grant and Co. Discuss what occurred and prepare a summary of the court findings.

5) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to 10 years in prison.
A) True
B) False
Answer
Terms: Sarbanes-Oxley Act of 2002; Destruction of audit documentation punishable
Diff: Challenging
Objective: LO 5-7
AACSB: Reflective thinking skills
Topic: SOX

Learning Objective 5-8

1) Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation?
A) Private Securities Litigation Reform Act
B) Public Securities Damages and Settlements Act
C) Racketeer Influenced and Corrupt Organization Act
D) U.S. Securities Claims Reform Act
Answer
Terms: Federal law passé in 1995 significantly reduced potential damages
Diff: Challenging
Objective: LO 5-8
AACSB: Reflective thinking skills

2) The Private Securities Litigation Reform Act of 1995 reduced potential damages in securities-related litigation, but because the act applied only to federal courts, attorneys began taking cases to state courts. Which of the following eliminated this loophole?
A) Private Securities Litigation Reform Amendment
B) Securities Litigation Uniform Standards Act of 1998
C) Racketeer Influenced and Corrupt Organization Act
D) U.S. Securities Claims Reform Act
Answer
Terms: Private Securities Litigation Reform Act of 1995; Eliminated loophole
Diff: Challenging
Objective: LO 5-8
AACSB: Reflective thinking skills

3) Discuss at least 3 steps the AICPA and the accounting profession as a whole can and are taking to reduce the practitioner’s exposure to lawsuits.

4) Match eight of the following terms (a-n) with the definitions provided below (1-8):

a. Foreign Corrupt Practices Act
b. Securities Exchange Act of 1934
c. Securities Litigation Uniform Standards Act of 1998
d. Securities Act of 1933
e. Ultramares doctrine
f. Audit risk
g. Audit failure
h. Standards failure
i. Business failure
j. Absence of causal connection
k. Contributory negligence
l. Lack of duty to perform
m. Private Securities Litigation Reform Act
n. Nonnegligent performance

________ 1. A situation in which an incorrect audit opinion is issued because it failed to comply with the requirements of auditing standards.

________ 2. A federal statute dealing with companies that trade securities on national and over-the-counter exchanges. Auditors are involved because the annual reporting requirements include audited financial statements.

________ 3. An auditor’s legal defense under which the auditor claims that the client’s own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss.

________ 4. A federal statute that makes it illegal to offer a bribe to an official of a foreign country.

________ 5. A common-law approach to third-party liability in which ordinary negligence is insufficient for liability to third parties, because of the lack of privity of contract between the third-party and the auditor unless the third-party is a primary beneficiary.

________ 6. A federal statute designed to significantly reduce the potential damages in federal securities-related litigation by providing for proportionate liability in most cases.

________ 7. An auditor’s legal defense under which the auditor claims that the audit was performed in accordance with generally accepted auditing standards.

________ 8. An auditor’s legal defense under which the auditor claims that the failure to follow auditing standards did not cause the damages suffered by the client.

5) Discuss some of the steps individual practicing auditors can take to minimize their legal liability.

6) The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to the amount of the audit fees charged.
A) True
B) False
Answer
Terms: Private Securities Litigation Reform Act of 1995
Diff: Easy
Objective: LO 5-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 6 The CPA Profession

Learning Objective 6-1

1) The objective of the ordinary audit of financial statements is the expression of an opinion on:
A) the fairness of the financial statements in all material respects.
B) the accuracy of the financial statements.
C) the accuracy of the annual report.
D) the accuracy of the balance sheet and income statement.
Answer
Terms: Objective of ordinary audit of financial statements
Diff: Easy
Objective: LO 6-1
AACSB: Reflective thinking skills

2) If the auditor believes that the financial statements are not fairly stated or is unable to reach a conclusion because of insufficient evidence, the auditor:
A) should withdraw from the engagement.
B) should request an increase in audit fees so that more resources can be used to conduct the audit.
C) has the responsibility of notifying financial statement users through the auditor’s report.
D) should notify regulators of the circumstances.
Answer
Terms: Auditor believes that financial statements are nor fairly presented
Diff: Easy
Objective: LO 6-1
AACSB: Reflective thinking skills

3) Auditors accumulate evidence to:
A) defend themselves in the event of a lawsuit.
B) justify the conclusions they have otherwise reached.
C) satisfy the requirements of the Securities Acts of 1933 and 1934.
D) enable them to reach conclusions about the fairness of the financial statements.
Answer
Terms: Auditors accumulate evidence
Diff: Easy
Objective: LO 6-1
AACSB: Reflective thinking skills

Learning Objective 6-2

1) The responsibility for adopting sound accounting policies and maintaining adequate internal control rests with the:
A) board of directors.
B) company management.
C) financial statement auditor.
D) company’s internal audit department.
Answer
Terms: Responsibility for adopting sound accounting policies and maintaining adequate internal controls
Diff: Easy
Objective: LO 6-2
AACSB: Reflective thinking skills
2) If the auditor insists on financial statement disclosures that the management finds unacceptable, the auditor can:
A)
Issue an adverse audit report Issue a qualified audit report
Yes Yes

B)
Issue an adverse audit report Issue a qualified audit report
No No

C)
Issue an adverse audit report Issue a qualified audit report
Yes No

D)
Issue an adverse audit report Issue a qualified audit report
No Yes

Answer
Terms: Auditor insists on financial statement disclosures that management finds unacceptable
Diff: Easy
Objective: LO 6-2
AACSB: Reflective thinking skills

3) In certifying their annual financial statements, the CEO and CFO of a public company certify that the financial statements comply with the requirements of:
A) GAAP.
B) the Sarbanes-Oxley Act.
C) the Securities Exchange Act of 1934.
D) GAAS.
Answer
Terms: Certifying annual financial statements by CEO and CFO
Diff: Easy
Objective: LO 6-2
AACSB: Reflective thinking skills
Topic: Public

4) Which of the following statements is true of a public company’s financial statements?
A) Sarbanes-Oxley requires the CEO only to certify the financial statements.
B) Sarbanes-Oxley requires the CFO only to certify the financial statements.
C) Sarbanes-Oxley requires the CEO and CFO to certify the financial statements.
D) Sarbanes-Oxley neither requires the CEO nor the CFO to certify the financial statements.
Answer
Terms: Public company’s financial statements
Diff: Easy
Objective: LO 6-2
AACSB: Reflective thinking skills
Topic: SOX
5) The responsibility for the preparation of the financial statements and the accompanying footnotes belongs to:
A) the auditor.
B) management.
C) both management and the auditor equally.
D) management for the statements and the auditor for the notes.
Answer
Terms: Responsibility for preparation of the financial statements and the accompanying footnotes
Diff: Moderate
Objective: LO 6-2
AACSB: Reflective thinking skills

6) Responsibility for the fair presentation of financial statements rests equally with management and the auditor.
A) True
B) False
Answer
Terms: Responsibility for fair presentation of financial statements
Diff: Easy
Objective: LO 6-2
AACSB: Reflective thinking skills

Learning Objective 6-3

1) The auditor’s best defense when material misstatements are not uncovered is to have conducted the audit:
A) in accordance with generally accepted auditing standards.
B) as effectively as reasonably possible.
C) in a timely manner.
D) only after an adequate investigation of the management team.
Answer
Terms: Auditors’ best defense when material misstatements are not uncovered
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

2) In order to provide reasonable assurance the audit must be performed with an attitude of professional skepticism. Which of the following is most correct regarding the “attitude” of professional skepticism?
A) auditors should assume that management is dishonest
B) auditors should assume that management is neither dishonest nor honest
C) auditors should assume that management is honest and mistakes are unintentional
D) auditors should assume that management is incumbent in preparing financial statements
Answer
Terms: Attitude of professional skepticism
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills
3) Which of the following is not one of the reasons that auditors provide only reasonable assurance on the financial statements?
A) The auditor commonly examines a sample, rather than the entire population of transactions.
B) Accounting presentations contain complex estimates which involve uncertainty.
C) Fraudulently prepared financial statements are often difficult to detect.
D) Auditors believe that reasonable assurance is sufficient in the vast majority of cases.
Answer
Terms: Reasons auditors provide only reasonable assurance on financial statements
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

4) Which of the following statements is most correct regarding errors and fraud?
A) An error is unintentional, whereas fraud is intentional.
B) Frauds occur more often than errors in financial statements.
C) Errors are always fraud and frauds are always errors.
D) Auditors have more responsibility for finding fraud than errors.
Answer
Terms: Errors and fraud
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

5) When an auditor believes that an illegal act may have occurred, the auditor should first:
A) inquire of management at a level above those likely to be involved.
B) consult with legal counsel of others knowledgeable about the illegal acts.
C) accumulate additional evidence.
D) withdraw from the engagement.
Answer
Terms: Auditor believes and illegal act may have occurred
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

6) The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not ________ are detected.
A) important to the financial statements
B) statistically significant to the financial statements
C) material to the financial statements
D) identified by the client
Answer
Terms: Auditor has no responsibility to plan and perform audit to obtain reasonable assurance
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills
7) Fraudulent financial reporting is most likely to be committed by whom?
A) line employees of the company
B) outside members of the company’s board of directors
C) company management
D) the company’s auditors
Answer
Terms: Fraudulent financial reporting
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

8) Which of the following would most likely be deemed a direct-effect illegal act?
A) violation of federal employment laws
B) violation of federal environmental regulations
C) violation of federal income tax laws
D) violation of civil rights laws
Answer
Terms: Direct-effect illegal act
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

9) The concept of reasonable assurance indicates that the auditor is:
A) not a guarantor of the correctness of the financial statements.
B) not responsible for the fairness of the financial statements.
C) responsible only for issuing an opinion on the financial statements.
D) responsible for finding all misstatements.
Answer
Terms: Concept of reasonable assurance
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

10) Which of the following is the auditor least likely to do when aware of an illegal act?
A) Discuss the matter with the client’s legal counsel.
B) Obtain evidence about the potential effect of the illegal act on the financial statements.
C) Contact the local law enforcement officials regarding potential criminal wrongdoing.
D) Consider the impact of the illegal act on the relationship with the company’s management.
Answer
Terms: Illegal acts
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills
11) Auditing standards require that an audit be designed to provide reasonable assurance of detecting:
A) material errors in the financial statements.
B) fraud in the financial statements.
C) material errors and fraud in the financial statements.
D) inadequate disclosure in the notes to the financial statements.
Answer
Terms: Professional skepticism
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

12) The auditor has considerable responsibility for notifying users as to whether or not the statements are properly stated. This imposes upon the auditor a duty to:
A) provide reasonable assurance that material misstatements will be detected.
B) be a guarantor of the fairness in the statements.
C) be equally responsible with management for the preparation of the financial statements.
D) be an insurer of the fairness in the statements.
Answer
Terms: Auditor responsibility for notifying users as to whether statements are properly stated
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

13) “The auditor should not assume that management is dishonest, but the possibility of dishonesty must be considered.” This is an example of:
A) unprofessional behavior.
B) an attitude of professional skepticism.
C) due diligence.
D) a rule in the AICPA’s Code of Professional Conduct.
Answer
Terms: Auditor should consider the possibility of dishonesty of management
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

14) If the auditor were responsible for making certain that all of management’s assertions in the financial statements were absolutely correct:
A) bankruptcies could no longer occur.
B) bankruptcies would be reduced to a very small number.
C) audits would be much easier to complete.
D) audits would not be economically practical.
Answer
Terms: Auditor responsible for making certain that all of management’s assertions were absolutely correct
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills
15) The auditor’s best defense when existing material misstatements in the financial statements are not uncovered in the audit is:
A) the audit was conducted in accordance with auditing standards.
B) the financial statements are the client’s responsibility.
C) the client is guilty of contributory negligence.
D) the client is guilty of fraudulent misrepresentation.
Answer
Terms: Auditor’s best defense when existing material misstatements in the financial statements
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

16) Which of the following is most correct with regard to the auditor’s search of indirect-effect illegal acts that may have been committed by the client?
A) No reason to search unless there is sufficient evidence to believe they have occurred.
B) Same audit responsibility as the search for financial statement fraud.
C) Same audit responsibility as the search for misappropriated assets.
D) No reason to search as they would have an indirect effect on the financial statements.
Answer
Terms: Indirect-effect illegal acts
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

17) Which of the following statements is usually true?
A) It is easier for the auditor to uncover fraud than errors.
B) It is easier for the auditor to uncover indirect-effect illegal acts than fraud.
C) The auditor’s responsibility for detecting direct-effect illegal acts is similar to the responsibility to detect fraud.
D) The auditor’s responsibility for detecting indirect-effect illegal acts is similar to the responsibility to detect fraud.
Answer
Terms: Auditors responsibility for detecting/uncovering misstatements
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

18) Which is the following is most correct regarding the distinction(s) between the auditor’s responsibilities for searching for errors and fraud.
A) little
B) a significant
C) no
D) various
Answer
Terms: Auditor responsibility for searching for errors and fraud
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills
19) In comparing management fraud with employee fraud, the auditor’s risk of failing to discover the fraud is:
A) greater for management fraud because managers are inherently more deceptive than employees.
B) greater for management fraud because of management’s ability to override existing internal controls.
C) greater for employee fraud because of the higher crime rate among blue collar workers.
D) greater for employee fraud because of the larger number of employees in the organization.
Answer
Terms: Management fraud vs. employee fraud and auditor failure to detect both
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

20) Which of the following statements is correct with respect to the auditor’s responsibilities relative to the detection of indirect-effect illegal acts?
A) The auditor has no responsibility for searching for indirect-effect illegal acts.
B) The auditor has the same responsibility for searching for indirect-effect illegal acts as any other potential misstatement that may occur.
C) Auditors have responsibility for searching for any illegal act, whether direct-effect or indirect-effect.
D) Discovery of indirect-effect illegal acts is usually easier than discovery of fraud.
Answer
Terms: Indirect-effect illegal acts
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

21) When comparing the auditor’s responsibility for detecting employee fraud and for detecting errors, the profession has placed the responsibility:
A) more on discovering errors than employee fraud.
B) more on discovering employee fraud than errors.
C) equally on discovering either one.
D) on the senior auditor for detecting errors and on the manager for detecting employee fraud.
Answer
Terms: Fraud and errors
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

22) If several employees collude to falsify documents, the chance a normal audit would uncover such acts is:
A) very low.
B) very high.
C) zero.
D) none of the above.
Answer
Terms: Employees collude to falsify documents
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills
23) When planning the audit, if the auditor has no reason to believe that illegal acts exist, the auditor should:
A) include audit procedures which have a strong probability of detecting illegal acts.
B) still include some audit procedures designed specifically to uncover illegalities.
C) ignore the issue.
D) make inquiries of management regarding their policies for detecting and preventing illegal acts and regarding their knowledge of violations, and then rely on normal audit procedures to detect errors, irregularities, and illegalities.
Answer
Terms: Planning audit and illegal acts
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

24) When the auditor has reason to believe an illegal act has occurred, the auditor should:
A) inquire of management only at one level below those likely to be involved with the illegality.
B) begin communication with the FASB in accordance with PCAOB regulations.
C) consider accumulating additional evidence to determine if there is actually an illegal act.
D) withdraw from the engagement.
Answer
Terms: Illegal acts occurred
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

25) When the auditor knows that an illegal act has occurred, the auditor must:
A) report it to the proper governmental authorities.
B) consider the effects on the financial statements, including the adequacy of disclosure.
C) withdraw from the engagement.
D) issue an adverse opinion.
Answer
Terms: Auditor knows illegal act occurred
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

26) If an auditor uncovers an illegal act at a public company, the auditor must notify:
A) local law enforcement officials.
B) the Public Company Accounting Oversight Board.
C) the Securities and Exchange Commission.
D) all of the above.
Answer
Terms: Auditor uncovers illegal act at public company
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills
Topic: Public
27) If an auditor conducted an audit in accordance with auditing standards, which of the following would the auditor likely detect?
A) unrecorded transactions
B) errors in postings of recorded transactions
C) counterfeit signatures on paid checks
D) fraud involving collusion
Answer
Terms: Auditor conducted audit in accordance with auditing standards
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

28) Which of the following statements best describes the auditor’s responsibility with respect to illegal acts that do not have a material effect on the client’s financial statements?
A) Generally, the auditor is under no obligation to notify parties other than personnel within the client’s organization.
B) Generally, the auditor is under an obligation to inform the PCAOB.
C) Generally, the auditor is obligated to disclose the relevant facts in the auditor’s report.
D) Generally, the auditor is expected to compel the client to adhere to requirements of the Foreign Corrupt Practices Act.
Answer
Terms: Auditor responsibility with respect to illegal acts
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

29) Which of the following statements best describes the auditor’s responsibility regarding the detection of fraud?
A) The auditor is responsible for the failure to detect fraud only when such failure clearly results from nonperformance of audit procedures specifically described in the engagement letter.
B) The auditor is required to provide reasonable assurance that the financial statements are free of both material errors and fraud
C) The auditor may extend auditing procedures to actively search for evidence of fraud where the examination indicates that fraud may exist.
D) The auditor is responsible for the failure to detect fraud only when an unqualified opinion is issued.
Answer
Terms: Auditor responsibility regarding detection of fraud
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills
30) The essence of the attest function is to:
A) assure the consistent application of correct accounting procedures.
B) determine whether the client’s financial statements are fairly stated in accordance with an applicable financial reporting framework such as U.S. GAAP or IFRS.
C) examine individual transactions so that the auditor may certify as to their validity.
D) detect collusion and fraud.
Answer
Terms: Essence of attest function
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

31) The auditor’s evaluation of the likelihood of material employee fraud is normally done initially as a part of:
A) tests of controls.
B) tests of transactions.
C) understanding the entity’s internal control.
D) the assessment of whether to accept the audit engagement.
Answer
Terms: Evaluation of likelihood of material employee fraud
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

32) Illegal acts are defined in auditing standards as:
A) violations of laws or government regulations.
B) violations of laws or government regulations other than errors.
C) violations of laws or government regulations other than fraud.
D) violations of law which would result in the arrest of the perpetrator.
Answer
Terms: Illegal acts
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

33) Most illegal acts affect the financial statements:
A) directly.
B) only indirectly.
C) both directly and indirectly.
D) materially if direct; immaterially if indirect.
Answer
Terms: Illegal acts effect on financial statements
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills
34) With respect to the detection of indirect- effect illegal acts, auditing standards state that the auditor provides:
A) no assurance that they will be detected.
B) the same reasonable assurance provided for other items.
C) assurance that they will be detected, if material.
D) assurance that they will be detected, if highly material.
Answer
Terms: Detection of indirect-effect illegal acts
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

35) An auditor should recognize that the application of auditing procedures may produce evidence indicating the possibility of errors or fraud and therefore should:
A) plan and perform the engagement with an attitude of professional skepticism.
B) not rely on internal controls that are designed to prevent or detect errors or fraud.
C) design audit tests to detect unrecorded transactions.
D) extend the work to audit most recorded transactions and records of an entity.
Answer
Terms: Audit procedures that product evidence of errors or fraud
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

36) Discuss the differences between errors, frauds, and illegal acts. Give an example of each.
37) Discuss the actions an auditor should take when the auditor discovers an illegal act.

38) Discuss three reasons why auditors are responsible for “reasonable” but not “absolute” assurance.

39) Discuss the differences in the auditor’s responsibilities for discovering (1) material errors, (2) material fraud (3) direct-effect illegal acts, and (4) indirect-effect illegal acts.

40) Errors are usually more difficult for an auditor to detect than frauds.
A) True
B) False
Answer
Terms: Auditor detection of errors and frauds
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

41) Other than inquiring of management about policies they have established to prevent illegal acts and whether management knows of any laws or regulations that the company has violated, the auditor should not search for indirect-effect illegal acts unless there is reason to believe they may exist.
A) True
B) False
Answer
Terms: Auditor responsibility for searching for indirect-effect illegal acts
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

42) When an auditor believes that an illegal act may have occurred, the first step he or she should take is to gather additional evidence to determine the extent of the illegality.
A) True
B) False
Answer
Terms: Auditor believes illegal act may have occurred
Diff: Easy
Objective: LO 6-3
AACSB: Reflective thinking skills

43) Audits are expected to provide a higher degree of assurance for the detection of material frauds than is provided for an equally material error.
A) True
B) False
Answer
Terms: Degree of assurance for detection of material frauds and errors
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

44) Auditors have a higher degree of responsibility for detecting direct-effect illegal acts than indirect-effect illegal acts.
A) True
B) False
Answer
Terms: Auditor degree of responsibility for detecting direct-effect and indirect-effect illegal acts
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

45) The auditor’s first course of action when an illegal act is uncovered should be to immediately notify the appropriate authorities, including but not limited to the police, and for publicly held companies, the Securities and Exchange Commission.
A) True
B) False
Answer
Terms: Illegal act uncovered
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

46) An audit generally provides no assurance that indirect-effect illegal acts will be detected.
A) True
B) False
Answer
Terms: Indirect-effect illegal acts; No assurance
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

47) Auditing standards indicate that reasonable assurance is a moderate, but not absolute, level of assurance that the financial statements are free of material misstatement.
A) True
B) True
Answer
Terms: Moderate or high risk of management fraud
Diff: Moderate
Objective: LO 6-3
AACSB: Reflective thinking skills

48) An auditor must inform a client’s audit committee of an illegal act discovered during an audit in writing.
A) True
B) False
Answer
Terms: Auditor to inform of illegal act discovered during an audit
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

49) The objective of the audit of financial statements by an independent auditor is to verify that the financial statements are free of misstatements and accurately represent the company’s financial position and results of operations.
A) True
B) False
Answer
Terms: Objective of audit of financial statements
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills
50) The auditor’s responsibility for uncovering direct-effect illegal acts is the same as for fraud.
A) True
B) False
Answer
Terms: Auditor responsibility for uncovering direct-effect illegal acts and fraud
Diff: Challenging
Objective: LO 6-3
AACSB: Reflective thinking skills

Learning Objective 6-4

1) Why does the auditor divide the financial statements into smaller segments?
A) Using the cycle approach makes the audit more manageable.
B) Most accounts have few relationships with others and so it is more efficient to break the financial statements into smaller pieces.
C) The cycle approach is used because auditing standards require it.
D) All of the above are correct.
Answer
Terms: Reason auditor divides financial statements into smaller segments
Diff: Moderate
Objective: LO 6-4
AACSB: Reflective thinking skills

2) Why does the auditor divide the financial statements into segments around the financial statement cycles?
A) Most auditors are trained to audit cycles as opposed to entire financial statements.
B) The approach aids in the assignment of tasks to different members of the audit team.
C) The cycle approach is required by auditing standards.
D) The cycle approach allows the auditor to detect indirect-effect illegal acts.
Answer
Terms: Reason auditor divides financial statements into smaller segments
Diff: Moderate
Objective: LO 6-4
AACSB: Reflective thinking skills

3) The most important general ledger account included in and affecting several cycles is the:
A) cash account.
B) inventory account.
C) income tax expense and liability accounts.
D) retained earnings account.
Answer
Terms: Account included in and affected several cycles
Diff: Moderate
Objective: LO 6-4
AACSB: Reflective thinking skills

4) When using the cycle approach to segmenting the audit, the reason for treating capital acquisition and repayment separately from the acquisition of goods and services is that:
A) the transactions are related to financing a company rather than to its operations.
B) most capital acquisition and repayment cycle accounts involve few transactions, but each is often highly material and therefore should be audited extensively.
C) both A and B are correct.
D) neither A nor B is correct.
Answer
Terms: Cycle approach to segmenting an audit
Diff: Challenging
Objective: LO 6-4
AACSB: Reflective thinking skills

5) In describing the cycle approach to segmenting an audit, which of the following statements is not true?
A) All general ledger accounts and journals are included at least once.
B) Some journals and general ledger accounts are included in more than one cycle.
C) The “capital acquisition and repayment” cycle is closely related to the “acquisition of goods and services and payment” cycle.
D) The “inventory and warehousing” cycle may be audited at any time during the engagement since it is unrelated to the other cycles.
Answer
Terms: Cycle approach to segmenting an audit
Diff: Challenging
Objective: LO 6-4
AACSB: Reflective thinking skills

6) Which of the following journals would be included most often in the various audit cycles?
A) cash receipts journal
B) cash disbursements journal
C) general journal
D) sales journal
Answer
Terms: Journal included most often in various audit cycles
Diff: Challenging
Objective: LO 6-4
AACSB: Reflective thinking skills

7) Auditors generally use a financial statement cycle approach when performing a financial statement audit. Describe the transaction flow, using specific examples, from journals to financial statements that produce financial statements.
8) Under the cycle approach to segmenting an audit, transactions recorded in different journals should never be combined with the general ledger balances that result from those transactions.
A) True
B) False
Answer
Terms: Cycle approach to segmenting an audit
Diff: Moderate
Objective: LO 6-4
AACSB: Reflective thinking skills

1) Which of the following is not one of the three categories of assertions?
A) Assertions about classes of transactions and events for the period under audit
B) Assertions about financial statements and correspondence to GAAP
C) Assertions about account balances at period end
D) Assertions about presentation and disclosure
Answer
Terms: Categories of assertions
Diff: Easy
Objective: LO 6-6
AACSB: Reflective thinking skills

2) If a short-term note payable is included in the accounts payable balance on the financial statement, there is a violation of the:
A) completeness assertion.
B) existence assertion.
C) cutoff assertion.
D) classification and understandability assertion.
Answer
Terms: Violation of assertions
Diff: Easy
Objective: LO 6-6
AACSB: Reflective thinking skills

3) International auditing standards and U.S. GAAP classify assertions into three categories. Which of the following is not a category of assertions that management makes about the accounting information in financial statements?
A) Assertions about classes of transactions for the period under audit
B) Assertions about account balances at period end
C) Assertions about the quality of source documents used to prepare the financial statements
D) Assertions about presentation and disclosure
Answer
Terms: Management assertions
Diff: Easy
Objective: LO 6-6
AACSB: Reflective thinking skills
4) Management assertions are:
A) directly related to the financial reporting framework used by the company, usually U.S. GAAP or IFRS
B) stated in the footnotes to the financial statements.
C) explicitly expressed representations about the financial statements.
D) provided to the auditor in the assertions letter, but are not disclosed on the financial statements.
Answer
Terms: Management assertions
Diff: Moderate
Objective: LO 6-6
AACSB: Reflective thinking skills

5) Which of the following statements is true?
A) Auditors have generally found that the most effective and efficient way to conduct an audit is to obtain some assurance for each class of transaction and for the ending balance of the related account.
B) Management’s assertions follow and are closely related to the audit objectives.
C) The auditor’s primary responsibility is to find and disclose fraudulent management assertions.
D) Assertions about presentation and disclosure deal with whether the accounts have been included in the financial statements at appropriate amounts.
Answer
Terms: Management assertions
Diff: Moderate
Objective: LO 6-6
AACSB: Reflective thinking skills

6) Which of the following statements about the existence and completeness assertions is not true?
A) The existence and completeness assertions emphasize different audit concerns.
B) Existence deals with overstatements and completeness deals with understatements.
C) Existence deals with understatements and completeness deals with overstatements.
D) The completeness assertion deals with unrecorded transactions.
Answer
Terms: Existence and completeness assertions
Diff: Moderate
Objective: LO 6-6
AACSB: Reflective thinking skills

7) Which of the following assertions is described as “this assertion addresses whether all transactions that should be included in the financial statements are in fact included”?
A) occurrence
B) completeness
C) rights and obligations
D) existence
Answer
Terms: Assertion which addresses whether all transactions that should be included are included
Diff: Moderate
Objective: LO 6-6
AACSB: Reflective thinking skills
8) Which of the following management assertions is not associated with transaction-related audit objectives?
A) Occurrence
B) Classification and understandability
C) Accuracy
D) Completeness
Answer
Terms: Management assertion not associated with transaction-related audit objectives
Diff: Moderate
Objective: LO 6-6
AACSB: Reflective thinking skills

9) Briefly explain each management assertion related to classes of transactions and events for the period under audit.

10) Briefly explain each management assertion related to account balances at period end.

11) Briefly explain each management assertion related to presentation and disclosure.

Learning Objective 6-7

1) Which of the following statements is true regarding the distinction between general audit objectives and specific audit objectives for each account balance?
A) The specific audit objectives are applicable to every account balance on the financial statements.
B) The general audit objectives are applicable to every account balance on the financial statements.
C) The general audit objectives are stated in terms tailored to the engagement.
D) For any given class of transactions, usually only one audit objective must be met to conclude the transactions are properly recorded.
Answer
Terms: Difference between general and specific audit objectives
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

2) The auditor is determining that the recorded sales are for the amount of goods shipped are correctly billed and recorded. She is gathering evidence about which transaction related audit objective?
A) existence
B) completeness
C) accuracy
D) cut-off
Answer
Terms: Evidence for transaction related audit objective if recorded sales are for amount shipped and correctly billed and recorded
Diff: Moderate
Objective: LO 6-7
AACSB: Analytic skills
3) Which of the following combinations is correct?
A) Existence relates to whether the amounts in accounts are understated.
B) Occurrence relates to whether balances exist.
C) Existence relates to whether amounts included exist.
D) Occurrence relates to whether the amounts in accounts occurred in the proper year.
Answer
Terms: Existence and occurrence objectives
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

4) After general audit objectives are understood, specific audit objectives for each account balance on the financial statements can be developed. Which of the following statements is true?
A) There should be at least one specific objective for each relevant general objective.
B) There will be only one specific objective for each relevant general objective.
C) There will be many specific objectives developed for each relevant general objective.
D) There must be one specific objective for each general objective.
Answer
Terms: General and specific audit objectives
Diff: Challenging
Objective: LO 6-7
AACSB: Reflective thinking skills
5) In the context of the audit of sales, distinguish between the existence and completeness transaction-related audit objectives. State the effect on the sales account (overstatement or understatement) of a violation of each objective.

6) Below are five audit procedures, all of which are tests of transactions associated with the audit of the sales and collection cycle. Also below are the six general transaction-related audit objectives and the five management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested.

Audit Objectives
A. Occurrence
B. Completeness
C. Accuracy
D. Posting and summarization
E. Classification
F. Timing Assertions
V. Occurrence
W. Completeness
X. Accuracy
Y. Classification
Z. Cutoff

1. Vouch recorded sales from the sales journal to the file of bills of lading.
(1) ________.
(2) ________.

2. Compare dates on the bill of lading, sales invoices, and sales journal to test for delays in recording sales transactions.
(1) ________.
(2) ________.

3. Account for the sequence of prenumbered bills of lading and sales invoices.
(1) ________.
(2) ________.

4. Trace from a sample of prelistings of cash receipts to the cash receipts journal, testing for names, amounts, and dates.
(1) ________.
(2) ________.

5. Examine customer order forms for credit approval by the credit manager.
(1) ________.
(2) ________.

7) Below are five audit procedures, all of which are tests of transactions associated with the audit of the acquisition and payment cycle. Also below are the six general transaction-related audit objectives and the five management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested.

Audit Objectives
A. Occurrence
B. Completeness
C. Accuracy
D. Posting and summarization
E. Classification
F. Timing Assertions
V. Occurrence
W. Completeness
X. Accuracy
Y. Classification
Z. Cutoff

1. Foot the purchases journal and trace the totals to the related general ledger accounts.
(1) ________.
(2) ________.

2. Recompute the cash discounts taken by the client.
(1) ________.
(2) ________.

3. Compare dates on cancelled checks with the bank cancellation date.
(1) ________.
(2) ________.

4. Trace from a sample of cancelled checks to the cash disbursements journal.
(1) ________.
(2) ________.

5. Examine supporting documentation for a sample of transactions for authorized payee and amount and to determine services or goods were received.
(1) ________.
(2) ________.

8) General transaction-related audit objectives vary from audit to audit, depending on the nature and characteristics of the client’s business and industry.
A) True
B) False
Answer
Terms: General transaction-related audit objectives
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

9) The audit objective of posting and summarization is associated with the management assertion of accuracy.
A) True
B) False
Answer
Terms: Audit objective of posting and summarization; Accuracy management assertion
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

10) The transaction-related audit objective of timing is related to the assertion of cutoff.
A) True
B) False
Answer
Terms: Transaction-related audit objective of timing; Cutoff assertion
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills
11) The effect of a violation of the existence transaction-related audit objective for the sales account would be an overstatement of that account.
A) True
B) False
Answer
Terms: Existence transaction-related audit objective
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

12) The effect of a violation of the completeness transaction-related audit objective for cash disbursements transactions would be an overstatement of cash disbursements.
A) True
B) False
Answer
Terms: Completeness transaction-related audit objective
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

13) The transaction-related audit objective that deals with whether recorded transactions have actually occurred is the completeness objective.
A) True
B) False
Answer
Terms: Transaction-related audit objective; Completeness objective
Diff: Moderate
Objective: LO 6-7
AACSB: Reflective thinking skills

Learning Objective 6-8

1) In testing for cutoff, the objective is to determine:
A) whether all of the current period’s transactions are recorded.
B) whether transactions are recorded in the correct accounting period.
C) the proper cutoff between capitalizing and expensing expenditures.
D) the proper cutoff between disclosing items in footnotes or in account balances.
Answer
Terms: Objective in testing cutoff
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills

2) The detail tie-in objective is not concerned that the details in the account balance:
A) agree with related subsidiary ledger amounts.
B) are properly disclosed in accordance with GAAP.
C) foot to the total in the account balance.
D) agree with the total in the general ledger.
Answer
Terms: Detail tie-in objective
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills
3) The detail tie-in is part of the ________ assertion for account balances.
A) classification
B) valuation and allocation
C) rights and obligations
D) completeness
Answer
Terms: Detail tie-in is and assertion for account balances
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills

4) The primary difference between an audit of the balance sheet and an audit of the income statement is that the audit of the income statement deals with the verification of:
A) transactions.
B) balances.
C) costs.
D) cutoffs.
Answer
Terms: Difference between audit of balance sheet and income statement
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills

5) Which of the following best describes tests of details of balances?
A) audit procedures designed to test for monetary misstatements in the accounts summarized in the financial statements
B) audit procedures designed to test for the monetary amounts of transactions
C) audit procedures designed to test for reasonableness of account balances
D) audit procedures designed to test for effectiveness in recording accounting information
Answer
Terms: Details of balances
Diff: Challenging
Objective: LO 6-8
AACSB: Reflective thinking skills

6) Which of the following statements is not true?
A) Balance-related audit objectives are applied to ending account balances.
B) Transaction-related audit objectives are applied to classes of transactions.
C) Balance-related audit objectives are applied to the ending balance in balance sheet accounts.
D) Balance-related audit objectives are applied to both beginning and ending balances in balance sheet accounts.
Answer
Terms: Balance-related and transaction-related audit objectives
Diff: Moderate
Objective: LO 6-7 and LO 6-8
AACSB: Reflective thinking skills
7) An important balance related objective is realizable value. Describe what is the purpose of this audit objective, what it is concerned with, and give an example.

8) Below are five audit procedures, all of which are tests of balances associated with the audit of accounts receivable. Also below are the eight general balance-related audit objectives and the four management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested.

Audit Objectives
A. Existence
B. Completeness
C. Accuracy
D. Classification
E. Cutoff
F. Detail tie-in
G. Realizable value
H. Rights and obligations Assertions
V. Existence
W. Completeness
X. Valuation and allocation
Y. Rights and obligations

1. Obtain an aged listing of accounts receivable. For a sample of individual customers on the listing, agree the customer’s name, amount, and other information with the corresponding information in the accounts receivable master file.
(1) ________.
(2) ________.

2. Examine details of sales for five days before and five days after year-end to determine whether sales have been recorded in the proper period.
(1) ________.
(2) ________.

3. Assess the reasonableness of the balance in the allowance for doubtful accounts.
(1) ________.
(2) ________.

4. Inquire as to whether any accounts receivable have been factored or sold during the period.
(1) ________.
(2) ________.

5. Inquire as to whether there are any receivables from related parties.
(1) ________.
(2) ________.

9) Auditors have found that the most efficient way to conduct audits is to focus primarily on testing classes of transactions and performing tests of ending account balances.
A) True
B) False
Answer
Terms: Testing classes of transactions and ending account balances
Diff: Easy
Objective: LO 6-7 and LO 6-8
AACSB: Reflective thinking skills

10) Balance-related audit objectives are usually applied to the ending balance in income statement accounts; transaction-related audit objectives are usually applied to transactions reflected in balance sheet accounts.
A) True
B) False
Answer
Terms: Balance-related audit objectives; Transaction-related audit objectives
Diff: Moderate
Objective: LO 6-7 and LO 6-8
AACSB: Reflective thinking skills

11) Tests of details of balances typically involve the use of comparisons and relationships to assess the overall reasonableness of account balances.
A) True
B) False
Answer
Terms: Test of details of balances
Diff: Easy
Objective: LO 6-8
AACSB: Reflective thinking skills

12) The general balance-related audit objective that deals with determining that details in the account balance agree with related master file amounts, foot to the total in the account balance, and agree with the total in the general ledger is the detail tie-in objective.
A) True
B) False
Answer
Terms: Detail tie-in objective; General balance-related objective
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills
13) The cutoff objective, “transactions near the balance sheet date are recorded in the proper period,” is a balance-related audit objective.
A) True
B) False
Answer
Terms: Cutoff objective; Balance-related audit objective
Diff: Moderate
Objective: LO 6-8
AACSB: Reflective thinking skills
Learning Objective 6-9

1) There are no questions for this Learning Objective.
Answer:

Learning Objective 6-10

1) Tests of details of balances are specific audit procedures that are intended to:
A) test for monetary errors in the financial statements.
B) prove that the accounts with material balances are classified correctly.
C) prove that the trial balance is in balance.
D) identify the details of the internal control system.
Answer
Terms: Tests of details balances; Specific audit procedures
Diff: Easy
Objective: LO 6-10
AACSB: Reflective thinking skills

2) Which of the following statements is not correct?
A) There are many ways an auditor can accumulate evidence to meet overall audit objectives.
B) Sufficient appropriate evidence must be accumulated to meet the auditor’s professional responsibility.
C) It is appropriate to minimize the cost of accumulating evidence.
D) Gathering evidence and minimizing costs are equally important considerations that affect the approach the auditor selects.
Answer
Terms: Considerations for accumulating evidence
Diff: Moderate
Objective: LO 6-10
AACSB: Reflective thinking skills
3) Two overriding considerations affect the many ways an auditor can accumulate evidence:

1. Sufficient appropriate evidence must be accumulated to meet the auditor’s professional responsibility.
2. Cost of accumulating evidence should be minimized.

In evaluating these considerations:
A) the first is more important than the second.
B) the second is more important than the first.
C) they are equally important.
D) it is impossible to prioritize them.
Answer
Terms: Considerations for accumulating evidence
Diff: Moderate
Objective: LO 6-10
AACSB: Reflective thinking skills

4) If the auditor has obtained a reasonable level of assurance about the fair presentation of the financial statements through understanding internal control, assessing control risk, testing controls, and analytical procedures, then the auditor:
A) can issue an unqualified opinion.
B) can significantly reduce other substantive tests.
C) can write the engagement letter.
D) needs to perform additional tests of controls so that the assurance level can be increased.
Answer
Terms: Auditor obtained reasonable level of assurance about fair presentation
Diff: Moderate
Objective: LO 6-10
AACSB: Reflective thinking skills

5) After the auditor has completed all audit procedures, it is necessary to combine the information obtained to reach an overall conclusion as to whether the financial statements are fairly presented. This is a highly subjective process that relies heavily on:
A) generally accepted auditing standards.
B) the AICPA’s Code of Professional Conduct.
C) generally accepted accounting principles.
D) the auditor’s professional judgment.
Answer
Terms: After auditor completed all audit procedures
Diff: Moderate
Objective: LO 6-10
AACSB: Reflective thinking skills

6) List the four phases of a Financial Statement Audit

7) Describe what analytical procedures and tests of details of balances are and give an example of each.

8) Match seven of the terms (a-k) with the definitions provided below (1-7):

a. Tests of details of balances
b. Tests of controls
c. Substantive tests of transactions
d. Analytical procedures
e. Transaction-related audit objectives
f. Management assertions
g. Balance-related audit objectives
h. Fraud
i. Illegal act
j. Error
k. Management fraud

________ 1. An intentional misstatement of the financial statements.

________ 2. A set of six audit objectives the auditor must meet, including timing, posting and summarization, and accuracy.

________ 3. Implied or expressed representations made by the client about classes of transactions, account balances and disclosures in the financial statements.

________ 4. Audit procedures testing for monetary misstatements to determine whether the balance-related audit objectives have been satisfied for each significant account balance.

________ 5. A set of nine audit objectives the auditor must meet, including completeness, detail tie-in, and rights and obligations.

________ 6. Audit procedures designed to test the effectiveness of control policies and procedures.

________ 7. Use of comparisons and relationships to assess whether account balances or other data appears reasonable.

9) When an auditor has reduced assessed control risk based on tests of controls, he or she may then reduce the extent to which the accuracy of the financial statement information directly related to those controls must be supported through the accumulation of evidence using substantive tests.
A) True
B) False
Answer
Terms: Tests of controls; Assessed control risk
Diff: Easy
Objective: LO 6-10
AACSB: Reflective thinking skills

10) For a private company audit, tests of controls are normally performed only on those internal controls the auditor believes have not been operating effectively during the period under audit.
A) True
B) False
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 6-10
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 7 Audit Evidence

Learning Objective 7-1

1) There are no questions for this Learning Objective.
Answer:

Learning Objective 7-2

1) Auditors must make decisions regarding what evidence to gather and how much to accumulate. Which of the following is a decision that must be made by auditors related to evidence?
A)
Sample size Timing of audit procedures
Yes Yes

B)
Sample size Timing of audit procedures
No No

C)
Sample size Timing of audit procedures
Yes No

D)
Sample size Timing of audit procedures
No Yes

Answer
Terms: Decision to be made by auditors related to evidence
Diff: Easy
Objective: LO 7-2
AACSB: Reflective thinking skills

2) Audit procedures are concerned with the nature, extent, and timing in gathering audit evidence. Which, of the following, is true as to the timing of audit procedures?
A)
Prior to the fiscal year-end of the client Subsequent to the fiscal year-end of the client
Yes Yes

B)
Prior to the fiscal year-end of the client Subsequent to the fiscal year-end of the client
No No

C)
Prior to the fiscal year-end of the client Subsequent to the fiscal year-end of the client
Yes No

D)
Prior to the fiscal year-end of the client Subsequent to the fiscal year-end of the client
No Yes

Answer
Terms: Timing of audit procedures
Diff: Easy
Objective: LO 7-2
AACSB: Reflective thinking skills

Learning Objective 7-3

1) Audit evidence has two primary qualities for the auditor; relevance and reliability. Given the choices below which provides the auditor with the most reliable audit evidence?
A) general ledger account balances
B) confirmation of accounts receivable balance received from a customer
C) internal memo explaining the issuance of a credit memo
D) copy of month-end adjusting entries
Answer
Terms: Audit evidence qualities of relevance and reliability
Diff: Easy
Objective: LO 7-3
AACSB: Analytic skills

2) Which of the following is not a characteristic of the reliability of evidence?
A) effectiveness of client internal controls
B) education of auditor
C) independence of information provider
D) timeliness
Answer
Terms: Characteristic of reliability of evidenc
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills
3) The auditor must gather sufficient and appropriate evidence during the course of the audit. Sufficient evidence must:
A) be well documented and cross-referenced in the audit documents.
B) be based on sources that are external to company.
C) provide evidence that prove or disprove an audit objective/assertion.
D) be persuasive enough to enable the auditor to issue an audit report.
Answer
Terms: Sufficient evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

4) Audit evidence obtained directly by the auditor will not be reliable if:
A) the auditor lacks the competence to evaluate the evidence.
B) it is provided by the client’s attorney.
C) the client denies its veracity.
D) it is impossible for the auditor to obtain additional corroboratory evidence.
Answer
Terms: Audit evidence obtained directly by auditor
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

5) Appropriateness of evidence is a measure of the:
A) quantity of evidence.
B) quality of evidence.
C) sufficiency of evidence.
D) meaning of evidence.
Answer
Terms: Appropriateness of evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

6) Which of the following statements regarding the relevance of evidence is correct?
A) To be relevant, evidence must pertain to the audit objective of the evidence.
B) To be relevant, evidence must be persuasive.
C) To be relevant, evidence must relate to multiple audit objectives.
D) To be relevant, evidence must be derived from a system including effective internal controls.
Answer
Terms: Relevance of evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills
7) Two determinants of the persuasiveness of evidence are:
A) competence and sufficiency.
B) relevance and reliability.
C) appropriateness and sufficiency.
D) independence and effectiveness.
Answer
Terms: Determinants of persuasiveness of evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

8) The two characteristics of the appropriateness of evidence are:
A) relevance and timeliness.
B) relevance and accuracy.
C) relevance and reliability.
D) reliability and accuracy.
Answer
Terms: Appropriateness of evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

9) Which of the following forms of evidence would be least persuasive in forming the auditor’s opinion about marketable securities and other investments held by the company?
A) Responses to auditor’s questions by the president and controller regarding the investments account.
B) Correspondence with a stockbroker regarding the quantity of client’s investments held in street name by the broker.
C) Minutes of the board of directors authorizing the purchase of stock as an investment.
D) The auditor’s count of marketable securities.
Answer
Terms: Least persuasive form of evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

10) Which of the following statements is not correct?
A) It is possible to vary the sample size from one unit to 100% of the items in the population.
B) The decision of how many items to test should not be influenced by the increased costs of performing the additional tests.
C) The decision of how many items to test must be made by the auditor for each audit procedure.
D) The sample size for any given procedure is likely to vary from audit to audit.
Answer
Terms: Testing of items; Sample size
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills
11) For audit evidence to be compelling to the auditor it must be sufficient and appropriate. Which statement below is not correct regarding the appropriateness of audit evidence?
A) The more effective the internal control system, the more assurance it provides the auditor about the reliability of financial reporting by the client.
B) An auditor’s opinion, to be economically useful and profitable to the auditing firm needs to be formed within a reasonable time and based on evidence obtained that assures profits for the auditing firm.
C) Evidence obtained from independent sources outside the entity is generally more reliable than evidence secured solely within the entity.
D) The independent auditor’s direct personal knowledge, obtained through inquiry, observation and inspection, is generally more persuasive than information obtained indirectly.
Answer
Terms: Appropriateness of audit evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

12) Which one of the following is not one of the primary purposes of audit documentation prepared by the audit team?
A) A basis for planning the audit.
B) A record of the evidence accumulated and the results of the tests.
C) A basis for review by supervisors and partners.
D) A basis for determining work deficiencies by peer review teams.
Answer
Terms: Purposes of audit documentation
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

13) Which of the following is the most objective type of evidence?
A) A letter written by the client’s attorney discussing the likely outcome of outstanding lawsuits.
B) The physical count of securities and cash.
C) Inquiries of the credit manager about the collectability of noncurrent accounts receivable.
D) Observation of cobwebs on some inventory bins.
Answer
Terms: Most objective type of evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills
14) Due professional care, the third general standard, is concerned with what is done by the independent auditor and how well it is done. For example, due care in the matter of audit documentation requires that audit documentation of the evidence gathered by the auditor meets which of the following criteria?
A) Workpapers be indexed to the general ledger accounts and include both a permanent file and a general file.
B) The content be sufficient to provide support for the auditor’s opinion, including the auditor’s representation as to compliance with auditing standards.
C) Audit evidence is principally gathered to determine if the client’s financial statements, as prepared by management, can be relied upon to make managerial decisions about the firm.
D) Audit evidence as displayed in the workpapers is primarily performed to protect the auditing firm in the case of a lawsuit by investors.
Answer
Terms: Audit evidence gathered by auditors meets which criteria
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

15) Which items affect the sufficiency of evidence when choosing a sample?
A)
Selecting items with a high likelihood of misstatement The randomness of the items selected
Yes Yes

B)
Selecting items with a high likelihood of misstatement The randomness of the items selected
No No

C)
Selecting items with a high likelihood of misstatement The randomness of the items selected
Yes No

D)
Selecting items with a high likelihood of misstatement The randomness of the items selected
No Yes

Answer
Terms: Sufficiency of evidence when choosing a sample
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills
16) Determine which of the following is most correct regarding the reliability of audit evidence.
A) Information that is indirectly obtained from external sources is the most reliable audit evidence.
B) Reliability of audit evidence is dependent upon the evidence being convincing.
C) Reliability of evidence refers to the amount of evidence obtained.
D) An effective internal control system provides more reliable audit evidence.
Answer
Terms: Reliability of audit evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

17) Evidence is generally considered appropriate when:
A) it has been obtained by random selection.
B) there is enough of it to afford a reasonable basis for an opinion on financial statements.
C) it has the qualities of being relevant, objective, and free from known bias.
D) it consists of written statements made by managers of the enterprise under audit.
Answer
Terms: Evidence considered appropriate
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

18) Given the economic and time constraints in which auditors can collect evidence about management assertions about the financial statements, the auditor normally gathers evidence that is:
A) irrefutable.
B) conclusive.
C) persuasive.
D) completely convincing.
Answer
Terms: Auditor normally gathers evidence that is
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

19) Which of the following statements is not a correct use of the terminology in relation to audit evidence?
A) Evidence obtained from an independent source outside the client organization is more reliable than that obtained from within.
B) Documentary evidence is more reliable when it is received by the auditor indirectly rather than directly.
C) Documents that originate outside the company are considered more reliable than those that originate within the client’s organization.
D) External evidence, such as communications from banks, is generally regarded as more reliable than answers obtained from inquiries of the client.
Answer
Terms: Terminology related to audit evidence
Diff: Challenging
Objective: LO 7-3
AACSB: Reflective thinking skills
20) Evidence is usually more persuasive for balance sheet accounts when it is obtained:
A) as close to the balance sheet date as possible.
B) only from transactions occurring on the balance sheet date.
C) from various times throughout the client’s year.
D) from the time period when transactions in that account were most numerous during the fiscal period.
Answer
Terms: Evidence is more persuasive for balance sheet accounts
Diff: Challenging
Objective: LO 7-3
AACSB: Reflective thinking skills

21) Which of the following statements is true?
A) A large sample of highly competent evidence is persuasive if it is relevant to the objective being tested.
B) A large sample of evidence that is neither competent nor timely is not persuasive.
C) A small sample of only one or two pieces of relevant, competent, and timely evidence lacks persuasiveness.
D) The persuasiveness of evidence can be evaluated after considering its sufficiency.
Answer
Terms: Samples and evidence
Diff: Challenging
Objective: LO 7-3
AACSB: Reflective thinking skills
22) Which of the following statements relating to the competence of evidential matter is always true?
A) Evidence from outside an enterprise is always reliable.
B) Accounting data developed under satisfactory conditions of internal control are more relevant than data developed under unsatisfactory internal control conditions.
C) Oral representations made by management are not reliable evidence.
D) Evidence must be both reliable and relevant to be considered appropriate.
Answer
Terms: Competence of evidential matter
Diff: Challenging
Objective: LO 7-3
AACSB: Reflective thinking skills

23) Distinguish between internal documentation and external documentation as types of audit evidence. Give two examples of each. Which type is considered more reliable?
Answer: Internal documentation involves the auditor’s examination of documents that have been prepared and used within the client’s organization and are retained without ever going to an outside party. Examples would include duplicate sales invoices, employees’ time reports, and inventory receiving reports.

External documentation involves the auditor’s examination of documents that have been in the hands of someone outside the client’s organization. Examples include vendors’ invoices, cancelled checks, cancelled notes payable, and insurance policies.
External documents are regarded as more reliable evidence than internal documents.
Terms: Internal and external documentation; Reliability of evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

24) Discuss three of the following influences on the persuasiveness of evidence.
1. Relevance
2. Independence of provider
3. Effectiveness of client’s internal controls
4. Auditor’s direct knowledge
5. Degree of objectivity
6. Timeliness

25) Why is the appropriateness of audit evidence obtained by the auditor important in forming an audit opinion? Describe the qualities information should have to be considered appropriate by the auditor.

26) The reliability of evidence refers to the degree to which evidence is considered believable or trustworthy. There are six factors that affect the reliability of audit evidence. One factor is the independence of the provider; i.e., evidence obtained from a source outside the client company is more reliable than that obtained within. Identify and discuss any two of the remaining five factors:

27) Below are 10 documents typically examined during an audit. Classify each document as either internal or external.
Type of Document Documents
1. Canceled checks for payments of accounts payable.
2. Payroll time cards.
3. Duplicate sales invoices.
4. Vendors’ invoices.
5. Bank statements.
6. Minutes of the board of directors’ meetings.
7. Signed lease agreements.
8. Notes receivable.
9. Subsidiary accounts receivable records.
10. Remittance advices.

28) Audit evidence to support an opinion about the fairness of a client’s financial statements consists entirely of written information.
A) True
B) False
Answer
Terms: Audit evidence to support an opinion
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

29) The relevance of audit evidence depends on the audit objective being tested.
A) True
B) False
Answer
Terms: Relevance of audit evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

30) Inquiries of the client are usually sufficient to provide appropriate evidence to satisfy an audit objective.
A) True
B) False
Answer
Terms: Inquiries of client; Appropriate evidence
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

31) A canceled check written by the client, made payable to a local supplier and drawn on the client’s bank account is one type of internal document.
A) True
B) False
Answer
Terms: Internal document
Diff: Easy
Objective: LO 7-3
AACSB: Reflective thinking skills

32) Objective evidence is more reliable, and hence more persuasive, than subjective evidence.
A) True
B) False
Answer
Terms: Objective evidence more reliable
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

33) Relevance of evidence can only be considered in terms of specific audit objectives.
A) True
B) False
Answer
Terms: Relevance of evidence
Diff: Moderate
Objective: LO 7-3
AACSB: Reflective thinking skills

Learning Objective 7-4

1) Calculating the gross margin for the current year under audit as a percent of sales and comparing it with previous years is what type of evidence?
A) physical examination
B) analytical procedures
C) observation
D) inquiry
Answer
Terms: Calculate and compare gross margin
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

2) When the auditor develops supporting evidence for amounts posted to account balances with documentary evidence, that process is called:
A) inquiry.
B) confirmation.
C) vouching.
D) physical examination.
Answer
Terms: Auditor develops supporting evidence for amounts posted with documentary evidence
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

3) An example of an external document that provides reliable information for the auditor is:
A) employees’ time reports.
B) bank statements.
C) purchase order for company purchases.
D) carbon copies of checks.
Answer
Terms: External document
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

4) An example of a document the auditor receives from the client, but which was prepared by someone outside the client’s organization, is a:
A) confirmation.
B) sales invoice.
C) vendor invoice.
D) bank reconciliation.
Answer
Terms: Example of document auditor receives from client but prepared by outside source
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

5) “The use of comparisons and relationships to assess whether account balances or other data appear reasonable compared to the auditor’s expectations” is a definition of:
A) analytical procedures.
B) tests of transactions.
C) tests of balances.
D) auditing.
Answer
Terms: Use of comparisons and relationships to assess whether account balances
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

6) Often, auditor procedures result in significant differences being discovered by the auditor. The auditor should investigate further if:
A)
Significant differences are not expected but do exist Significant differences are expected but do not exist
Yes Yes

B)
Significant differences are not expected but do exist Significant differences are expected but do not exist
No No

C)
Significant differences are not expected but do exist Significant differences are expected but do not exist
Yes No

D)
Significant differences are not expected but do exist Significant differences are expected but do not exist
No Yes

Answer
Terms: Audit procedures result in significant differences
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills
7) When the auditor uses tracing as an audit procedure for tests of transactions she is primarily concerned with which audit objective?
A) Occurrence
B) Completeness
C) Cutoff
D) Classification
Answer
Terms: Tracing as an audit procedure concerned with audit objective
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

8) When the auditor used the audit procedure vouching she is primarily concerned with which of the following audit objectives when testing classes of transactions?
A) Occurrence
B) Completeness
C) Authorization
D) Classification
Answer
Terms: Vouching as an audit procedure concerned with audit objective
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

9) When auditors use documentation to support recorded transactions and amounts, the process is usually called:
A) tracing.
B) confirmations.
C) vouching.
D) reperformance.
Answer
Terms: Directional testing
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
10) Analytical procedures must be used during which phase(s) of the audit?
A)
Test of Controls Planning Completion
Yes Yes Yes

B)
Test of Controls Planning Completion
No Yes Yes

C)
Test of Controls Planning Completion
Yes No No

D)
Test of Controls Planning Completion
No No No

Answer
Terms: Analytical procedures use during phases of the audit
Diff: Moderate
Objective: LO 7-4
AACSB: Analytic skills

11) Auditors may decide to replace tests of details with analytical procedures when possible because the:
A) analytical procedures are more reliable.
B) analytical procedures are considerably less expensive.
C) analytical procedures are more persuasive.
D) tests of details are more difficult to interpret.
Answer
Terms: Tests of details of balances; Substantive analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

12) When making decisions about evidence for a given audit, the auditor’s goal is to obtain a sufficient amount of timely, reliable evidence that is relevant to the information being verified. In addition, the goal of audit efficiency is to gather and evaluate the information:
A) no matter the cost involved in obtaining such evidence.
B) even if cost is irrelevant to the auditor, because they bill the client for costs incurred.
C) at the lowest possible total cost.
D) at the cost suggested in the engagement letter.
Answer
Terms: Goal of audit efficiency
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
13) “Physical examination” is the inspection or count by the auditor of items such as:
A) cash, inventory, and payroll timecards.
B) cash, inventory, canceled checks, and sales documents.
C) cash, inventory, canceled checks, and tangible fixed assets.
D) cash, inventory, securities, notes receivable, and tangible fixed assets.
Answer
Terms: Physical examination
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

14) Which of the following statements is most correct regarding the primary purpose of audit procedures?
A) to detect all errors or fraudulent activities as well as illegal activities
B) to comply with auditing standards promulgated by the PCAOB for publicly held clients
C) to gather corroborative audit evidence about management’s assertions regarding the client’s financial statements
D) to determine the amount of errors in the balance sheet accounts in order to adjust the accounts to actual
Answer
Terms: Primary purpose of audit procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

15) Given the audit procedures below, which one provides the most reliable evidence?
A) Confirmations
B) Recalculation
C) Reperformance
D) Observations
Answer
Terms: Audit procedure that provides most reliable evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

16) Confirmations would almost always be used, assuming all the accounts below are material, for:
A) individual transactions between organizations, such as sales transactions.
B) bank balances and accounts receivable.
C) fixed asset additions.
D) payroll expenses.
Answer
Terms: Confirmations
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
17) To be considered reliable evidence, confirmations must be controlled by:
A) a client employee responsible for accounts receivable.
B) a financial statement auditor.
C) a client’s internal audit department.
D) a client’s controller or CFO.
Answer
Terms: Confirmations controlled to be considered reliable evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

18) Indicate whether confirmation of accounts receivable and accounts payable, provided they each are significant accounts, is required or optional:
A)
Accounts Receivable Accounts Payable
Required Required

B)
Accounts Receivable Accounts Payable
Required Optional

C)
Accounts Receivable Accounts Payable
Optional Required

D)
Accounts Receivable Accounts Payable
Optional Optional

Answer
Terms: Confirmation of accounts receivable and accounts payable
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

19) The Auditing Standards Board has concluded that analytical procedures are so important that they are required during:
A) planning and test of control phases.
B) planning and completion phases.
C) test of control and completion phases.
D) planning, test of control, and completion phases.
Answer
Terms: Analytical procedures required
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
20) A benefit obtained from comparing the client’s data with industry averages is that it provides a(n):
A) benchmark to compare the company against industry averages.
B) indication where errors exist in the statements.
C) benchmark to be used in evaluating a client’s budgets.
D) comparison of “what is” with “what should be.”
Answer
Terms: Comparing client data with industry averages
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

21) The primary purpose of performing analytical procedures in the planning phase of an audit is to:
A) help the auditor obtain an understanding of the client’s industry and business.
B) assess the going concern assumption.
C) indicate possible misstatements.
D) reduce detailed tests.
Answer
Terms: Primary purpose of analytical procedures in planning phase of audit
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

22) Which of the following is not a correct combination of terms and related type of audit evidence?
A) Inquire  inquiries of client
B) Count  physical examination
C) Recompute  documentation
D) Read  documentation
Answer
Terms: Combination of terms and related audit evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

23) Which of the following is not one of the major types of analytical procedures?
A) compare client with industry averages
B) compare client with prior year
C) compare client with budget
D) compare client with SEC averages
Answer
Terms: Major type of analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
24) An important benefit of industry comparisons is as:
A) an aid to understanding the client’s business.
B) an indicator of errors.
C) an indicator of fraud.
D) a least-cost indicator for audit procedures.
Answer
Terms: Benefit of industry comparisons
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

25) The auditor is concerned that a client is failing to bill customers for shipments. An audit procedure that would gather relevant evidence would be to:
A) select a sample of duplicate sales invoices and trace each to related shipping documents.
B) trace a sample of shipping documents to related duplicate sales invoices.
C) trace a sample of Sales Journal entries to the Accounts Receivable subsidiary ledger.
D) compare the total of the Schedule of Accounts Receivable with the balance of the Accounts Receivable account in the general ledger.
Answer
Terms: Audit procedure to gather relevant evidence that client fails to bill
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

26) In performing your audit for a privately-held firm your inquiries have yielded that one of the company’s owner’s primary motivations is to pay the least amount of income tax that is possible. Based on this observation which audit objective for ending inventory would the auditor be most concerned about ascertaining?
A) Completeness
B) Accuracy
C) Rights and obligations
D) Existence
Answer
Terms: Audit objective for ending inventory
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

27) 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.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

28) You are auditing the company’s purchasing process for goods and services. You are primarily concerned with the company not recording all purchase transactions. Which audit procedure below would be the most effective audit procedure in this case?
A) Vouching from the accounts payable account to the vendor invoices.
B) Tracing vendor invoices to recorded amounts in the accounts payable account.
C) Confirmation accounts payable recorded amounts.
D) Reconciling the accounts payable subsidiary ledger to the accounts payable account.
Answer
Terms: Audit procedure for recording all purchase transactions
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

29) Which of the following discoveries through the use of analytical procedures would most likely indicate a relatively high risk of financial failure?
A) A decline in gross margin percentages.
B) An increase in the balance in fixed assets.
C) An increase in the ratio of allowance for uncollectible accounts to gross accounts receivable, while at the same time accounts receivable turnover also decreased.
D) A higher than normal ratio of long-term debt to net worth as well as a lower than average ratio of profits to total assets.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

30) Which of the following statements is correct regarding the costs involved in obtaining evidence?
A)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
Yes Yes

B)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
No No

C)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
Yes No

D)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
No Yes

Answer
Terms: Costs in obtaining evidence
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

31) An analytical procedure used to test the reasonableness of an account balance occurs when the auditor calculates the expected balance and compares it with the actual balance. The auditor’s expected account balance may be determined by:
A) using industry standards.
B) using Dun and Bradstreet reports.
C) relating it to another account that involves financial statement articulation.
D) inquiry of the client.
Answer
Terms: Analytical procedure used to test reasonableness of an account balance
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

32) One purpose of performing analytical procedures in the planning phase of an audit is to assess the client’s financial condition. Explain how the assessment of a client’s financial condition can affect the auditor’s decisions concerning evidence accumulation in later phases of the audit.

33) There are four important purposes of analytical procedures. Identify three of these four purposes and, for each purpose, give a specific example of an analytical procedure that an auditor might perform.

34) Define the following terms commonly used in audit procedures:
1. Examine
2. Scan
3. Compute
4. Foot
5. Compare
6. Count
7. Vouch

35) Below are 12 audit procedures. Classify each procedure according to the following types of audit evidence: (1) physical examination, (2) confirmation, (3) documentation, (4) observation, (5) inquiry of the client, (6) reperformance, and (7) analytical procedure.

Type of Evidence Audit Procedures
1. Watch client employees count inventory to determine whether company procedures are being followed.
2. Count inventory items and record the amount in the audit files.
3. Trace postings from the sales journal to the general ledger accounts.
4. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year.
5. Obtain information about the client’s internal controls by asking questions of client personnel.
6. Trace column totals from the cash disbursements journal to the general ledger.
7. Examine a piece of equipment to make sure a recent purchase of equipment was actually received and is in operation.
8. Review the total of repairs and maintenance for each month to determine whether any month’s total was unusually large.
9. Compare vendor names and amounts on purchase invoices with entries in the purchases journal.
10. Foot entries in the sales journal to determine whether they were correctly totaled by the client.
11. Make a surprise count of petty cash to verify that the amount of the petty cash fund is intact.
12. Obtain a written statement from the client’s bank stating the client’s year-end balance on deposit.

36) Match nine of the terms (a-k) with the definitions provided below (1-9):

a. Foot
b. Compute
c. Scan
d. Inquire
e. Count
f. Trace
g. Reperform
h. Read
i. Examine
j. Observe
k. Compare

________ 1. A calculation done by the auditor independent of the client.

________ 2. Addition of a column of numbers to determine if the total is the same as the client’s.

________ 3. A comparison of information in two different locations.

________ 4. A use of the senses to assess certain activities.

________ 5. Following details of transactions from original documents to journals.

________ 6. A less detailed examination of a document or record to determine if there is something unusual warranting further investigation.

________ 7. Obtaining information from the client in response to specific questions.

________ 8. A determination of assets on hand at a given time.

________ 9. An examination of written information to determine facts pertinent to the audit.

37) Match five of the terms (a-h) with the definitions provided below (1-5):

a. Audit documentation
b. Audit procedures
c. Audit objectives
d. Analytical procedures
e. Budgets
f. Reliability of evidence
g. Sufficiency of evidence
h. Persuasiveness of evidence

________ 1. Use of comparisons and relationships to assess the reasonableness of account balances.

________ 2. Detailed instructions for the collection of a type of audit evidence.

________ 3. The degree to which evidence can be considered believable or trustworthy.

________ 4. Contains all the information that the auditor considers necessary to conduct an adequate audit and to provide support for the audit report.

________ 5. This is determined by the amount of evidence obtained.

38) Confirmations are among the most expensive type of evidence to obtain.
A) True
B) False
Answer
Terms: Confirmations; Cost of evidence
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

39) Whenever practical and reasonable, the confirmation of accounts receivable is required of CPAs.
A) True
B) False
Answer
Terms: Confirmations of accounts receivable required of CPAs
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

40) Inquiries of clients and reperformance normally have a low cost associated with them.
A) True
B) False
Answer
Terms: Inquiries of clients and reperformance have low cost
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

41) When analytical procedures reveal unusual fluctuations in an account balance, the auditor will probably perform fewer tests of details for that account and increase the tests of controls related to the account.
A) True
B) False
Answer
Terms: Analytical procedures reveal unusual fluctuations
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

42) The type of audit evidence known as inquiry requires the auditor to obtain oral information from the client in response to questions.
A) True
B) False
Answer
Terms: Audit evidence; Inquiry
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills
43) Auditor judgment is the primary determinant in determining the amount of evidence gathered.
A) True
B) False
Answer
Terms: Auditor judgment; Evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

44) Analytical procedures must be used in the planning and completion phases of the audit.
A) True
B) False
Answer
Terms: Analytical procedures used in planning and completion phases of audit
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

45) Confirmations are ordinarily used to verify account balances, but may be used to verify transactions.
A) True
B) False
Answer
Terms: Confirmations to verify balances and transactions
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

46) Accounts receivable confirmations must be controlled by the client from the time they are prepared until the time they are returned to the auditor.
A) True
B) False
Answer
Terms: Confirmations control
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

47) Cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size.
A) True
B) False
Answer
Terms: Cost of audit procedures; Sample size
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
48) Analytical procedures can be used to provide reliable substantive evidence for all balance-related audit objectives.
A) True
B) False
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

49) One advantage of using statistical techniques when performing analytical procedures is that they eliminate the need for auditor judgment.
A) True
B) False
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

Learning Objective 7-5

1) Which of the following best describes one of the primary objectives of audit documentation?
A) Defend against claims of a deficient audit.
B) Provide a basis for reviewing the work of subordinates.
C) Provide reasonable assurance that the audit was conducted in accordance with auditing standards.
D) Provide additional support of recorded amounts to the client.
Answer
Terms: Primary objective of audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

2) The permanent files included as part of audit documentation do not normally include:
A) a copy of the current and prior years’ audit programs.
B) copies of articles of incorporation, bylaws and contracts.
C) information related to the understanding of internal control.
D) results of analytical procedures from prior years.
Answer
Terms: Permanent files as audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills
3) The auditor’s results of evidence gathering procedures are contained in audit documentation for the audit. When preparing the requisite audit, documentation should be cognizant of:
A) Documents are kept by the client for easy reference for their accounting staff.
B) Audit documents should be considered as a substitute for the clients accounting records.
C) Audit documents are designed to facilitate the review and supervision of the work performed by the audit team by a reviewing partner.
D) Audit documents are the sole source of evidence that an auditor uses in forming an opinion about the client’s financial statements.
Answer
Terms: Audit documentation for audit
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

4) Audit documentation should provide support for:
A)
The audit report The financial statements
Yes Yes

B)
The audit report The financial statements
No No

C)
The audit report The financial statements
Yes No

D)
The audit report The financial statements
No Yes

Answer
Terms: Audit documentation should provide support
Diff: Challenging
Objective: LO 7-5
AACSB: Reflective thinking skills

5) Audit documentation is the joint property of the auditor and the audit client.
A) True
B) False
Answer
Terms: Audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

6) Ordinarily, audit documentation can be provided to someone else only with the express permission of the client.
A) True
B) False
Answer
Terms: Audit documentation provided with permission of client
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

Learning Objective 7-6

1) What client information is needed by auditors in creating lead schedules?
A) Interim statements prepared by the client for the company’s 3rd quarter financial results.
B) General ledger information, including unadjusted ending balances and beginning balances for accounts.
C) A schedule of adjusting entries made by the client for all balance sheet accounts.
D) Detailed transaction information that may explain the changes in balance sheet accounts for the current year under audit.
Answer
Terms: Client information needed for auditor to create lead schedules
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills

2) Audit documentation should possess certain characteristics. Which of the following is true regarding those characteristics?
A)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
Yes Yes

B)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
No No

C)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
Yes No

D)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
No Yes

Answer
Terms: Audit documentation characteristics
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills

3) The permanent audit file would usually include the following:
A) client’s working trial balance
B) summary of the risk assessment procedures performed
C) organizational chart of the company’s employees
D) summary of the auditors test of controls for the current years audit
Answer
Terms: Permanent file
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills
4) When determining sufficient and appropriate audit evidence in order to form an opinion on the client’s financial statements the auditor compiles audit documentation to support the opinion. The largest portion of audit documentation will include detailed supporting schedules prepared by the client or the auditor in support of specific accounts on the financial statements. The major types of supporting schedules include analysis schedules and tests of reasonableness. Discuss those two schedules and give an example for each schedule.

5) The basis for preparing financial statements for companies is the general ledger. As soon as possible the auditor obtains the general ledger accounts of the client and prepares a working trial balance. Discuss the audit documentation in the current file that relates to the working trial balance. Include a description of lead and support schedules in your answer.

Auditing and Assurance Services, 14e (Arens)
Chapter 8 Audit Planning and Analytical Procedures

Learning Objective 8-1

1) A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued is the:
A) inherent risk.
B) acceptable audit risk.
C) statistical risk.
D) financial risk.
Answer
Terms: Measure of how willing auditor is to accept that the financial statements may be materially misstated after audit is completed
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

2) A measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of the client’s internal control is called:
A) control risk.
B) acceptable audit risk.
C) statistical risk.
D) inherent risk.
Answer
Terms: A measure of auditor’s assessment of likelihood that there are material misstatements in an account before considering internal control
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

3) When inherent risk is high, there will need to be:
A)
A lower assessment of audit risk More evidence accumulated by the auditor
Yes Yes

B)
A lower assessment of audit risk More evidence accumulated by the auditor
No No

C)
A lower assessment of audit risk More evidence accumulated by the auditor
Yes No

D)
A lower assessment of audit risk More evidence accumulated by the auditor
No Yes

Answer
Terms: Inherent risk is high
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills
4) In what order should the following steps occur?
A. assess client business risk
B. understand the client’s business and industry
C. perform preliminary analytical procedures
D. assess acceptable audit risk
A) D, B, C, A
B) B, A, D, C
C) B, D, A, C
D) D, C, B, A
Answer
Terms: Steps in planning an audit
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills

5) The auditor uses knowledge gained from the understanding of the client’s business and industry to assess:
A) client business risk.
B) control risk.
C) inherent risk.
D) audit risk.
Answer
Terms: First standard of fieldwork; Proper planning
Diff: Challenging
Objective: LO 8-1
AACSB: Analytic skills
6) There are three main reasons why an auditor should properly plan audit engagements. Discuss each of these reasons.

7) When an auditor decides there is higher inherent risk for an account, one potential effect is that more audit evidence will be required for that account.
A) True
B) False
Answer
Terms: Inherent risk
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills
8) As acceptable audit risk is decreased, the likely cost of conducting an audit increases.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

9) Acceptable audit risk is a measure of the auditor’s willingness to accept that the financial statements do not contain material misstatements after the audit is completed and a qualified audit report has been issued.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills

10) Two major factors that affect acceptable audit risk are the likely users of the financial statements and the likelihood of issuing an unqualified audit opinion.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills
Learning Objective 8-2

1) One of the purposes of an engagement letter is to avoid misunderstandings with the client. This is important for:
A)
Good client relations Facilitating high-quality work at a reasonable cost
Yes Yes

B)
Good client relations Facilitating high-quality work at a reasonable cost
No No

C)
Good client relations Facilitating high-quality work at a reasonable cost
Yes No

D)
Good client relations Facilitating high-quality work at a reasonable cost
No Yes

Answer
Terms: Engagement letter
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

2) The auditor is likely to accumulate more evidence when the audit is for a company:
A)
Which has large amounts of debt Which is to be sold in the near future
Yes Yes

B)
Which has large amounts of debt Which is to be sold in the near future
No No

C)
Which has large amounts of debt Which is to be sold in the near future
Yes No

D)
Which has large amounts of debt Which is to be sold in the near future
No Yes

Answer
Terms: Auditors accumulate more evidence when audit is for company
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills
3) Initial audit planning involves four matters. Which of the following is not one of these?
A) Develop an overall audit strategy.
B) Request that bank balances be confirmed.
C) Schedule engagement staff and audit specialists.
D) Identify the client’s reason for the audit.
Answer
Terms: Initial audit planning
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

4) Rodgers CPA has requested permission to communicate with predecessor auditor in order to review certain workpapers for high risk accounts for a new audit client. The new audit clients refusal to allow this communication to occur would impact Rodgers decision concerning:
A) the auditor’s ability to design audit tests.
B) possible scope exception due to lack of access.
C) integrity of management concerning possible accounting misstatements.
D) violation of the GAAP rules concerning consistency and comparability of financial information.
Answer
Terms: New audit clients refusal to allow communication between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

5) A successor auditor may perform which of the following for a new audit client?
A)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
Yes Yes

B)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
No No

C)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
Yes No

D)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
No Yes

Answer
Terms: Successor auditor may perform communication for new audit client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
6) Which of the following is not correct regarding an auditor’s decision that a lower acceptable audit risk is appropriate?
A) More evidence is accumulated.
B) Less evidence is accumulated.
C) Special care is required in assigning experienced staff.
D) Review of audit documentation is performed by personnel not assigned to the engagement.
Answer
Terms: Lower acceptable audit risk
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

7) A written understanding detailing what the auditors will do in determining if the financial statements are fair representations of the company’s financial statements and what the auditor expects from the client in performing an audit will normally be expressed in the:
A) management letter requested by the auditor.
B) engagement letter.
C) Audit Plan.
D) Audit Strategy for the client.
Answer
Terms: Written understanding detailing what auditor will do and what auditor expects from client in performing audit
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

8) If an auditor is requested to perform nonaudit services for a public company audit client, who is responsible for agreeing to those services with the audit firm?
A) the client’s management
B) the client’s chief executive officer
C) the client’s chief financial officer
D) the client’s audit committee
Answer
Terms: Responsibility for agreeing nonaudit services for a public company audit client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
Topic: SOX

9) Which of the following statements is true regarding communications between predecessor and successor auditors?
A) The burden of initiating the communication rests with the predecessor.
B) The predecessor’s response can be limited to stating that no information will be provided.
C) The predecessor should communicate with the successor only if the client is public.
D) There must be communication between the predecessor and successor if the successor is to accept the engagement.
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
10) The purpose of an engagement letter is to:
A) document the CPA firm’s responsibility to external users of the audited financial statements.
B) document the terms of the engagement.
C) notify the audit staff of an upcoming engagement so that personnel scheduling can be facilitated.
D) emphasize management’s responsibility for approving the audit program.
Answer
Terms: Purpose of engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
11) Written communication that the auditor will provide reasonable assurance for the detection of fraud is found in:
A) engagement letter.
B) representation letter.
C) responsibility letter.
D) client letter.
Answer
Terms: Written communication that auditor will provide reasonable assurance
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

12) Which of the following normally signs the engagement letter for an audit of a private company?
A) Management.
B) Board of directors representative
C) Audit committee representative
D) Corporate treasurer
Answer
Terms: Normally signs engagement letter for audit of private company
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

13) The first standard of field work, which states that the work is to be adequately planned and that assistants, if any, are to be properly supervised, recognizes that:
A) early appointment of the auditor is advantageous to the auditor and the client.
B) acceptance of an audit engagement after the close of the client’s fiscal year is generally not permissible.
C) appointment of the auditor subsequent to the physical count of inventories requires a disclaimer of opinion.
D) performance of substantial parts of the examination is necessary at interim dates.
Answer
Terms: Standard of field work; Audit planning
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
14) An engagement letter sent to a publicly held audit client usually would not include a:
A) reference to the auditor’s responsibility for the detection of errors or irregularities.
B) estimation of the time to be spent on the audit work by audit staff and management.
C) statement that management advisory services would be made available upon request.
D) reference to management’s responsibility for the financial statements.
Answer
Terms: Engagement letter sent to publicly held client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

15) Jennings and Company has repositioned the firm’s business strategy from the basis of competing on costs to competing on product differentiation. All the following will increase, except:
A) Audit risk.
B) Business Risk.
C) Financial risk.
D) Risk of Material Misstatements.
Answer
Terms: Client repositioned firm’s business strategy
Diff: Moderate
Objective: LO 8-2
AACSB: Analytic skills

16) The purpose of the requirement in having communication between the predecessor and successor auditors is to:
A) allow the predecessor to disclose information which would otherwise be confidential.
B) help the successor auditor to evaluate whether to accept the engagement.
C) help the client by facilitating the change of auditors.
D) ensure the predecessor collects all unpaid fees prior to a change in auditor.
Answer
Terms: Purpose of having communication between predecessor and successor audit
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

17) The predecessor auditor is required to respond to the request of the successor auditor for information, but the response can be limited to stating that no information will be provided when:
A) the predecessor auditor has poor relations with the successor auditor.
B) the client is dissatisfied with the predecessor’s work.
C) there are actual or potential legal problems between the client and the predecessor.
D) the predecessor believes that the client lacks integrity.
Answer
Terms: Predecessor auditor respond to request of successor auditor for information
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills
18) Which of the following best expresses the requirement to establish with the client an understanding of the responsibilities the auditor and company is taking for the audit engagement?
A) Management asserts there are no material misstatements in the financials.
B) Auditors assert that the primary audit goal is audit efficiency.
C) Auditors assert that their primary responsibility is to plan and perform the audit in order to provide reasonable assurance as to the detection of material misstatement due to error or fraud.
D) Management’s assertion that they will provide the auditor with a risk assessment as to material misstatements due to errors or fraud in the company’s financial statements.
Answer
Terms: Understand responsibilities of the auditor and company for the audit
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

19) Early appointment of the independent auditor will enable:
A) a more thorough examination to be performed.
B) a proper study and evaluation of internal control to be performed.
C) sufficient competent evidential matter to be obtained.
D) a more efficient examination to be planned.
Answer
Terms: Early appointment of auditor
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

20) An auditor who accepts an audit engagement and does not possess the industry expertise of the business entity should:
A) engage financial experts familiar with the nature of the business entity.
B) obtain a knowledge of matters that relate to the nature of the entity’s business.
C) refer a substantial portion of the audit to another CPA who will act as the principal auditor.
D) first inform management that an unqualified opinion cannot be issued.
Answer
Terms: Auditor accepts audit engagement and does not possess industry expertise
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills
21) Which is usually included in an engagement letter?
A)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
Yes Yes

B)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
No No

C)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
Yes No

D)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
22) Which is usually included in an engagement letter?
A)
A reference to GAAP A reference to GAAS
Yes Yes

B)
A reference to GAAP A reference to GAAS
No No

C)
A reference to GAAP A reference to GAAS
Yes No

D)
A reference to GAAP A reference to GAAS
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

23) Which is usually included in an engagement letter?
A)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
Yes Yes

B)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
No No

C)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
Yes No

D)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

24) When may the auditor refer to a specialist in the audit report?
A)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
Yes Yes

B)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
No No

C)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
Yes No

D)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
No Yes

Answer
Terms: Auditors refer to specialist in audit report
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

25) Which is usually included in the engagement letter?
A)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
Yes Yes

B)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
No No

C)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
Yes No

D)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

26) Which is usually included in the engagement letter?
A)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
Yes Yes

B)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
No No

C)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
Yes No

D)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

27) Discuss the factors an auditor should consider before accepting a company as an audit client.

28) Discuss the primary purpose of an audit engagement letter. Is an engagement letter required?

29) Discuss the essential activities involved in the initial planning of an audit.

30) Discuss the required communications between predecessor and successor auditors.

31) Discuss several reasons why an auditor may not wish to continue a relationship with an existing audit client.

32) Discuss four of the matters that should be specified in an engagement letter.

33) Before accepting a new client, most CPA firms investigate the company to determine its acceptability. However, AICPA confidentiality requirements prohibit CPA firms from contacting certain parties–namely the company’s attorneys and bankers–during this investigation.
A) True
B) False
Answer
Terms: Acceptance of new client
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

34) For prospective clients that have previously been audited by another CPA firm, the predecessor auditor is required to communicate with the successor auditor.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

35) When a successor auditor contacts a company’s previous auditor, the predecessor auditor is required to respond fully and without limit to the request for information.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

36) A predecessor auditor who has been contacted by a successor auditor for information about the client does not have to obtain permission from the former client before providing any confidential information to the successor auditor because the confidentiality requirement does not extend to former clients.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

37) An auditor must evaluate a specialist’s professional qualifications and understand the objectives of the specialist’s work.
A) True
B) False
Answer
Terms: Auditor evaluate specialist’s work
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

38) To evaluate a specialist’s work the auditor must himself/herself be considered a specialist.
A) True
B) False
Answer
Terms: Auditor evaluated specialist’s work
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

39) An engagement letter establishes a clear understanding of the terms of the engagement between the client and the auditor, but it is optional for private companies.
A) True
B) False
Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

40) Because of the requirements of Rule 201 of the AICPA’s Code of Professional Conduct which state that auditors should “undertake only those professional services that the member or the member’s firm can reasonably expect to be completed with professional competence,” auditors are not normally permitted to consult with, or rely on the work of, outside specialists during an audit engagement.
A) True
B) False
Answer
Terms: Use of outside specialists during audit engagement
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills
41) If a prospective client has been audited in the past, the successor auditor will typically rely solely on the representations about the client by the predecessor auditor.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

42) A major consideration in assigning staff to an audit engagement is the experience levels required for the work, while a less important consideration is maintaining staff continuity on the engagement.
A) True
B) False
Answer
Terms: Consideration in assigning staff to audit engagement
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

43) When a successor auditor requests information from a company’s previous auditor, and there are legal problems or disputes between the client and the predecessor auditor, the predecessor auditor’s response to the new auditor may be limited to stating that no information will be provided.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

44) An engagement letter can affect the CPA firm’s legal responsibilities to the client, but does not affect responsibility to external users of audited financial statements.
A) True
B) False
Answer
Terms: Engagement letter
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

Learning Objective 8-3

1) In making client acceptance decisions the audit firm will consider:
A) inherent and control risk of the client.
B) audit risk to the CPA Firm.
C) the client’s business risk and the CPA Firm’s engagement risk.
D) CPA Firm’s potential ongoing revenue from the audit client.
Answer
Terms: Client acceptance decisions
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

2) Most auditors assess inherent risk as high for related parties and related-party transactions because:
A) of the unique classification of related-party transactions required on the balance sheet.
B) of the lack of independence between the parties.
C) of the unique classification of related-party transactions required on the income statement.
D) it is required by generally accepted accounting principles.
Answer
Terms: Inherent risk assessed high for relate parties and transactions
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

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.
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.
Answer
Terms: Information about new client’s business and industry
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

4) The auditor determines that Mathews Company occupies the 3rd floor of an office tower for which it pays no rent. The most likely explanation is:
A) they got lucky the landlord hasn’t noticed the lack of payments.
B) landlord has weak internal controls over billings.
C) related party transaction in which a major shareholder owns the office tower.
D) Matthews Company is engaging in fraudulent activities.
Answer
Terms: Auditor determines client occupies office for which it pays no rent
Diff: Moderate
Objective: LO 8-3
AACSB: Analytic skills

5) An official record of meetings of the board of directors and stockholders is included in the corporate:
A) bylaws.
B) charter.
C) minutes.
D) license.
Answer
Terms: Official record of meetings of board of directors and stockholders
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

6) Related party transactions may be indicated when another company:
A) Subsidizes certain operating expenses of the company
B) Purchases its securities at their fair value
C) Loans to company at market rates
D) Has had a distributor relationship with the company for 10 years
Answer
Terms: Related party transactions
Diff: Moderate
Objective: LO 8-3
AACSB: Analytic skills

7) Which one of the following is not an inherent risk factor in the financial statements?
A) The company made 3 acquistions during the year in different lines of business.
B) The company’s industry is experiencing downward pricing pressure for its goods and services.
C) The company’s inventory, because of multiple locations, is difficult to count.
D) The company has hired 3 different chief accounting officers for the year.
Answer
Terms: Inherent risk factor
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

8) An auditor should examine minutes of the board of directors’ meetings:
A) through the date of the financial statements.
B) through the date of the audit report.
C) only at the beginning of the audit.
D) on a test basis.
Answer
Terms: Minutes of the board of directors’ meetings
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

9) Which of the following would not likely be classified as a related-party transaction?
A) an advance of one week’s salary to an employee
B) sales of merchandise between affiliated companies
C) loans or credit sales to the principal owner of the client company
D) exchanges of equipment between two companies owned by the same person
Answer
Terms: Related-party transaction
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

10) Which of the following best describes the coporate minutes of an entity?
A) official record of the meetings of the board of directors and the stockholders
B) unofficial record of the meeting of the board of directors
C) official record of management meeting with investors and creditors of the company
D) unofficial record of the board of directors meetings
Answer
Terms: Corporate minutes
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

11) An auditor searching for related party transactions should obtain an understanding of each subsidiary’s relationship to the total entity because:
A) the business structure may be deliberately designed to obscure related party transactions.
B) this may reveal whether transactions would have taken place if the parties had been unrelated.
C) transactions may have been consummated on terms equivalent to arm’s-length transactions.
D) this may permit the audit of intercompany account balances to be performed as of concurrent dates.
Answer
Terms: Related party transactions; subsidiary relationships to total entity
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

12) Define the term “related party” and discuss why an auditor should identify the client’s related parties early in the audit.
Answer related party is an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. Auditors need to be aware of who the client’s related parties are early in the audit to enable the auditor to identify related-party transactions, especially those that have not been disclosed.
Terms: Related party
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

13) What documents do auditors routinely obtain to aid in their understanding of a client’s governance system? Briefly discuss each of these documents.
Answeruditors commonly obtain organizational structure, code of ethics, and the minutes of meetings of the board of directors and shareholders. Companies frequently communicate the entity’s values and ethical standards through policy statements and codes of conduct. The corporate minutes are the official record of the meetings of the board of directors and stockholders. They include summaries of the most important topics discussed and decisions made at the board meetings.
Terms: Documents for client’s governance system
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

14) What are three factors that have increased the importance of obtaining an understanding of a client’s business and industry? How can an auditor obtain this understanding?

15) There are three primary reasons for obtaining a thorough understanding of the client’s industry and external environment. What are these reasons?

16) Auditors should obtain copies of the client’s code of ethics and minutes of the meetings of the board of directors to aid in their understanding of the company’s management and governance structure.
A) True
B) False
Answer
Terms: Code of ethics and board of directors’ meeting minutes; Understanding of company management and governance structure
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

17) Inherent risks typically vary across industries.
A) True
B) False
Answer
Terms: Inherent risk
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

18) Transactions with related parties must be disclosed in the financial statements if they are deemed to be material.
A) True
B) False
Answer
Terms: Related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

19) All known related parties must be identified and included in the auditor’s permanent files related to the client.
A) True
B) False
Answer
Terms: Related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

20) Generally, auditors assess inherent risk as moderate for related party transactions because they expect clients to be aware of their scrutiny of such transactions.
A) True
B) False
Answer
Terms: Inherent risk for related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

21) The cr code of ethics typically establishes the company’s fiscal year and frequency of stockholder meetings.
A) True
B) False
Answer
Terms: Code of ethics
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

22) Ordinarily, the auditor should review corporate minutes during the later stages of an audit.
A) True
B) False
Answer
Terms: Corporate minutes
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

23) Material transactions between the client and the client’s related parties must be disclosed in the auditor’s report.
A) True
B) False
Answer
Terms: Material related party transactions
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

24) Two categories of audit-relevant information found in corporate code of ethics are authorizations and discussions of matters affecting inherent risk.
A) True
B) False
Answer
Terms: Code of ethics
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

Learning Objective 8-4

1) An auditor has accessed client business risk and the risk to material misstatements to the clients financial statements. These are done in order to:
A) apply the audit risk model in determining the appropriate audit procedures to perform.
B) determine the reliance on the company’s internal control systems for financial reporting.
C) determine the test of balances to be performed by the audit team.
D) assure the CPA firm that they can perform the audit effectively and efficiently,
Answer
Terms: Business risk and risk of material misstatements
Diff: Moderate
Objective: LO 8-4
AACSB: Reflective thinking skills

2) Which of the following statements is most correct concerning audit risk?
A) Audit risk can be quantified with a reasonable degree of certainty.
B) Audit risk cannot be quantified with certainty.
C) Audit risk is the same for all audit client in the same industry.
D) Audit risk can be eliminated by having the correct audit procedures.
Answer
Terms: Audit risk
Diff: Moderate
Objective: LO 8-4
AACSB: Reflective thinking skills

3) Define business risk. List several factors that may impact the auditor’s assessment of business risk.
Answerusiness risk is the risk that a company will fail to achieve its objectives.
Factors that may impact business risk include:
• General economic conditions,
• Extent of competition within an industry,
• Changing regulatory requirements,
• Competence of management,
• Ability to maintain sufficient cash flows and secure financing, and
• Successful implementation of business strategies.
Terms: Business risk and factors that impact auditor’s assessment
Diff: Challenging
Objective: LO 8-4
AACSB: Reflective thinking skills

Learning Objective 8-5

1) Auditors routinely conduct analytical procedures in the planning, testing, and completion phases of the audit. Identify the primary and secondary purposes of performing analytical procedures in each phase of the audit.

Learning Objective 8-6

1) During audit planning, the auditor uses analytical procedures primarily to:
A) identify weaknesses in internal control.
B) determine if the company’s financial statements appear reasonable and are free of material misstatement.
C) determine the correspondence of the company’s financial statements to the valuation and accuracy audit objectives.
D) understand the client’s business and industry and to indicate possible misstatements.
Answer
Terms: Audit planning phase and primary purpose of analytical procedures
Diff: Moderate
Objective: LO 8-6
AACSB: Reflective thinking skills

2) Which of the following is most correct with respect to the use of analytical procedures?
A) Analytical procedures may be used in evaluating balances in the testing phase as long as the auditor also uses them in assessing the going concern assumption.
B) Analytical procedures must be used throughout the audit.
C) Analytical procedures used in the testing phase of the audit are primarily used to direct an auditor’s attention so that the auditor’s understanding of the business is improved.
D) Analytical procedures are performed by studying plausible relationships between financial and nonfinancial data.
Answer
Terms: Use of analytical procedures
Diff: Challenging
Objective: LO 8-6
AACSB: Reflective thinking skills

3) Which of the following statements is not correct?
A) Analytical procedures used in the planning phase of the audit are primarily directed at understanding the client’s business and directing the auditor’s attention to areas that may contain possible misstatements.
B) Analytical procedures used in the completion phase are primarily aimed at assessing going concern and secondarily aimed at directing the auditor’s attention to areas that may contain possible misstatements.
C) Analytical procedures must be used in the planning and completion phases of the audit, and are optional in the testing phase.
D) Analytical procedures used in the completion phase are primarily aimed at directing the auditor’s attention to areas that may contain possible misstatements and secondarily aimed at assessing going concern.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 8-6
AACSB: Reflective thinking skills

4) Discuss the four primary purposes of analytical procedures performed during the planning phase of an audit.

5) One purpose of performing preliminary analytical procedures in the planning phase of an audit is to help the auditor make a preliminary assessment of control risk.
A) True
B) False
Answer
Terms: Preliminary analytical procedures
Diff: Moderate
Objective: LO 8-6
AACSB: Reflective thinking skills

Learning Objective 8-7

1) Which of the following best describes the first standard of field work?
A) The auditor must adequately plan the work and properly supervise any assistants.
B) The auditor must have adequate technical training and proficiency to perform the audit.
C) The auditor must maintain independence in mental attitude in all matters relating to the audit.
D) The auditor must exercise due professional care in the performance of the audit and the preparation of the report.
Answer
Terms: Risk of material misstatement with accounting estimates
Diff: Easy
Objective: LO 8-7
AACSB: Reflective thinking skills

2) Which of the following would not be classified as an analytical procedure?
A) Benchmarking the company’s profitability ratios against others in the industry.
B) Variance analysis of actual versus budgeted amounts for production.
C) Reperforming the client’s depreciation expense using the client’s accounting policies for capital expenditures made during the year.
D) Reconciling fixed asset dispositions with the fixed asset ledger .
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 8-7
AACSB: Reflective thinking skills

3) Which of the following statements is not correct with respect to analytical procedures?
A) Auditing standards emphasize the need for auditors to develop and use expectations.
B) Analytical procedures must be performed throughout the audit.
C) Analytical procedures may be performed at any time during the audit.
D) Analytical procedures use comparisons and relationships to assess whether account balances appear reasonable.
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 8-7
AACSB: Reflective thinking skills

4) When performing planning analytical procedures for a client the auditor detected that the gross profit percentage had declined by 50% from the previous year to the year currently under audit. The auditor should:
A) investgate the possibility the client may have made an error in their cost of goods sold computation.
B) assist management in developing greater cost efficiencies in their product line.
C) prepare a going concern opinion for the client.
D) advise the client to have extensive disclosure to alleviate investor concerns.
Answer
Terms: Analytical procedures in planning phase
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills
5) When are auditors likely to encounter judgment problems in the use of analytical procedures?
A) Whenever the auditor places reliance on management’s explanations for unusual fluctuations in account balances without first developing independent expectations.
B) Whenever the auditor allows unaudited balances to unduly influence his/her expectations of current balances.
C) Whenever the auditor fails to consider the pattern reflected by several unusual fluctuations when trying to explain what caused them.
D) The auditor is likely to encounter judgment problems in each of the above instances.
Answer
Terms: Judgment problems in use of analytical procedures
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills

6) The major concern when using nonfinancial data in analytical procedures is the:
A) accuracy of the nonfinancial data.
B) source of the nonfinancial data.
C) type of nonfinancial data.
D) presence of multiple sources of nonfinancial data.
Answer
Terms: Concern when using nonfinancial data in analytical procedures
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills

7) Whenever an auditor compares client data to client-prepared budgets, there are two special concerns. Indicate if the two items below are concerns.
A)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
A concern A concern

B)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
Not a concern Not a concern

C)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
A concern Not a concern

D)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
Not a concern A concern

Answer
Terms: Comparison of client data to client-prepared budgets
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills
Learning Objective 8-8

1) Which is a liquidity activity ratio?
A) Profit margin
B) Inventory turnover
C) Return on assets
D) Times interest earned
Answer
Terms: Liquidity ratio
Diff: Moderate
Objective: LO 8-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 9 Materiality and Risk

Learning Objective 9-1

1) If it is probable that the judgment of a reasonable person will be changed or influenced by the omission or misstatement of information, then that information is, by definition of FASB Statement No. 2:
A) material.
B) insignificant.
C) significant.
D) relevant.
Answer
Terms: FASB Statement No. 2; Probable judgment of a reasonable person
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

2) The scope paragraph of the standard unqualified auditor’s report states that “… the standards require that we plan and perform the audit to obtain ________ assurance about whether the financial statements are free of material misstatement”. What type of assurance is given?
A) immediate
B) limited
C) reasonable
D) absolute
Answer
Terms: Type of assurance provided
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

3) Auditors are responsible for determining whether financial statements are materially misstated, so upon discovering a material misstatement they must bring it to the attention of:
A) regulators.
B) the audit firm’s managing partner.
C) the client shareholders.
D) the client’s management.
Answer
Terms: Discovery of a material misstatement must bring it to the attention
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

4) The FASB definition of materiality focuses on potential users of financial statements.
A) True
B) False
Answer
Terms: Materiality focuses on potential users
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills
Learning Objective 9-2

1) Audit standards require the auditor to consider materiality early in the audit. Which statement(s) regarding preliminary materiality are true?
I. Preliminary materiality may change during the engagement.
II. Preliminary materiality is the maximum amount the auditor by which the auditor believes the financials could be misstated and still not affect the decisions of reasonable users.
A) I only
B) II only
C) both I and II
D) neither are true
Answer
Terms: Preliminary materiality assessment
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

2) Why do auditors establish a preliminary judgment about materiality?
A) To determine the appropriate level of staff to assign to the audit.
B) So that the client can know what records to make available to the auditor.
C) To plan the appropriate audit evidence to accumulate and develop an overall audit strategy.
D) To finalize the control risk assessment.
Answer
Terms: Purpose to establish preliminary judgment about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

3) If an auditor establishes a relatively high level for materiality, then the auditor will:
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.
Answer
Terms: High level for materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

4) The preliminary judgment about materiality and the amount of audit evidence accumulated are ________ related.
A) directly
B) indirectly
C) not
D) inversely
Answer
Terms: Preliminary judgment about materiality and amount of evidence accumulated
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
5) Which of the following is the primary basis used to decide materiality for a for-profit entity?
A) net sales
B) net assets
C) net income before tax
D) all of the above
Answer
Terms: Primary basis to decide materiality for a for-profit entity
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

6) Auditing standards ________ that the basis used to determine the preliminary judgment about materiality be documented in the audit files.
A) permit
B) do not allow
C) require
D) strongly encourage
Answer
Terms: Auditing standards; Preliminary judgment about materiality documented
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

7) Amounts involving fraud are usually considered ________ important than unintentional errors of equal dollar amounts.
A) less
B) no less
C) no more
D) more
Answer
Terms: Amounts involving fraud
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

8) Qualitative factors can affect an auditor’s assessment of materiality. Which of the following qualitative factors could influence the assessment of materiality?
I. Misstatements that are otherwise immaterial may be material if they affect earnings trends.
II. Minor misstatements resulting from the consequences of contractual obligations.
A) I only
B) II only
C) I and II
D) neither I nor II
Answer
Terms: Qualitative factors can affect auditor’s assessment of materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
9) The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement.
2. Estimate the total misstatement in the segment.
3. Set preliminary judgment about materiality.
4. Allocate preliminary judgment about materiality to segments.
5. Compare combined estimate with preliminary judgment about materiality.
The first three steps in correct sequence would be:
A) 1, 2, 5
B) 3, 4, 2
C) 2, 1, 5
D) 3, 2, 4
Answer
Terms: Five steps in applying materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

10) Which of the following statements is not correct?
A) Materiality is a relative rather than an absolute concept.
B) The most important base used as the criterion for deciding materiality is total assets.
C) Qualitative factors as well as quantitative factors affect materiality.
D) Given equal dollar amounts, frauds are usually considered more important than errors.
Answer
Terms: Materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

11) Certain types of misstatements are likely to be more important than other types to users, even if the dollar amounts are the same. Which of the following demonstrates this?
A)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
Yes Yes

B)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
No No

C)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
Yes No

D)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
No Yes

Answer
Terms: Certain types of misstatements are likely more important than other types
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

12) When setting a preliminary judgment about materiality:
A) more evidence is required for a low dollar amount than for a high dollar amount.
B) less evidence is required for a low dollar amount than for a high dollar amount.
C) the same amount of evidence is required for either low or high dollar amounts.
D) there is no relationship between it and the dollar amount of evidence needed.
Answer
Terms: Setting preliminary judgment about materiality
Diff: Challenging
Objective: LO 9-2
AACSB: Reflective thinking skills

13) Lewis Corporation has a few large accounts receivable that total one million dollars whereas
Clark Corporation has many small accounts receivable that total one million dollars. Misstatement in any one account is more significant for Lewis corporation because of the concept of:
A) Materiality.
B) Audit risk.
C) Reasonable assurance.
D) Comparative analysis.
Answer
Terms: Misstatements
Diff: Challenging
Objective: LO 9-2
AACSB: Reflective thinking skills
14) Material misstatement is the magnitude of misstatement that makes a reasonable person either change their mind or be influenced by the misstatement. Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor’s preliminary judgment about materiality.

15) Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor’s materiality judgment, and give an example of each.

16) The auditor’s preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users.
A) True
B) False
Answer
Terms: Preliminary judgments about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
17) Preliminary judgments about materiality are often changed during the course of the engagement.
A) True
B) False
Answer
Terms: Preliminary judgments about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

18) Net assets are the most often used base for deciding materiality.
A) True
B) False
Answer
Terms: Base for deciding materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

19) The lower the dollar amount of the preliminary judgment the more audit evidence is required.
A) True
B) False
Answer
Terms: Amount of preliminary judgment and audit evidence required
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

20) Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment.
A) True
B) False
Answer
Terms: Qualitative factors affecting preliminary materiality judgment; Fraud
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

21) Auditors have difficulty applying the concept of materiality in practice because they often do not know who the users of the financial statements are or what decisions will be made.
A) True
B) False
Answer
Terms: Difficulty in applying concept of materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills
22) Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establish a preliminary materiality level, thus eliminating the need for subjective auditor judgment in this task.
A) True
B) False
Answer
Terms: Statements on Auditing Standards; Objective guidance on establishing preliminary materiality level
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

23) If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease.
A) True
B) False
Answer
Terms: Preliminary judgment of materiality and audit evidence
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

24) Net income before tax is the normal base used to determine materiality in a non-for-profit company.
A) True
B) False
Answer
Terms: Base used to determine materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

Learning Objective 9-3

1) When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is referred to as:
A) the materiality range.
B) the error range.
C) tolerable materiality.
D) tolerable misstatement.
Answer
Terms: Allocate preliminary judgment about materiality to account balances
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills
2) Auditors generally allocate the preliminary judgment about materiality to the:
A) balance sheet only.
B) income statement only.
C) income statement and balance sheet.
D) statement of cash flows.
Answer
Terms: Preliminary materiality allocation
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills

3) Which of the following is an incorrect statement regarding the allocation of the preliminary judgment about materiality to balance sheet accounts?
A) Auditors expect certain accounts to have more misstatements than others.
B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence.
C) Auditors expect to identify overstatements as well as understatements in the accounts.
D) Relative audit costs affect the allocation.
Answer
Terms: Allocation of preliminary judgment about materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

4) Which of the following statements is true concerning the allocation of preliminary materiality?
A) It is necessary to allocate preliminary materiality to financial statements as a whole rather than by segments.
B) Preliminary materiality should be allocated to income statement accounts only.
C) It is required by the SEC.
D) When preliminary materiality is allocated to segments it is termed tolerable misstatement.
Answer
Terms: Allocation of preliminary materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

5) Which of the following statements is false?
A) Either an overstatement of an asset account or an understatement of a liability account would have the same effect on the income statement.
B) A misclassification in the balance sheet will have no effect on operating income.
C) Either an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
D) Either an understatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
Answer
Terms: Effects of misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
6) Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts?
A)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes No Yes

B)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes Yes No

C)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes Yes Yes

D)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
No Yes No

Answer
Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

7) When tolerable misstatement is exceeded by ________ the auditor should request the client to adjust their account balance.
I. Known misstatements
II. Projected misstatement
A) I only
B) II only
C) I and II
D) None of the above
Answer
Terms: Tolerable misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
8) When allocating materiality, most practitioners choose to allocate to:
A) the income statement accounts because they are more important.
B) the balance sheet accounts because there are fewer.
C) both balance sheet and income statement accounts because there could be errors on either.
D) all of the financial statements because it is required by GAAS.
Answer
Terms: Allocating materiality
Diff: Challenging
Objective: LO 9-3
AACSB: Reflective thinking skills

9) Tolerable misstatement as set by the auditor:
A) decreases acceptable audit risk.
B) increases inherent risk and control risk.
C) affects planned detection risk.
D) does not affect any of the four risks.
Answer
Terms: Tolerable misstatements
Diff: Challenging
Objective: LO 9-3
AACSB: Reflective thinking skills

10) Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts.
Answerllocating the preliminary judgment about materiality to individual accounts (segments) is necessary because evidence is accumulated for accounts (segments) rather than for the financial statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement amount for each account, which helps the auditor decide the appropriate audit evidence to accumulate for each account. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because most income statement misstatements have an equal effect on the balance sheet due to the nature of double-entry accounting. Because there are fewer balance sheet accounts than income statement accounts in most audits, and because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts.
Terms: Allocation of the preliminary judgment about materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
11) Auditor’s allocate the preliminary judgment about materiality to financial statement segments rather than by financial statements as a whole. What is the term for the auditor’s allocation of preliminary misstatement to account balances? What are three difficulties auditor’s face when allocating materiality to balance sheet accounts?

12) Most practitioners allocate the preliminary judgment about materiality to balance sheet accounts.
A) True
B) False
Answer
Terms: Allocate preliminary judgment about materiality to balance sheet accounts
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

13) The primary purpose of allocating the preliminary judgment about materiality to financial statement accounts is to help the auditor decide the appropriate evidence to accumulate.
A) True
B) False
Answer
Terms: Primary purpose of allocating the preliminary judgment about materiality
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills

14) Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts.
A) True
B) False
Answer
Terms: Allocating materiality; Consideration of overstatements and understatements
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills
15) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would need to obtain more audit evidence for that account than if $100,000 had been assigned.
A) True
B) False
Answer
Terms: Tolerable misstatements and audit evidence
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

16) To maximize audit efficiency, the auditor should allocate less tolerable misstatement to accounts that can be verified by using low-cost audit procedures, such as analytical procedures, than to accounts that are more costly to audit.
A) True
B) False
Answer
Terms: Maximize audit efficiency, allocate less tolerable misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

Learning Objective 9-4

1) Auditors are ________ to document the known and likely misstatements in the financial statements under audit.
A) permitted
B) required
C) not allowed
D) strongly encouraged
Answer
Terms: Known and likely misstatements in the financial statements
Diff: Easy
Objective: LO 9-4
AACSB: Reflective thinking skills

2) ________ misstatements are those where the auditor can determine the amount of the misstatement in the account.
A) Potential
B) Likely
C) Known
D) Projected
Answer
Terms: Misstatements where auditor can determine the amount
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

3) Likely misstatements can result from:
A)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
No Yes Yes

B)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
Yes Yes No

C)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
No No Yes

D)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
Yes No No

Answer
Terms: Likely misstatements result from
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

4) When expressing an unqualified opinion, the auditor who evaluates the audit findings should be satisfied that the:
A) amount of known misstatement is documented in the management representation letter.
B) estimate of the total known and likely misstatements is less than a material amount.
C) estimate of the total likely misstatement includes sample error.
D) amount of known misstatement is acknowledged and recorded by the client.
Answer
Terms: Evaluating audit findings and materiality
Diff: Challenging
Objective: LO 9-4
AACSB: Reflective thinking skills
5) Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur.

6) Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged.

1. An increase in acceptable audit risk.________.
2. An increase in inherent risk. ________.
3. A decrease in control risk. ________.
4. An increase in planned detection risk. ________.
5. An increase in tolerable misstatement. ________.

7) The preliminary judgment on materiality is compared to an estimated total misstatements to determine if an account balance is materially misstated.
A) True
B) False
Answer
Terms: Preliminary judgment on materiality; Estimated total misstatments
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

8) Total estimated misstatements include known misstatements and projected misstatements plus a sampling error.
A) True
B) False
Answer
Terms: Total estimated misstatements and sampling error
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

Learning Objective 9-5

1) An auditor who audits a business cycle that has low inherent risk should:
A) increase the amount of audit evidence gathered.
B) assign more experienced staff to that area.
C) increase the tolerable misstatement for the area.
D) expand planning procedures.
Answer
Terms: Low inherent risk
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills

2) Which of the following audit risk components may be assessesed in non-quantitative terms?
A)
Control Risk Inherent Risk Detection Risk
Yes Yes Yes

B)
Control Risk Inherent Risk Detection Risk
Yes Yes No

C)
Control Risk Inherent Risk Detection Risk
No No Yes

D)
Control Risk Inherent Risk Detection Risk
No No No

Answer
Terms: Audit risk components assessed in non-quantitative terms
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills
3) Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would:
A) increase materiality levels.
B) decrease detection risk.
C) decrease substantive testing.
D) increase inherent risk.
Answer
Terms: Control risk and planned audit risk model
Diff: Moderate
Objective: LO 9-5
AACSB: Reflective thinking skills

4) Which of the following underlies the application of generally accepted auditing standards?
A) the elements of materiality and relative risk
B) the element of internal control
C) the element of corroborating evidence
D) the element of reasonable assurance
Answer
Terms: Underlies application of generally accepted auditing standards
Diff: Challenging
Objective: LO 9-2 and LO 9-5
AACSB: Reflective thinking skills

5) Why do auditors use the audit risk model when planning an audit?

6) The risk of material misstatement is a combination of two client controlled factors: inherent risk and control risk. What is inherent risk, why is it important and give examples of inherent risk factors.

7) The most important element of the audit risk model is control risk.
A) True
B) False
Answer
Terms: Audit risk model and control risk
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills

8) The audit risk model that must be used for planning audit procedures and evaluating audit results is:
DR
IR × CR = AAR.
A) True
B) False
Answer
Terms: Audit risk model
Diff: Moderate
Objective: LO 9-5
AACSB: Reflective thinking skills
Learning Objective 9-6

1) The measurement of the auditor’s assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal controls is defined as:
A) Audit risk.
B) Inherent risk.
C) Sampling risk.
D) Detection risk.
Answer
Terms: Assessment of likelihood of material misstatements due to error or fraud
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

2) The risk that audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement is:
A) Audit risk.
B) Control risk.
C) Inherent risk.
D) Planned detection risk.
Answer
Terms: Risk audit evidence will fail to detect misstatements
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

3) As the risk of material misstatement increases, detection risk should:
A) medium increase.
B) decrease.
C) stay the same.
D) Is indeterminate.
Answer
Terms: Risk of material misstatement increases, detection risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

4) Inherent risk is ________ related to detection risk and ________ related to the amount of audit evidence.
A) directly, inversely
B) directly, directly
C) inversely, inversely
D) inversely, directly
Answer
Terms: Relationship of inherent risk, detection risk, and amount of audit evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
5) Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________.
A) detection risk
B) audit report risk
C) acceptable audit risk
D) inherent risk
Answer
Terms: Audit assurance, overall assurance and level of assuranc
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

6) If planned detection risk is reduced, the amount of evidence the auditor accumulates will:
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.
Answer
Terms: Planned detection risk and amount of evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

7) Planned detection risk
I. determines the amount of substantive evidence the auditor plans to accumulate.
II. is dependent on inherent risk and control risk.
A) I only
B) II only
C) I and II
D) None of the above
Answer
Terms: Planned detection risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

8) Inherent risk is often high for an account such as:
A) inventory.
B) land.
C) cash.
D) notes payable.
Answer
Terms: Inherent risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
9) Inherent risk and control risk:
A) are inversely related to each other.
B) are inversely related to detection risk.
C) are directly related to detection risk.
D) are directly related to audit risk.
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

10) To what extent do auditors typically rely on internal controls of their public company clients?
A) extensively
B) only very little
C) infrequently
D) never
Answer
Terms: Extent auditor rely on internal controls of public company client
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
Topic: Public

11) Auditors typically rely on internal controls of their private company clients:
A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
B) only if the controls are determined to be effective.
C) only if the client asks an auditor to test controls.
D) only if the controls are sufficient to increase Control Risk to an acceptable level.
Answer
Terms: Extent auditor rely on internal controls of private company client
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

12) Acceptable audit risk is ordinarily set by the auditor during planning and:
A) held constant for each major cycle and account.
B) held constant for each major cycle but varies by account.
C) varies by each major cycle and by each account.
D) varies by each major cycle but is constant by account.
Answer
Terms: Acceptable audit risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills
13) The risk of material misstatement refers to:
A) control risk and acceptable audit risk.
B) inherent risk.
C) the combination of inherent risk and control risk.
D) inherent risk and audit risk.
Answer
Terms: Risk of material misstatements
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

14) The risk of material misstatement differs from detection risk in that it:
A) arises because audit procedures have been misapplied.
B) can be controlled and changed by the auditor.
C) can be assessed in quantitative and non-quantitative terms.
D) is controllable by the client.
Answer
Terms: Difference between material misstatement and detection risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

15) Auditors may assess inherent risk and control risk:
A)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
Yes Yes

B)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
No No

C)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
Yes No

D)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
No Yes

Answer
Terms: Auditor may assess inherent risk and control risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills
16) In a financial statement audit, inherent risk is evaluated to help an auditor asses which of the following?
A) The internal audit department’s objectivity in reporting a material misstatement of a financial statement assertion it detects to the audit committee.
B) The risk the internal control system will not detect a material misstatement of a financial statement assertion.
C) The risk that the audit procedures implemented will not detect a material misstatement of a financial statement assertion.
D) The susceptibility of a financial statement assertion to a material misstatement assuming there are no related controls.
Answer
Terms: Inherent risk assessment
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

17) Which of the following statements is not true?
A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required.
B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit evidence required.
C) Inherent risk is the susceptibility of the financial statements to material error, assuming no internal controls.
D) Inherent risk and control risk are assessed by the auditor and function independently of the financial statement audit.
Answer
Terms: Inherent risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

18) Match nine of the terms (a-i) with the definitions provided below (1-9):

a. Business risk
b. Preliminary judgment about materiality
c. Inherent risk
d. Planned detection risk
e. Audit assurance
f. Acceptable audit risk
g. Tolerable misstatement
h. Control risk
i. Materiality

________ 1. A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.

________ 2. The risk that the auditor or audit firm will suffer harm because of a client relationship, even though the audit report rendered for the client was correct.

________ 3. A measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client’s internal controls.

________ 4. A measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued.

________ 5. The materiality allocated to any given account balance.

________ 6. The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.

________ 7. This term is synonymous with acceptable audit risk.

________ 8. The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed.

________ 9. A measure of the auditor’s assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control.

19) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high.
A) True
B) False
Answer
Terms: Relationship of acceptable audit risk, inherent risk, control risk, and planned detection risk.
Diff: Easy
Objective: LO 9-5 and LO 9-6
AACSB: Reflective thinking skills

20) Tolerable misstatement does not affect audit risk, inherent risk, control risk, or planned detection risk yet the combination of the tolerable misstatement and the four risks will determine the amount of planned audit evidence.
A) True
B) False
Answer
Terms: Tolerable misstatements; Audit risk, inherent risk, control risk, and planned detection risk
Diff: Challenging
Objective: LO 9-3 and LO 9-6
AACSB: Reflective thinking skills
21) A high detection risk equates to a low amount of audit evidence needed.
A) True
B) False
Answer
Terms: Detection risk and amount of evidence needed
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

22) For a private company client, auditors are required to test any internal controls they believe have not been operating effectively during the period under audit.
A) True
B) False
Answer
Terms: Auditors required to test internal controls for private companies
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

23) Insert risk and control risk are normally assessed for the each segment but sets audit risk at the financial statement level.
A) True
B) False
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

24) Acceptable audit risk and the amount of substantive evidence required are inversely related.
A) True
B) False
Answer
Terms: Acceptable audit risk and substantive evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

25) As control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase.
A) True
B) False
Answer
Terms: Control risk and substantive evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
26) Inherent risk and control risk are directly related.
A) True
B) False
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

27) An acceptable audit risk assessment of low indicates a risky client requiring more extensive evidence, assignment of more experienced personnel, and/or a more extensive review of audit files.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

Learning Objective 9-7

1) If an auditor believes the chance of financial failure is high and there is a corresponding increase in business risk for the auditor, acceptable audit risk would likely:
A) be reduced.
B) be increased.
C) remain the same.
D) be calculated using a computerized statistical package.
Answer
Terms: Increase in business risk, acceptable audit risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

2) When management has an adequate level of integrity for the auditor to accept the engagement but cannot be regarded as completely honest in all dealings, auditors normally:
A) reduce acceptable audit risk and increase inherent risk.
B) reduce inherent risk and control risk.
C) increase inherent risk and control risk.
D) increase acceptable audit risk and reduce inherent risk.
Answer
Terms: Management integrity
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills
3) When the auditor is attempting to determine the extent to which external users rely on a client’s financial statements, they may consider several factors except for:
A) client size.
B) concentration of ownership.
C) types and amounts of liabilities.
D) assessment of detection risk.
Answer
Terms: Extent to which external users rely on client’s financial statements
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

4) There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit risk. Discuss three of these factors.
Answerusiness risk and acceptable audit risk are affected by:
• The degree to which external users will rely on the statements. For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal.
• The likelihood that a client will have financial difficulties after the audit report is issued. Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties.
• The auditor’s evaluation of management’s integrity. Business risk is greater and acceptable audit risk will be lower when the client’s management has questionable integrity.
Terms: Factors that affect business risk and acceptable audit risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills
5) Describe the audit risk model and each of its components.

6) Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk.
A) True
B) False
Answer
Terms: Audit assurance and planned detection risk
Diff: Moderate
Objective: LO 9-6 and LO 9-7
AACSB: Reflective thinking skills
7) If an auditor believes the client will have financial difficulties after the audit report is issued, and external users will be relying heavily on the financial statements, the auditor will probably set acceptable audit risk as low.
A) True
B) False
Answer
Terms: Auditor believes client will have financial difficulties after audit report is issued; External users rely heavily on financial statements
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

8) Engagement risk is effectively the audit firm’s business risk.
A) True
B) False
Answer
Terms: Engagement risk and business risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

Learning Objective 9-8

1) Which of the following statements regarding inherent risk is correct?
A) Inherent risk is unaffected by the auditor’s experience with client’s organization.
B) Most auditors set a low inherent risk in the first year of an audit and increase it if experience shows that it was incorrect.
C) Most auditors set a high inherent risk in the first year of an audit and reduce it in subsequent years as they gain experience, even when there is inherent risk.
D) Inherent risk is dependent upon the strengths in client’s internal control system.
Answer
Terms: Inherent risk
Diff: Easy
Objective: LO 9-8
AACSB: Reflective thinking skills

2) Auditors begin their assessments of inherent risk during audit planning. Which of the following would not help in assessing inherent risk during the planning phase?
A) Obtaining client’s agreement on the engagement letter.
B) Obtaining knowledge about the client’s business and industry.
C) Touring the client’s plant and offices.
D) Identifying related parties.
Answer
Terms: Assessment of inherent risk during audit planning
Diff: Easy
Objective: LO 9-8
AACSB: Reflective thinking skills
3) Which of the following is not a primary consideration when assessing inherent risk?
A) nature of client’s business
B) existence of related parties
C) degree of separation of duties
D) susceptibility to defalcation
Answer
Terms: Assessing inherent risk
Diff: Challenging
Objective: LO 9-8
AACSB: Reflective thinking skills

4) Harker, CPA is in the audit planning phase of Dracule Industries. An understanding needs to be established regarding the responsibilities of Harker and Dracule’s Management. For each of the task items listed below indicate the responsible party from the list of choices given. Each choice may be used once, more than once or not at all.
Task to be performed:
1. Obtain an understanding of internal controls
2. Preparation of the financial statements
3. Assess inherent risk
4. Following GAAP or IFRS
5. Establish internal controls
6. Detect Material Error
7. Comply with laws and regulations
8. Assess the risk of the allowance for doubtful accounts estimate
9. Determine the known and likely errors or misstatements Responsible Party:
a. Auditor is responsible
b. Management is responsible
c. Both are responsible
d. Neither are responsible

1) As the acceptable level of detection risk increases, an auditor may change the:
A) timing of substantive tests by performing them at an interim date rather than year end.
B) timing of the tests on controls by performing them throughout the year rather than at one time.
C) assess the level of inherent risk to a lower amount.
D) increase the sample size to achieve a more effective test.
Answer
Terms: Detection risk
Diff: Moderate
Objective: LO 9-9
AACSB: Reflective thinking skills

2) In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or acceptable audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for planned detection risk and the amount of evidence you would plan to gather (“planned evidence”) using the terms high, medium, or low.
Acceptable audit risk
Inherent risk
Control risk
Planned detection risk
Planned evidence
SITUATION
1
Low
High
High
________
________
SITUATION
2
Low
Low
Low
________
________
SITUATION
3
High
Low
Medium
________
________
SITUATION
4
High
Low
Low
________
________

3) Dracule Industries is a privately owned business that sells medical product and devices to hospitals, clinics and the public. Certain changes have occurred in Dracule Industries during the year undergoing the audit. Harker needs to evaluate the effect these changes have on audit risk. Audit risk at the financial statement level is influenced by the risk of material misstatement; which include factors related to management, the industry and the entity or a combination thereof. For each of the following changes that have occurred during the year under audit identify the appropriate audit response for the list of responses. Each response can be used once, more than once or not at all.
Client changes:
1. An internal audit department has been established.
2. A new inventory control system has been installed that reduces the access of unauthorized parties.
3. Inexperienced accounting personnel were hired in the accounting department.
4. Excess cash was used to purchase complex derivatives.
5. Controls over the sales credit approval process have laxed.
6. New government regulations now apply to Dracule Industries.
7. Management has become overly aggressive in reaching target goals.
8. An expert was hired to help determine the value of the ore content in ending materials inventory. Possible effect on the audit:
a. Increase the acceptable level of detection risk.
b. Decrease the acceptable level of detection risk.
c. Change has no effect on the acceptable level of detection risk.

Auditing and Assurance Services, 14e (Arens)
Chapter 10 Section 404 Audits of Internal Control and Control Risk

Learning Objective 10-1

1) Which of the following is not one of the three primary objectives of effective internal control?
A) reliability of financial reporting
B) efficiency and effectiveness of operations
C) compliance with laws and regulations
D) assurance of elimination of business risk
Answer
Terms: Internal control objective
Diff: Easy
Objective: LO 10-1
AACSB: Analytic skills

2) The Public Company Accounting Oversight Board states that reasonable assurance allows a:
A) small likelihood of ineffective internal controls.
B) remote likelihood that material misstatements will not be prevented or detected by internal control.
C) likelihood that material misstatements will not be prevented or detected by internal control.
D) high likelihood that material misstatements will not be prevented or detected by internal control.
Answer
Terms: Reasonable assurance
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: Public

3) Which of the following is most correct regarding the requirements under Section 404 of the Sarbanes Oxley Act?
A) The audits of internal control and the financial statements provide reasonable assurance as to misstatements.
B) The audit of internal control provides absolute assurance of misstatement.
C) The audit of financial statements provides absolute assurance of misstatement.
D) The audits of internal control and the financial statements provide absolute assurance as to misstatements.
Answer
Terms: Sarbanes Oxley Act Section 404
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills

4) Which of management’s assertions with respect to implementing internal controls is the auditor primarily concerned?
A) efficiency of operations
B) reliability of financial reporting
C) effectiveness of operations
D) compliance with applicable laws and regulations
Answer
Terms: Management’s assertions
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills

5) To issue a report on internal control over financial reporting for a public company, an auditor must:
A) evaluate management’s assessment process.
B) independently assess the design and operating effectiveness of internal control.
C) evaluate management’s assessment process and independently assess the design and operating effectiveness of internal control.
D) test controls over significant account balances.
Answer
Terms: Internal control over financial reporting for public company
Diff: Moderate
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: Public

6) A company frequently sells products at a price below inventory cost. Essential controls in the risk assessment process would include:
A) adequate controls that address the risk of overstating inventory.
B) adequate controls that address the risk of not including a purchased item in inventory.
C) adequate controls that address the risk of understatement of inventory.
D) adequate controls that address the risk of overstatement of cost of goods sold.
Answer
Terms: Controls in risk assessment process
Diff: Moderate
Objective: LO 10-1
AACSB: Analytic skills

7) Internal controls are not designed to provide reasonable assurance that:
A) all frauds will be detected.
B) transactions are executed in accordance with management’s authorization.
C) access to assets is permitted only in accordance with management’s authorization.
D) company personnel comply with applicable rules and regulations.
Answer
Terms: Internal controls; reasonable assurance
Diff: Moderate
Objective: LO 10-1
AACSB: Analytic skills

8) Describe each of the three broad objectives management typically has for internal control. With which of these objectives is the auditor primarily concerned?

9) The Sarbanes-Oxley Act of 2002 requires that public companies issue an internal control report.
A) True
B) False
Answer
Terms: Sarbanes-Oxley Act
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: SOX

10) The primary emphasis by auditors when evaluating and testing internal control is on controls over classes of transactions rather than controls over account balances.
A) True
B) False
Answer
Terms: Evaluating and testing internal controls
Diff: Moderate
Objective: LO 10-1
AACSB: Reflective thinking skills

Learning Objective 10-2

1) Which of the following is responsible for establishing a private company’s internal control?
A) Senior Management
B) Internal Auditors
C) Senior Management and auditors
D) Audit committee
Answer
Terms: Internal control
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

2) Two key concepts that underlie management’s design and implementation of internal control are:
A) costs and materiality.
B) absolute assurance and costs.
C) inherent limitations and reasonable assurance.
D) collusion and materiality.
Answer
Terms: Internal control design and implementation
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills

3) The PCAOB places responsibility for the reliability of internal controls over the financial reporting process to:
A) the company’s board of directors.
B) the audit committee of the board of directors.
C) the CEO and the CFO.
D) the CFO and the Independent Auditors.
Answer
Terms: PCAOB; internal control responsibility
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

4) Which of the following parties provides an assessment of the effectiveness of internal control over financial reporting for public companies?
A)
Management Financial statement auditors
Yes Yes

B)
Management Financial statement auditors
No No

C)
Management Financial statement auditors
Yes No

D)
Management Financial statement auditors
No Yes

Answer
Terms: Internal control effectiveness
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

5) An act of two or more employees to steal assets and cover their theft by misstating the accounting records would be referred to as:
A) collusion.
B) a material weakness.
C) a control deficiency.
D) a significant deficiency.
Answer
Terms: Employees steal assets
Diff: Easy
Objective: LO 10-2
AACSB: Ethical understanding and reasoning abilities

6) Sarbanes-Oxley requires management to issue an internal control report that includes two specific items. Which of the following is one of these two requirements?
A) A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
B) A statement that management and the board of directors are jointly responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
C) A statement that management, the board of directors, and the external auditors are jointly responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
D) A statement that the external auditors are solely responsible.
Answer
Terms: Sarbanes-Oxley; Internal control report
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: SOX
7) When management is evaluating the design of internal control, management evaluates whether the control can do which of the following?
A)
Detect material misstatements Correct material misstatements
Yes Yes

B)
Detect material misstatements Correct material misstatements
No No

C)
Detect material misstatements Correct material misstatements
Yes No

D)
Detect material misstatements Correct material misstatements
No Yes

Answer
Terms: Internal control design
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills
Topic: SOX

8) When one material weakness is present at the end of the year, management of a public company must conclude that internal control over financial reporting is:
A) insufficient.
B) inadequate.
C) ineffective.
D) inefficient.
Answer
Terms: Internal control weakness; Public company
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills
Topic: Public

9) The auditors primary purpose in auditing the client’s system of internal control over financial reporting is:
A) to prevent fraudulent financial statements from being issued to the public.
B) to evaluate the effectiveness of the company’s internal controls over all relevant assertions in the financial statements.
C) to report to management that the internal controls are effective in preventing misstatements from appearing on the financial statements.
D) to efficiently conduct the Audit of Financial Statements.
Answer
Terms: Primary purpose to audit system of internal control
Diff: Moderate
Objective: LO 10-2
AACSB: Analytic skills
Topic: Public
10) Management must disclose material weaknesses in internal control in its audit report:
A) whenever the weakness is deemed significant to a single class of transactions.
B) whenever the weakness is significant to overall financial reporting objectives.
C) if the weakness exists at the end of the year.
D) only if the auditor identifies the weakness as significant.
Answer
Terms: Material weaknesses in internal control
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

11) In performing the audit of internal control over financial reporting the auditor emphasizes internal control over class of transactions because:
A) the accuracy of accounting system outputs depends heavily on the accuracy of inputs and processing.
B) the class of transaction is where most fraud schemes occur.
C) account balances are less important to the auditor then the changes in the account balances.
D) classes of transactions tests are the most efficient manner to compensate for inherent risk.
Answer
Terms: Internal control over class of transactions
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

12) Internal controls can never be regarded as completely effective. Even if company personnel could design an ideal system, its effectiveness depends on the:
A) adequacy of the computer system.
B) proper implementation by management.
C) ability of the internal audit staff to maintain it.
D) competency and dependability of the people using it.
Answer
Terms: Internal control effectiveness
Diff: Moderate
Objective: LO 10-2
AACSB: Ethical understanding and reasoning abilities

13) Even with the most effectively designed internal control, the auditor must obtain audit evidence, beyond testing the controls, for every:
A) transaction.
B) financial statement account.
C) material financial statement account.
D) financial statement account that will be relied upon by third parties.
Answer
Terms: Effectively designed internal controls; testing of controls
Diff: Moderate
Objective: LO 10-2
AACSB: Analytic skills
14) Of the following statements about internal controls, which one is least likely to be correct?
A) No one person should be responsible for the custodial responsibility and the recording responsibility for an asset.
B) Transactions must be properly authorized before such transactions are processed.
C) Because of the cost-benefit relationship, a client may apply controls on a test basis.
D) Control procedures reasonably ensure that collusion among employees cannot occur.
Answer
Terms: Internal controls
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills

15) The Sarbanes-Oxley Act requires:
A) all public companies to issue reports on internal controls.
B) all public companies to define adequate internal controls.
C) the auditor of public companies to design effective ICFR.
D) the auditor of public companies to provide recommendations to correct material weaknesses.
Answer
Terms: Sarbanes-Oxley Act
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: SOX

16) The financial statements may not correctly reflect accounting frameworks such as AAP or IFRS if the:
A) controls affecting the reliability of financial reporting are inadequate.
B) company’s controls do not promote efficiency.
C) company’s controls do not promote effectiveness.
D) company’s controls do not promote compliance with applicable rules and regulations.
Answer
Terms: Financial statements reflect accounting frameworks
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills

17) The primary emphasis by auditors is on controls over:
A) classes of transactions.
B) account balances.
C) both A and B, because they are equally important.
D) both A and B, because they vary from client to client.
Answer
Terms: Primary emphasis by auditors on controls
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills
18) An auditor should consider two key issues when obtaining an understanding of a client’s internal controls. These issues are:
A) the effectiveness and efficiency of the controls.
B) the frequency and effectiveness of the controls.
C) the design and implementation of the controls.
D) the implementation and efficiency of the controls.
Answer
Terms: Key issues understanding client’s internal controls
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills

19) When a company designs and implements internal controls, cost of the controls is not a valid consideration.
A) True
B) False
Answer
Terms: Design and implement internal control; cost
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

Learning Objective 10-3

1) Which of the following activities would be least likely to strengthen a company’s internal control?
A) separating accounting from other financial operations
B) maintaining insurance for fire and theft
C) fixing responsibility for the performance of employee duties
D) carefully selecting and training employees
Answer
Terms: Not strengthen internal control
Diff: Easy
Objective: LO 10-3
AACSB: Analytic skills

2) Which of the following components of the control environment define the existing lines of responsibility and authority?
A) Organizational Structure
B) Management philosophy and operating style
C) Human resource policies and practices
D) Management integrity and ethical values
Answer
Terms: Control environment components; Responsibility and authority
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

3) Which of the following factors may increase risks to an organization?
A)
Geographic dispersion of
company operations Presence of new information technologies
Yes Yes

B)
Geographic dispersion of
company operations Presence of new information technologies
No No

C)
Geographic dispersion of
company operations Presence of new information technologies
Yes No

D)
Geographic dispersion of
company operations Presence of new information technologies
No Yes

Answer
Terms: Increase risks to an organization
Diff: Moderate
Objective: LO 10-3
AACSB: Analytic skills

4) Which of the following statements is most correct with respect to separation of duties?
A) Employees should not have temporary and permanent custody of assets.
B) Employees who authorize transactions should not have custody of related assets.
C) It is permissible to allow an employee to open cash receipts and record those receipts.
D) Employees who authorize transactions should have recording responsibility for these transactions.
Answer
Terms: Separation of duties
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

5) Authorizations can be either general or specific. Which of the following is not an example of a general authorization?
A) Automatic reorder points for raw materials inventory.
B) A sales manager’s authorization for a sales return.
C) Credit limits for various classes of customers.
D) A sales price list for merchandise.
Answer
Terms: General or specific authorizations
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
6) Which of the following is correct with respect to the design and use of business documents?
A) Not all documents used for internal purposes need to be prenumbered.
B) Documents should be designed for single purposes only to avoid confusion in their use.
C) Documents should be designed to be understandable only by those who use them.
D) Documents designed for external use must be prenumbered.
Answer
Terms: Design and use of business documents
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

7) Which of the following best describes the purpose of control activities?
A) the actions, policies and procedures that reflect the overall attitudes of management
B) the identification and analysis of risks relevant to the preparation of financial statements
C) the policies and procedures that help ensure that necessary actions are taken to address risks to the achievement of the entity’s objectives
D) activities that deal with the ongoing assessment of the quality of internal control by management
Answer
Terms: Control activities
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

8) Which of the following deal with ongoing or periodic assessment of the quality of internal control by management?
A) Quality monitoring activities
B) Monitoring activities
C) Oversight activities
D) Management activities
Answer
Terms: Quality of internal control
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

9) Which of the following best describes an entity’s accounting information and communication system?
A)
Monitor
transactions Record and
process
transactions Initiate transactions
Yes Yes Yes

B)
Monitor
transactions Record and
process
transactions Initiate transactions
No No No

C)
Monitor
transactions Record and
process
transactions Initiate transactions
Yes No No

D)
Monitor
transactions Record and
process
transactions Initiate transactions
No Yes Yes

Answer
Terms: Accounting information and communication system
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

10) An audit procedure that would most likely be used by an auditor in performing tests of control procedures in which the segregation of functions and that leaves no “audit” trail is:
A) inspection.
B) observation.
C) reperformance.
D) reconciliation.
Answer
Terms: Tests of control procedures; segregation of functions
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

11) Internal controls normally include procedures designed to provide reasonable assurance that:
A) employees act with integrity when performing their assigned tasks.
B) transactions are executed in accordance with management’s authorization.
C) decision processes leading to management’s authorization of transactions are sound.
D) collusive activities would be detected by segregation of employee duties.
Answer
Terms: Internal controls; reasonable assurance
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
12) Which of the following is not one of the subcomponents of the control environment?
A) management’s philosophy and operating style
B) organizational structure
C) adequate separation of duties
D) commitment to competence
Answer
Terms: Subcomponents of control environment
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

13) It is important for the CPA to consider the competence of the clients’ personnel because their competence bears directly and importantly upon the:
A) cost/benefit relationship of the system of internal control.
B) achievement of the objectives of internal control.
C) comparison of recorded accountability with assets.
D) timing of the tests to be performed.
Answer
Terms: Competence of client personnel
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

14) Proper segregation of functional responsibilities calls for separation of:
A) authorization, execution, and payment.
B) authorization, recording, and custody.
C) custody, execution, and reporting.
D) authorization, payment, and recording.
Answer
Terms: Segregation of functional responsibilities
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

15) Which of the following is correct regarding management’s documentation of internal controls?
A) inadequate documentation is not a control deficiency
B) documentation needs to focus on interim controls
C) documentation needs to have some focus on controls designed to detect fraud
D) documentation should only focus on system design
Answer
Terms: Documentation of internal control
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills
16) Which of the following groups establishes and maintains the company’s internal controls?
A) Internal auditors
B) Board of Directors
C) Management
D) Audit committee
Answer
Terms: Establishes and maintains company’s internal control
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

17) The independent auditor should acquire an understanding of the internal audit function as it relates to the independent auditor’s study and evaluation of internal control because the:
A) audit programs, working papers, and reports of internal auditors can often be used as a substitute for the work of the independent auditor’s staff.
B) procedures performed by the internal audit staff may eliminate the independent auditor’s need for an extensive study and evaluation of internal control.
C) work performed by internal auditors may be a factor in determining the nature, timing, and extent of the independent auditor’s procedures.
D) understanding of the internal audit function is an important substantive test to be performed by the independent auditor.
Answer
Terms: Understanding of internal audit functions
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills

18) To promote operational efficiency, the internal audit department would ideally report to:
A) line management.
B) senior management.
C) Chief Accounting Officer.
D) audit committee.
Answer
Terms: Operational efficiency
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

19) Hanlon Corp. maintains a large internal audit staff that reports directly to the chief financial officer. Audit reports prepared by the internal auditors indicate that the system is functioning as it should and that the accounting records are reliable. An independent auditor will probably:
A) eliminate tests of controls.
B) increase the depth of the study and evaluation of administrative controls.
C) avoid duplicating the work performed by the internal audit staff.
D) place limited reliance on the work performed by the internal audit staff.
Answer
Terms: Internal audit
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills
20) External financial statement auditors must obtain evidence regarding what attributes of an internal audit (IA) department if the external auditors intend to rely on IA’s work?
A) Integrity
B) Objectivity
C) Competence
D) All of the above
Answer
Terms: External auditor reliance on internal auditors’ work
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

21) To obtain an understanding of an entity’s control environment, an auditor should concentrate on the substance of management’s policies and procedures rather than their form because:
A) management may establish appropriate policies and procedures but not act on them.
B) the board of directors may not be aware of management’s attitude toward the control environment.
C) the auditor may believe that the policies and procedures are inappropriate for that particular entity.
D) the policies and procedures may be so weak that no reliance is contemplated by the auditor.
Answer
Terms: Substance of management’s policies and procedures
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills

22) Control activities help assure that the necessary actions are taken to address risks to the achievement of the company’s objectives. List the five types of control activities.

several of these principles.

24) Management’s identification and analysis of risk is an ongoing process and is a critical component of effective internal control. An important first step is for management to identify factors that may increase risk. Identify at least five factors, observable by management, which may lead to increased risk in a typical business organization.

25) Separation of duties is essential in preventing errors and intentional misstatements on the financial statements. List below the four general guidelines.

26) In developing an understanding of the client’s accounting information system the auditor follows a sequential process. Describe the process below:

27) The internal control framework developed by COSO includes five so-called “components” of internal control. Discuss each of these five components.

28) Discuss what is meant by the term “control environment” and identify four control environment subcomponents that the auditor should consider.

29) Adequate separation of duties is an important control activity. Discuss the four general guidelines for separation of duties to prevent both intentional and unintentional misstatements that are of significance to auditors.

30) As a client’s information system becomes more complex, it is likely that an auditor will increase reliance on controls and decrease substantive tests to support a control risk assessment.
A) True
B) False
Answer
Terms: Complex information system
Diff: Easy
Objective: LO 10-3
AACSB: Analytic skills

31) Adequate documents and records is a subcomponent of the control environment.
A) True
B) False
Answer
Terms: Control environment
Diff: Easy
Objective: LO 10-3
AACSB: Reflective thinking skills

32) The chart of accounts is a control and is closely related to the controls related to adequate documents and records.
A) True
B) False
Answer
Terms: Chart of accounts
Diff: Easy
Objective: LO 10-3
AACSB: Reflective thinking skills

33) Auditing standards prohibit reliance on the work of internal auditors due to the lack of independence of the internal auditors.
A) True
B) False
Answer
Terms: Auditing standards; internal auditors
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
34) If an auditor wishes to rely on the work of internal auditors (IA), the auditor must obtain satisfactory evidence related to the IA’s competence, integrity, and objectivity.
A) True
B) False
Answer
Terms: Internal auditors
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

Learning Objective 10-4

1) When the auditor attempts to understand the operation of the accounting system by tracing a few transactions through the accounting system, the auditor is said to be:
A) tracing.
B) vouching.
C) performing a walk-through.
D) testing controls.
Answer
Terms: Tracing transactions through accounting system
Diff: Easy
Objective: LO 10-4
AACSB: Analytic skills

2) The purpose of phase 3 in the “process for understanding internal control and assessing control risk” is to:
A) design, perform and evaluate tests of controls.
B) obtain and document an understanding of internal control design an operation.
C) assess control risk.
D) decide planned detection risk and substantive tests.
Answer
Terms: Process for understanding internal control and assessing risk
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

3) Narratives, flowcharts, and internal control questionnaires are three common methods of:
A) testing the internal controls.
B) documenting the auditor’s understanding of internal controls.
C) designing the audit manual and procedures.
D) documenting the auditor’s understanding of a client’s organizational structure.
Answer
Terms: Narratives, flowcharts, and internal control questionnaires
Diff: Easy
Objective: LO 10-4
AACSB: Reflective thinking skills
4) Audit evidence concerning proper segregation of duties normally is best obtained by:
A) direct personal observation of the employee who applies control procedures.
B) making inquiries of co-workers about the employee who applies control procedures.
C) preparation of a flowchart of duties performed and available personnel.
D) inspection of third-party documents containing the initials of who applied control procedures.
Answer
Terms: Evidence of proper segregation of duties
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

5) Audit evidence regarding the separation of duties is normally best obtained by:
A) preparing flowcharts of operational processes.
B) preparing narratives of operational processes.
C) observation of employees applying control activities.
D) inquiries of employees applying control activities.
Answer
Terms: Audit evidence of separation of duties
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

6) Section 404 requires auditors to perform walkthroughs to assist in understanding internal control.
A) True
B) False
Answer
Terms: Walkthroughs; understanding internal control
Diff: Easy
Objective: LO 10-4
AACSB: Reflective thinking skills
Topic: Public

7) Procedures used to obtain an understanding of internal control are normally performed on fewer transactions than procedures used to test controls.
A) True
B) False
Answer
Terms: Understanding internal controls
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

8) For most uses, flowcharts are superior to narratives as a method of communicating the characteristics of internal control.
A) True
B) False
Answer
Terms: Flowcharts
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills
9) When documenting their understanding of a client’s internal controls, auditors are required to use narratives.
A) True
B) False
Answer
Terms: Understanding internal controls; narratives
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

Learning Objective 10-5

1) The person responsible for reconciling sales invoices to customer orders does not access to the company’s master price list in order to correctly compute sales. This is an example of a(n):
A) operating deficiency.
B) design deficiency.
C) training deficiency.
D) management deficiency.
Answer
Terms: Reconciling sales invoices to correctly compute sales
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills

2) You are performing the audit of internal control for Clifton Company. Which of the following would represent a material weakness in internal control?
A) The company’s audit committee has experienced unusual turnover of members.
B) The company’s CFO was indicted for embezzling from the company.
C) Bank reconciliations are done monthly.
D) The CEO was forced to resign due to an inappropriate relationship with an outside vendor.
Answer
Terms: Material weaknesses in internal control
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
Topic: Public

3) The employee in charge of authorizing credit to the company’s customers does not fully understand the concept of credit risk. This lack of knowledge would constitute:
A) a deficiency in operation of internal controls.
B) a deficiency in design of internal controls.
C) a deficiency of management.
D) not constitute a deficiency.
Answer
Terms: Lack of knowledge
Diff: Moderate
Objective: LO 10-5
AACSB: Ethical understanding and reasoning abilities

4) Section 404 requires auditors to evaluate the effectiveness of the audit committee’s oversight of the company’s:
A)
External financial
reporting Efficiency of
operations Internal control over financial reporting
Yes No Yes

B)
External financial
reporting Efficiency of
operations Internal control over financial reporting
No No Yes

C)
External financial
reporting Efficiency of
operations Internal control over financial reporting
Yes Yes No

D)
External financial
reporting Efficiency of
operations Internal control over financial reporting
No Yes No

Answer
Terms: Effectiveness of audit committee’s oversight
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
Topic: Public

5) Once auditors determine that entity level controls are designed and placed in the operation they:
A) make a preliminary assessment for each transaction-related audit objective for each major type of transaction.
B) make a preliminary assessment of control risk.
C) obtain an understanding of the design and implementation of internal control.
D) prepare audit documentation in order to opine on the company’s internal control system.
Answer
Terms: Entry level controls
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills

6) Which of the following is the correct definition of “control deficiency”?
A) A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis.
B) A control deficiency exists if one or more deficiencies exist that adversely affect a company’s ability to prepare external financial statements reliably.
C) A control deficiency exists if the design or operation of controls results in a more than remote likelihood that controls will not prevent or detect misstatements.
D) A control deficiency exists if the design or operation of controls results in a more than probable likelihood that controls will prevent or detect misstatements.
Answer
Terms: Control deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
7) Which of the following deficiency exists if a necessary control is missing or not properly formulated?
A) control
B) significant
C) design
D) operating
Answer
Terms: Control deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

8) To determine if significant internal control deficiencies are material weaknesses, they must be evaluated on their:
A)
Likelihood Significance
Yes Yes

B)
Likelihood Significance
No No

C)
Likelihood Significance
Yes No

D)
Likelihood Significance
No Yes

Answer
Terms: Internal control deficiencies are material weaknesses
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
9) Significant deficiencies need to be communicated to the company’s audit committee because:
A) they represent material weaknesses that allow fraud to be perpetrated.
B) they represent significant design flaws in internal controls.
C) they represent falsification of accounting records.
D) they represent disclosure of information related to issuance of a “going-concern” opinion.
Answer
Terms: Significant deficiencies
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
10) Before making the final assessment of internal control at the end of an integrated audit, the auditor must:
A)
Test controls Perform substantive tests of details
Yes Yes

B)
Test controls Perform substantive tests of details
No No

C)
Test controls Perform substantive tests of details
Yes No

D)
Test controls Perform substantive tests of details
No Yes

Answer
Terms: Final assessment of internal control for integrated audit
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
Topic: Public

11) Significant deficiencies and material weaknesses in internal control of a public company must be reported in writing to which of the following?
A) the Public Company Accounting Oversight Board
B) members of management who are responsible for the related area of the company
C) audit committee of the company’s board of directors
D) the AICPA
Answer
Terms: Internal controls; significant deficiencies; material weaknesses
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
Topic: Public

12) Significant deficiencies are matters that come to an auditor’s attention and should be communicated to an entity’s audit committee because they represent:
A) material frauds perpetrated by high-level management.
B) internal control deficiencies that could adversely affect a company’s ability to initiate, record, process, or report external financial statements reliably.
C) flagrant violations of the entity’s documented conflict-of-interest policies.
D) intentional attempts by client personnel to limit the scope of the auditor’s field work.
Answer
Terms: Significant deficiencies; audit committee
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
13) How must significant deficiencies and material weaknesses be communicated to those charged with governance?
A) Either oral or written communication is acceptable.
B) Oral communication is required.
C) Written communication is required.
D) Written communication is required for material weaknesses, but oral communication is allowed for significant deficiencies.
Answer
Terms: Significant deficiencies and material weaknesses; governance
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

14) When considering internal control, an auditor should be aware of the concept of reasonable assurance, which recognizes that the:
A) segregation of incompatible functions is necessary to ascertain that internal control is effective.
B) employment of competent personnel provides assurance that the objectives of internal control will be achieved.
C) establishment and maintenance of internal control is an important responsibility of the management and not of the auditor.
D) concept allows for only a remote likelihood that material misstatements will not be prevented or detected on a timely basis.
Answer
Terms: Internal control; reasonable assurance
Diff: Challenging
Objective: LO 10-5
AACSB: Analytic skills

15) When planning an audit, the auditor’s assessed level of control risk is:
A) determined by using actuarial tables.
B) calculated by using the audit risk model.
C) a judgment issue, based on auditor knowledge.
D) calculated by using the formulas provided in the AICPA’s auditing standards.
Answer
Terms: Assessed level of control risk
Diff: Challenging
Objective: LO 10-5
AACSB: Reflective thinking skills

16) When a compensating control exists, the absence of a key control:
A) is no longer a concern because there is no longer a significant deficiency or material weakness.
B) is still a major concern to the auditor.
C) could cause a material loss, so it must be tested using substantive procedures.
D) is magnified and must be removed from the sampling process and examined in its entirety.
Answer
Terms: Compensating control; key control
Diff: Challenging
Objective: LO 10-5
AACSB: Analytic skills
17) You are the audit manager for a new audit client. Your staff auditors are unsure of what constitutes a control deficiency. Discuss the definition of control deficiency. In your response include at least two examples of control deficiencies.
Answer control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis in the normal course of performing assigned functions.

Design Deficiency exists if a necessary control is missing or not properly designed.

Operating Deficiency exists if a well-designed control does not operate as designed or if the person performing the control is insufficiently qualified or authorized.
Terms: Control deficiency; Design deficiency; Operating deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

18) Define the following terms: control deficiency, significant deficiency, and material weakness.

19) Describe the auditor’s responsibilities related to required communications between the auditor and those charged with governance (remove auditor committee) regarding internal control.

20) The text suggested a five-step approach to identify deficiencies, significant deficiencies, and material weaknesses. Describe this approach.

21) The most important component of internal control is risk assessment.
A) True
B) False
Answer
Terms: Internal control risk assessment
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

Learning Objective 10-6

1) If the results of tests of controls support the design and operations of controls as expected, the auditor uses ________ control risk as the preliminary assessment.
A) a lower
B) the same
C) a higher
D) either a lower or higher
Answer
Terms: Control risk as preliminary assessment
Diff: Moderate
Objective: LO 10-6
AACSB: Analytic skills

2) An auditor is likely to use four types of procedures to support the operating effectiveness of internal controls. Which of the following would generally NOT be used?
A) make inquiries of appropriate client personnel
B) examine documents, records, and reports
C) reperform client procedures
D) inspect design documents
Answer
Terms: Operating effectiveness of internal controls
Diff: Moderate
Objective: LO 10-6
AACSB: Reflective thinking skills

3) After considering a client’s internal controls, an auditor has concluded that it is well designed and is functioning as intended. Under these circumstances the auditor would most likely:
A) perform tests of controls to the extent outlined in the audit program.
B) determine the control procedures that should prevent or detect errors and irregularities.
C) not increase the extent of predetermined substantive tests.
D) determine whether transactions are recorded to permit preparation of financial statements in conformity with generally accepted accounting principles.
Answer
Terms: Internal control design and functioning
Diff: Challenging
Objective: LO 10-6
AACSB: Analytic skills

4) In evaluating the operational effectiveness of internal controls the auditor is likely to use four types of audit procedures. List the procedures below.

5) When internal controls are highly effective in processing accounting transactions, the extent of substantive tests should be reduced.
A) True
B) False
Answer
Terms: Processing accounting transactions; substantive tests
Diff: Easy
Objective: LO 10-6
AACSB: Analytic skills

6) When internal controls over a given financial statement account are assessed as highly effective, the auditor need not obtain audit evidence for that account beyond testing the controls.
A) True
B) False
Answer
Terms: Internal controls highly effective
Diff: Moderate
Objective: LO 10-6
AACSB: Analytic skills

Learning Objective 10-7

1) In performing an audit of internal control over financial reporting which of the following is the auditor required to do?
A) Test routine and nonroutine transactions equally.
B) Form an opinion on the effectiveness of internal for financial reporting.
C) Rely on the work on internal auditors in order to promote audit efficiency.
D) Use the audit conclusions before starting the audit of financial statements.
Answer
Terms: Internal control audit requirements of auditor
Diff: Easy
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: SOX

2) The criterion that is most likely to be used as a framework in evaluating a company’s internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act is the Enterprise Risk Management framework.
A) True
B) False
Answer
Terms: Section 404 of the Sarbanes-Oxley Act
Diff: Challenging
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: SOX

3) To issue an unqualified opinion on internal control over financial reporting, there must be no identified material weaknesses and no restrictions on the scope of the audit.
A) True
B) False
Answer
Terms: Unqualified opinion on internal control
Diff: Moderate
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: Public

Learning Objective 10-8

1) A control available in a small company, which may be necessitated because of lack of competent personnel, is:
A) a wider segregation of duties.
B) a voucher system.
C) fewer transactions to process.
D) the owner-manager’s direct involvement in the control process.
Answer
Terms: Control; smaller company; competent personnel
Diff: Easy
Objective: LO 10-8
AACSB: Ethical understanding and reasoning abilities

2) When auditing a private company, the auditor should obtain an understanding of internal control sufficient to:
A) provide reasonable protection against client fraud and defalcations by client employees.
B) assess control risk.
C) provide a basis for suggestions to the client for improving the accounting system.
D) provide a method for safeguarding assets, checking the accuracy and reliability of accounting data, promoting operational efficiency, and encouraging adherence to prescribed managerial policies.
Answer
Terms: Internal control understanding; Private company
Diff: Easy
Objective: LO 10-8
AACSB: Reflective thinking skills

3) In the audit of a private company, the auditor will test internal controls when control risk is initially assessed at:
A)
Low Moderate High
Yes No Yes

B)
Low Moderate High
No No Yes

C)
Low Moderate High
Yes Yes No

D)
Low Moderate High
No Yes No

Answer
Terms: Control risk
Diff: Moderate
Objective: LO 10-8
AACSB: Analytic skills
4) The auditor’s consideration of a private company’s internal control is:
A) required by GAAP.
B) required by GAAS.
C) required by the IRS.
D) recommended by the SEC.
Answer
Terms: Private company’s internal control
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

5) Which of the following may represent the biggest challenge smaller public companies face in implementing effective internal control?
A) a lack of expertise
B) reduced importance
C) limited resources
D) limited available guidance
Answer
Terms: Internal control biggest challenge
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills
Topic: Public

6) Which of the following is most correct for audits of non-public companies?
A) an audit of internal control is required
B) an audit of internal control is not required
C) an audit of the design of internal controls is required
D) an audit of the operational effectiveness of internal controls is required
Answer
Terms: Audits of non-public companies
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

7) Match seven of the terms (a-i) with the definitions provided below (1-7):

a. Control environment
b. Control activities
c. Independent checks on performance
d. Internal control
e. Monitoring
f. Separation of duties
g. General authorization
h. Specific authorization
i. Risk assessment

________ 1. Management’s ongoing and periodic assessment of the quality of internal control performance to determine that controls are operating as intended and are modified when needed.

________ 2. Company-wide policies for the approval of all transactions within stated limits.

________ 3. The actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about internal control and its importance to the entity.

________ 4. Segregation of the following activities in an organization: custody of assets, accounting, authorization, and operational responsibility.

________ 5. Management’s identification and analysis of risks relevant to the preparation of financial statements in accordance with an applicable accounting framework.

________ 6. Policies and procedures that help ensure that necessary actions are taken to address risks in the achievement of the entity’s objectives.

________ 7. A process designed to provide reasonable assurance regarding the achievement of management’s objectives in the following categories: (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with applicable laws and regulations.

8) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably set a high assessment of control risk.
A) True
B) False
Answer
Terms: Control activities; control risk
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills

9) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably reassess whether the client is auditable.
A) True
B) False
Answer
Terms: Control activities
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills
10) Auditors of private companies may rely on prior periods’ tests of controls.
A) True
B) False
Answer
Terms: Private companies; test of controls
Diff: Easy
Objective: LO 10-8
AACSB: Reflective thinking skills

11) In an audit of a non-public company, the less control risk there is, the smaller the amount of planned substantive evidence that is required.
A) True
B) False
Answer
Terms: Non-public company; control risk; substantive evidence
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills

12) For proper internal control, there should be adequate separation of duties. However, the extent of separation of duties considered “adequate” does not depend on the size of the organization.
A) True
B) False
Answer
Terms: Separation of duties
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

13) In an audit of a non-public company, the auditor’s assessment of control risk and the extent of tests of controls are inversely related.
A) True
B) False
Answer
Terms: Non-public companies; control risk
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

14) Smaller companies usually have less extensive internal controls than larger companies which result in more frauds being committed at small companies.
A) True
B) False
Answer
Terms: Internal controls for smaller companies
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 11 Fraud Auditing

Learning Objective 11-1

1) Which of the following best defines fraud in a financial statement auditing context?
A) Fraud is an unintentional misstatement of the financial statements.
B) Fraud is an intentional misstatement of the financial statements.
C) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on materiality.
D) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on consistency.
Answer©
Terms: Definition of fraud in financial statement auditing
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

2) Companies may intentionally understate earnings when income is high to create a reserve of “earnings” that may be used in future years to increase earnings. This practice is known as:
A) performance-based management.
B) earnings management.
C) asset management.
D) expense management.
Answer
Terms: Intentionally understate earnings; Reserve earnings
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

3) Which of the following is a category of fraud?
A)
Fraudulent financial reporting Misappropriation of assets
Yes Yes

B)
Fraudulent financial reporting Misappropriation of assets
No No

C)
Fraudulent financial reporting Misappropriation of assets
Yes No

D)
Fraudulent financial reporting Misappropriation of assets
No Yes

Answer
Terms: Category of fraud
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills
4) With respect to misappropriation of assets, most frauds involve:
A)
Inventory or liquid asset theft Intentional misstatements of amounts
Yes Yes

B)
Inventory or liquid asset theft Intentional misstatements of amounts
No No

C)
Inventory or liquid asset theft Intentional misstatements of amounts
Yes No
Yes No
D)
Inventory or liquid asset theft Intentional misstatements of amounts
No Yes

Answer
Terms: Misappropriation of assets fraud
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

5) ________ is fraud that involves theft of an entity’s assets.
A) Fraudulent financial reporting
B) A “cookie jar” reserve
C) Misappropriation of assets
D) Income smoothing
Answer
Terms: Fraud that involves theft of entity’s assets
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

6) Which of the following would the auditor be most concerned about regarding a heightened risk of intentional misstatement?
A) senior management emphasizes that it is very important to beat analyst estimates of earnings every reporting period
B) senior management emphasizes that budgeted amounts for expenses are to be achieved for each reporting period or explained in the variance analysis report
C) senior management emphasizes that job rotation is a worthwhile corporate objective
D) senior management emphasizes that job evaluations are based on performance
Answer
Terms: Heightened risk of intentional misstatement
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills
7) Which of the following is a form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings?
A) fraudulent financial reporting
B) expense smoothing
C) income smoothing
D) each of the above is correct
Answer
Terms: Form of earnings management where revenues and expenses are shifted between periods
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

8) Who is most likely to perpetrate fraudulent financial reporting?
A) members of the board of directors
B) production employees
C) management of the company
D) the internal auditors
Answer
Terms: Fraudulent financial reporting
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

9) Misappropriation of assets is normally perpetrated by:
A) members of the board of directors.
B) employees at lower levels of the organization.
C) management of the company.
D) the internal auditors.
Answer
Terms: Misappropriation of assets normally perpetrated by
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

10) Determine from the following the factor that would most likely elevate the auditor’s concern about the risk of financial statement fraud.
A) company cannot borrow debt capital without restrictive covenants
B) company finds it difficult to sell equity capital for expansion
C) company has a significant portion of liquid assets on its balance sheet
D) company reports substantial net income but ever decreasing cash flow from operations
Answer
Terms: Most likely elevate auditor’s concern about risk of financial statement fraud
Diff: Moderate
Objective: LO 11-1
AACSB: Analytic skills
11) Define fraud and distinguish between the two main categories of fraud.

12) In the context of financial statement auditing, fraud is defined as an intentional misstatement of a material fact regarding balances, transactions or presentation of the financial statements.
A) True
B) False
Answer
Terms: Fraud in financial statement auditing
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

13) The two main categories of fraud are fraudulent financial reporting and misappropriation of assets.
A) True
B) False
Answer
Terms: Categories of fraud; Fraudulent financial reporting and misappropriation of assets
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

14) “Cookie jar reserves” are often created by companies whenever their earnings are high to create reserves for future periods when earnings need to be “boosted” upward.
A) True
B) False
Answer
Terms: Cookie jar reserves
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

15) Misappropriation of assets is normally perpetrated at the lowest levels of the organization hierarchy.
A) True
B) False
Answer
Terms: Misappropriation of assets
Diff: Moderate
Objective: LO 11-1
AACSB: Reflective thinking skills
16) Fraudulent financial reporting usually involves manipulation of amounts rather than disclosures.
A) True
B) False
Answer
Terms: Fraudulent financial reporting
Diff: Moderate
Objective: LO 11-1
AACSB: Reflective thinking skills

Learning Objective 11-2

1) Which of the following is one of the conditions for fraud described in SAS No. 99?
A)
Attitudes/rationalization Risk Factors Opportunities
Yes No Yes

B)
Attitudes/rationalization Risk Factors Opportunities
No Yes Yes

C)
Attitudes/rationalization Risk Factors Opportunities
Yes No No

D)
Attitudes/rationalization Risk Factors Opportunities
No Yes No

Answer
Terms: Conditions for fraud described in SAS No. 99
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills

2) Financial statement manipulation risk is arguably present for all companies’ financial statements. However, the risk is elevated for companies that:
A) are heavily regulated.
B) have foreign subsidiaries.
C) have to make significant judgments for accounting estimates.
D) operate in stable economic environments.
Answer
Terms: Financial statement manipulation risk is elevated
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills
3) Which of the following is not a factor that relates to opportunities to commit fraudulent financial reporting?
A) Lack of controls related to the calculation and approval of accounting estimates.
B) Ineffective oversight of financial reporting by the board of directors.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer
Terms: Factor relates to opportunities to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

4) Fraud is more prevalent in smaller businesses and not-for-organizations because it is more difficult for them to maintain:
A) adequate separation of duties.
B) adequate compensation.
C) adequate financial reporting standards.
D) adequate supervisory boards.
Answer
Terms: Fraud more prevalent in smaller business and not-for-profit organizations
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

5) Which of the following is a factor that relates to incentives or pressures to commit fraudulent financial reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer
Terms: Factor that relates to incentives or pressures to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

6) Which of the following is a factor that relates to attitudes or rationalization to commit fraudulent financial reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.
Answer
Terms: Factor that relates to attitudes or rationalization to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
7) Which of the following is not a factor that relates to opportunities to misappropriate assets?
A) Inadequate internal controls over assets.
B) Presence of large amounts of cash on hand.
C) Inappropriate segregation of duties or independent checks on performance.
D) Adverse relationships between management and employees.
Answer
Terms: Factor that relates to opportunities to misappropriate assets
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

8) Which of the following is a factor that relates to incentives to misappropriate assets?
A) Significant accounting estimates involving subjective judgments.
B) Significant personal financial obligations.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.
Answer
Terms: Factor that relates to incentives to misappropriate assets
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

9) Which of the following does NOT represent an increased opportunity to commit fraud?
A) Related Party Transactions
B) the company founder is the CEO and Chairman of the Board
C) the financial statements involve accounting estimates
D) the company is a new audit client for the CPA firm
Answer
Terms: Increased opportunity to commit fraud
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

10) In the fraud triangle, fraudulent financial reporting and misappropriation of assets:
A) share little in common.
B) share most of the same risk factors.
C) share the same three conditions.
D) share most of the same conditions.
Answer
Terms: Fraud triangle
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
11) List and briefly describe the three conditions for fraud arising from fraudulent financial reporting and misappropriation of assets as described in SAS No. 99.

12) List and briefly describe examples of risk factors for each condition of fraud for fraudulent financial reporting.

13) These two conditions are generally present when material misstatements due to fraud occur—incentives and opportunities.
A) True
B) False
Answer
Terms: Conditions present when material misstatements due to fraud occur
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills
14) Fraud is more prevalent in large businesses than small businesses and not-for-profit organizations.
A) True
B) False
Answer
Terms: Fraud prevalence in organizations
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills

15) The same three fraud triangle risk conditions apply to fraudulent financial reporting and misappropriation of assets.
A) True
B) False
Answer
Terms: Fraud triangle risk conditions
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

16) “An attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act ….” describes the opportunities condition included in the fraud triangle.
A) True
B) False
Answer
Terms: Opportunities conditions included in fraud triangle
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

17) An example of a fraud risk factor describing incentives/pressures is “ineffective board of director oversight over financial reporting.”
A) True
B) False
Answer
Terms: Fraud risk factor describing incentives/pressures
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

18) An example of a fraud risk factor describing opportunities is “ineffective board of director oversight over financial reporting.”
A) True
B) False
Answer
Terms: Fraud risk factor describing opportunities
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
19) Auditors should consider risk factors related to incentives, opportunities, and attitudes whenever they assess the likelihood of material misstatements due to fraud.
A) True
B) False
Answer
Terms: Risk factors related to incentives, opportunities, and attitudes
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

Learning Objective 11-3

1) Auditor’s need to exhibit professional skepticism when auditing a client. This auditing standard is best expressed by which of the following?
A) the auditor neither assumes dishonesty or honesty of management
B) the auditor assumes dishonesty of management
C) the auditor assumes honesty of management
D) the auditor assumes management lacks integrity
Answer
Terms: Professional skepticism when auditing a client
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

2) SAS No. 99 requires auditors to document which of the following matters related to the auditor’s consideration of material misstatements due to fraud?
A) Reasons supporting a conclusion that there is not a significant risk of material improper expense recognition.
B) Procedures performed to obtain information necessary to identify and assess the risks of material fraud.
C) Results of the internal auditor’s procedures performed to address the risk of management override of controls.
D) Discussions with management regarding separation of duties.
Answer
Terms: SAS No. 99 requires auditors to document matters related to auditor consideration of material misstatements due to fraud
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

3) As part of the brainstorming sessions, auditors are directed to emphasize:
A)
The need for professional
skepticism The audit team’s response to potential fraud risks
Yes Yes

B)
The need for professional
skepticism The audit team’s response to potential fraud risks
No No

C)
The need for professional
skepticism The audit team’s response to potential fraud risks
Yes No

D)
The need for professional
skepticism The audit team’s response to potential fraud risks
No Yes

Answer
Terms: Auditors directed to emphasize in brainstorming sessions
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

4) While performing their audit, the audit team uncovers fraud that is likely to have an immaterial affect on the financial statements taken as whole. In this case the auditors should:
A) plan on additional audit procedures to determine the exact amount of the fraud.
B) communicate with legal authorities as to the identity of the fraudsters.
C) disclose the fraud to the appropriate level of management or to the audit committee.
D) call the whistleblower hotline and name the suspected individuals.
Answer
Terms: Audit team uncovers fraud that is immaterial to financial statements
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

5) Which of the following most accurately defines professional skepticism as it is used in auditing standards?
A) It either assumes management is honest or slightly dishonest, but neither all the time.
B) It neither assumes that management is dishonest nor assumes unquestioned honesty.
C) It assumes management is honest most of the time.
D) It assumes that management is dishonest in only rare instances.
Answer
Terms: Professional skepticism and auditing standards
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills
6) Which of the following is not a likely source of information to assess fraud risks?
A) Communications among audit team members.
B) Inquiries of management.
C) Analytical procedures.
D) Consideration of fraud risks discovered during recent audits of other clients.
Answer
Terms: Source of information to assess fraud risks
Diff: Challenging
Objective: LO 11-3
AACSB: Reflective thinking skills

7) Explain professional skepticism and the need for maintaining professional skepticism during an audit.

8) Briefly discuss the brainstorming session required by SAS No. 99. Be sure to include a list of ideas that should be addressed in the session.

9) Describe the sources of information gathered to assess fraud risks.

10) Financial statements of all companies are potentially subject to manipulation.
A) True
B) False
Answer
Terms: Financial statements subject to manipulation
Diff: Easy
Objective: LO 11-3
AACSB: Reflective thinking skills

11) Information and idea exchange sessions by the audit team are required by SAS No. 99.
A) True
B) False
Answer
Terms: Information and idea exchange by audit team sessions required by SAS No. 99
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

12) SAS No. 99 does not specifically indicate which members of an audit engagement team must attend a brainstorming session.
A) True
B) False
Answer
Terms: SAS No. 99 and audit engagement team brainstorming session
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

13) The presence of fraud risk factors increases the likelihood of fraud and may suggest that fraud is being perpetrated.
A) True
B) False
Answer
Terms: Presence of fraud risk factors
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

14) Professional skepticism requires auditors to “either assume that management is dishonest or they have questionable honesty.”
A) True
B) False
Answer
Terms: Professional skepticism
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

Learning Objective 11-4

1) Which of the following is the best reason for management to emphasize fraud prevention and deterrence?
A) collusion and false documentation make fraud detection difficult to detect
B) collusion is impossible to detect
C) false Documentation is impossible to detect
D) all of the above are equally valid reasons
Answer
Terms: Reason for management to emphasize fraud prevention and deferrence
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

2) Which of the following parties is responsible for implementing internal controls to minimize the likelihood of fraud?
A) External auditors
B) Audit committee members
C) Management
D) Committee of Sponsoring Organizations
Answer
Terms: Party responsible for implementing internal controls to minimize likelihood of fraud
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

3) Research indicates that the most effective way to prevent and deter fraud is to:
A) implement programs and controls that are based on core values embraced by the company.
B) hire highly ethical employees.
C) communicate expectations to all employees on an annual basis.
D) terminate employees who are suspected of committing fraud.
Answer
Terms: Most effective way to prevent and deter fraud
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

4) Fraud awareness training should be:
A) broad and all-encompassing.
B) extensive and include details for all functional areas.
C) specifically related to the employee’s job responsibility.
D) focused on employees understanding the importance of ethics.
Answer
Terms: Fraud awareness training
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

5) Which party has the primary responsibility to oversee an organization’s financial reporting and internal control process?
A) the board of directors
B) the audit committee
C) management of the company
D) the financial statement auditors
Answer
Terms: Party with primary responsibility to oversee organization’s financial reporting and internal control processes
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

6) Management is responsible for:
A)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
Yes Yes

B)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
No No

C)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
Yes No

D)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
No Yes

Answer
Terms: Management is responsibilities with fraud risks
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

7) The “tone at the top” provides a foundation upon which a more detailed code of conduct can be developed to provide specific guidance for the organization and its employees. Components of a code of conduct may include sections on 1) general employee conduct, 2) relationships with clients and suppliers and 3) conflicts of interest. Give a narrative description of what might be included in each of the above components of a code of conduct.

8) Senior management is responsible for promoting a culture of honesty and ethics. Describe what that implies for the organization.

9) Management and the board of directors are responsible for setting the “tone at the top.”
A) True
B) False
Answer
Terms: Responsibility for setting tone at the top
Diff: Easy
Objective: LO 11-4
AACSB: Reflective thinking skills

10) The audit committee is responsible for determining an organization’s financial reporting and internal control processes.
A) True
B) False
Answer
Terms: Responsibility for determining organization financial reporting and internal control
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

11) The board of directors has the primary oversight responsibility to assess fraud risks and establish corporate governance programs and controls to prevent, deter, and detect fraud.
A) True
B) False
Answer
Terms: Primary responsibility to assess fraud risks and establish corporate governance programs
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills

12) One of the strongest internal corporate governance mechanisms over senior management is the audit committee of the board of directors.
A) True
B) False
Answer
Terms: Strongest internal corporate governance mechanisms
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills

Learning Objective 11-5

1) As part of designing and performing procedures to address management override of controls, auditors must perform which of the following procedures?
A)
Examine all journal entries above the level of materiality Review accounting estimates for biases
Yes Yes

B)
Examine all journal entries above the level of materiality Review accounting estimates for biases
No No

C)
Examine all journal entries above the level of materiality Review accounting estimates for biases
Yes No

D)
Examine all journal entries above the level of materiality Review accounting estimates for biases
No Yes

Answer
Terms: Designing and performing procedures to address override controls
Diff: Moderate
Objective: LO 11-5
AACSB: Reflective thinking skills

2) Auditors may identify conditions during fieldwork that change or support a judgment about the initial assessment of fraud risks. Which of the following is not a condition which should alert an auditor that the initial assessment should be changed?
A) preliminary assessment of control risk has been modified
B) discrepancies in the accounting records
C) unusual relationships between the auditor and management
D) missing or conflicting evidence
Answer
Terms: Alert auditor to change initial assessment of fraud risks
Diff: Moderate
Objective: LO 11-5
AACSB: Reflective thinking skills
3) Auditors are required to perform certain procedures in every audit to address the risk of management override of internal controls. What are these procedures?

4) Because fraud perpetrators are often knowledgeable about audit procedures, SAS No. 99 requires auditors to incorporate unpredictability into the audit plan.
A) True
B) False
Answer
Terms: SAS No. 99 requires auditors to incorporate unpredictability into audit plan
Diff: Challenging
Objective: LO 11-5
AACSB: Reflective thinking skills

5) All misstatements the auditor finds during the audit should be evaluated for any indication of fraud.
A) True
B) False
Answer
Terms: All misstatements found during audit should be evaluated for indication of fraud
Diff: Challenging
Objective: LO 11-5
AACSB: Reflective thinking skills

Learning Objective 11-6

1) According to SAS No. 99, auditors are required to assume that which of the following has significant risk of fraud?
A) overstated assets
B) understated liabilities
C) improper revenue recognition
D) overstated expenses
Answer
Terms: SAS No. 99 requires auditors to assume significant risk of fraud
Diff: Moderate
Objective: LO 11-6
AACSB: Reflective thinking skills
2) Company management is often under pressure to increase revenue and/or net income. One approach is to use a “bill and hold” arrangement. This is an example of which of the following?
A) adjustments to revenue accounts
B) fictitious revenue recorded
C) premature revenue recognized
D) alteration of cutoff documents
Answer
Terms: Bill and hold arrangement to increase revenue and/or net income
Diff: Moderate
Objective: LO 11-6
AACSB: Reflective thinking skills

3) A company is concerned with the theft of cash after the sale has been recorded. One way in which fraudsters conceal the theft is by a process called “lapping”. Which of the following best describes lapping?
A) reduce the customer’s account by recording a sales return
B) write off the customer’s account
C) apply the payment from another customer to the customer’s account
D) reduce the customer’s account by recording a sales allowance
Answer
Terms: Lapping; Theft of cash
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills

4) Analytical procedures can be very effective in detecting inventory fraud. Which of the following analytical procedures would NOT be useful in detecting fraud?
A) Gross margin percentage
B) Inventory Turnover
C) Cost of sales percentage
D) Accounts payable turnover
Answer
Terms: Analytical procedures to detect inventory fraud
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills
5) What are the three main types of revenue manipulations employed to commit fraudulent financial reporting and give an example for each type?

6) You are conducting an audit and you are concerned about revenue recognition issues because of timing concerns due to proper cutoff and channel stuffing (sales to distributors above “normal” business needs. Describe at least two audit procedures that would best address your concerns?

7) The most common fraud in the acquisition and payment cycle is for the fraudster to issue payments to fictitious vendors and deposit the cash in fictitious accounts. What procedures could the company take to prevent this type of fraud?

Learning Objective 11-7

1) The audit team has identified and documented fraud risk. Their next step should be to:
A) evaluate factors that should reduce risk.
B) develop programs to test for fraud.
C) proceed with performing tests of controls.
D) proceed with performing substantive tests of balances.
Answer
Terms: Identified and documented fraud risk
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills

2) Which of the following is least likely to uncover fraud?
A) External auditors
B) Internal auditors
C) Internal controls
D) Management
Answer
Terms: Lease likely to uncover of fraud risks
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills
3) Which of the following is not a category of inquiry used by auditors?
A) Assessment inquiry
B) Declarative inquiry
C) Interrogative inquiry
D) Informational inquiry
Answer
Terms: Category of inquiry used by auditors
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

4) ________ inquiry is used when the auditor seeks responses from the interviewee about his or her knowledge of an event or circumstance.
A) Assessment
B) Declarative
C) Interrogative
D) Informational
Answer
Terms: Inquiry used when auditor seeks responses
Diff: Challenging
Objective: LO 11-7
AACSB: Analytic skills

5) ________ inquiry is used to ascertain whether information already obtained is correct, factual or truthful.
A) Assessment
B) Declarative
C) Interrogative
D) Informational
Answer
Terms: Inquiry used to ascertain whether information already obtained is correct
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

6) When the auditor suspects that fraud may be present, SAS No. 99 requires the auditor to:
A) terminate the engagement with sufficient notice given to the client.
B) issue an adverse opinion or a disclaimer of opinion.
C) obtain additional evidence to determine whether material fraud has occurred.
D) re-issue the engagement letter.
Answer
Terms: SAS No. 99 requires auditor to do when fraud is suspected
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills
7) With whom should the auditor communicate whenever he or she determines that senior management fraud may be present, even if the matter might be considered inconsequential?
A) PCAOB
B) audit committee
C) an appropriate level of management that is at least one level above those involved
D) the internal auditors
Answer
Terms: Auditor communicate with whom when senior management fraud may be present
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

8) What types of inquiry techniques might an auditor use when making inquiries of client personnel? What are the uses of each technique?

9) PCAOB Standard 5 indicates that material fraud by senior management is a material weakness.
A) True
B) False
Answer
Terms: Senior management fraud
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills
Topic: Public

10) Auditors must issue a qualified opinion on internal control whenever senior management commits fraud that is considered a material weakness.
A) True
B) False
Answer
Terms: Opinion issued on internal control with senior management fraud
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills
Topic: Public
Auditing and Assurance Services, 14e (Arens)
Chapter 12 The Impact of Information Technology on the Audit Process

Learning Objective 12-1

1) IT has several significant effects on an organization. Which of the following would not be important from an auditing perspective?
A) organizational changes
B) the visibility of information
C) the potential for material misstatement
D) None of the above; i.e., they are all important.
Answer
Terms: IT effects on organization
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills

2) Which of the following is not a benefit of using IT-based controls?
A) ability to process large volumes of transactions
B) ability to replace manual controls with computer-based controls
C) reduction in misstatements due to consistent processing of transactions
D) reduction in internal control evaluation in setting control risk
Answer
Terms: Not a benefit of using IT-based controls
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills

3) Discuss how the integration of IT into accounting systems enhances internal control.
Answernhancements to internal control resulting from the integration of IT into accounting systems include:
• Computer controls replace manual controls. Replacing manual procedures with programmed controls that apply checks and balances to each processed transaction and that process information consistently can reduce human error that is likely to occur in traditional manual environments.
• Higher quality information is available. IT systems typically provide management with more and higher quality information faster than most manual systems.
Terms: Integration of IT into accounting systems enhances internal control
Diff: Moderate
Objective: LO 12-1
AACSB: Reflective thinking skills

4) Control risk may be reduced for a company with a complex IT system when compared to a company that relies primarily on manual controls.
A) True
B) False
Answer
Terms: Control risk reduced for company with complex IT system
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills
Learning Objective 12-2

1) Which of the following is a significant risk to the auditor regarding an audit in a highly automated information environment?
A) does not place enough reliance on the processed information
B) places too much reliance on the processed information
C) processed information may not reveal the sources of the information
D) does not understand the processed information produced by the automated environment
Answer
Terms: Risk to auditor regarding audit in highly automated information environment
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

2) Which of the following is not a risk specific to IT environments?
A) reliance on the functioning capabilities of hardware and software
B) increased human involvement
C) loss of data due to insufficient backup
D) unauthorized access
Answer
Terms: Risks specific to IT environment
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

3) Which of the following is not an enhancement to internal control that will occur as a consequence of increased reliance on IT?
A) computer controls replace manual controls
B) higher quality information is available
C) computer-based controls provide opportunities to improve separation of duties
D) manual controls replace automated controls
Answer
Terms: Enhancements to internal control which occur as consequence of increased reliance on IT
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

4) Which of the following is not a risk in an IT system?
A) need for IT experienced staff
B) separation of IT duties from accounting functions
C) improved audit trail
D) hardware and data vulnerability
Answer
Terms: Risks in an IT system
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills
5) Which of the following may present itself as the biggest risk to centralizing information responsibilities that were traditionally separate?
A) IT personnel with access to software and master files may misappropriate assets
B) IT personnel with access to software and master files may lack the accounting skills necessary to provide useful information to management
C) IT personnel with access to software and master files may not understand the linkages between general and application controls
D) IT personnel with access to software and master files may not be able to convert the company’s operational policies to an IT environment
Answer
Terms: Biggest risk to centralizing information responsibilities
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

6) An important characteristic of IT is uniformity of processing. Therefore, a risk exists that:
A) auditors will not be able to access data quickly.
B) auditors will not be able to determine if data is processed consistently.
C) erroneous processing can result in the accumulation of a great number of misstatements in a short period of time.
D) all of the above.
Answer
Terms: Characteristics of IT and risk
Diff: Moderate
Objective: LO 12-2
AACSB: Reflective thinking skills

7) What are three specific risks to IT systems?

8) One potential disadvantage of IT systems is the reduction or elimination of source documents, which reduces the visibility of the audit trail.
A) True
B) False
Answer
Terms: Disadvantage of IT systems
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills
Learning Objective 12-3

1) Old and new systems operating simultaneously in all locations is a test approach known as:
A) pilot testing.
B) horizontal testing.
C) integrative testing.
D) parallel testing.
Answer
Terms: Old and new systems operating simultaneously
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

2) Which of the following is a component of general controls?
A) processing controls
B) output controls
C) back-up and contingency planning
D) input controls
Answer
Terms: Component of general controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

3) Which of the following statements related to application controls is correct?
A) Application controls relate to various aspects of the IT function including software acquisition and the processing of transactions.
B) Application controls relate to various aspects of the IT function including physical security and the processing of transactions in various cycles.
C) Application controls relate to all aspects of the IT function.
D) Application controls relate to the processing of individual transactions.
Answer
Terms: Application controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

4) General controls include all of the following except:
A) systems development.
B) online security.
C) processing controls.
D) hardware controls.
Answer
Terms: General controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills
5) Which of the following describes the process of implementing a new system in one part of the organization, while other locations continue to use the current system.
A) parallel testing
B) online testing
C) pilot testing
D) control testing
Answer
Terms: Process implementing new system in one part of organization
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

6) To determine that user ID and password controls are functioning, an auditor would most likely:
A) test the system by attempting to sign on using invalid user identifications and passwords.
B) write a computer program that simulates the logic of the client’s access control software.
C) extract a random sample of processed transactions and ensure that the transactions were appropriately authorized.
D) examine statements signed by employees stating that they have not divulged their user identifications and passwords to any other person.
Answer
Terms: ID and password controls function by testing
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

7) When IT programs or files can be accessed from terminals, users should be required to enter a(n):
A) echo check.
B) parity check.
C) self-diagnosis test.
D) authorized password.
Answer
Terms: Required for access to IT programs or files from terminals
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

8) Typical controls developed for manual systems which are still important in IT systems include:
A) management’s authorization of transactions.
B) competent personnel.
C) adequate preparation of input source documents.
D) all of the above.
Answer
Terms: Typical controls developed for manual systems still important in IT systems
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
9) Which of the following controls prevent and detect errors while transaction data are processed?
A) Software
B) Application
C) Processing
D) Transaction
Answer
Terms: Controls that prevent and detect errors while transaction data are processed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

10) Which of the following is not a characteristic associated with converting from a manual to an IT system?
A) It usually centralizes data.
B) It permits higher quality and more consistent controls over operations.
C) It may eliminate the control provided by division of duties of independent persons who perform related functions and compare results.
D) It may take the recordkeeping function and the document preparation function away from those who have custody of assets and put those functions into the IT center.
Answer
Terms: Characteristic associated with converting from manual to IT system
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

11) Output controls need to be designed for which of the following data integrity objectives?
A) detecting errors after the processing is completed
B) preventing errors before the processing is completed
C) detecting errors in the general ledger adjustment process
D) preventing errors in separation of duties for IT personnel
Answer
Terms: Output controls need to be designed for
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

12) Which of the following statements is correct?
A) Auditors should evaluate application controls before evaluating general controls.
B) Auditors should evaluate application controls and general controls simultaneously.
C) Auditors should evaluate general controls before evaluating application controls.
D) None of these statements is correct.
Answer
Terms: Auditors evaluation of application controls and general controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
13) Auditors should evaluate which of the following before evaluating application controls because of the potential for pervasive effects.
A) input controls
B) control environment
C) processing controls
D) general controls
Answer
Terms: Evaluate before evaluating application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

14) A control that relates to all parts of the IT system is called a(n):
A) general control.
B) systems control.
C) universal control.
D) applications control.
Answer
Terms: Control that relates to all parts of IT system
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

15) Controls which apply to a specific element of the system are called:
A) user controls.
B) general controls.
C) systems controls.
D) applications controls.
Answer
Terms: Controls which apply to a specific element of the syste,
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

16) Which of the following is not an example of an applications control?
A) Back-up of data to a remote site for data security.
B) There is a preprocessing authorization of the sales transactions.
C) There are reasonableness tests for the unit selling price of a sale.
D) After processing, all sales transactions are reviewed by the sales department.
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
17) Which of the following is least likely to be used in obtaining an understanding of client general controls?
A) examination of system documentation
B) inquiry of client personnel (e.g., key users)
C) walk through of a sales transaction
D) reviews of questionnaires completed by client IT personnel
Answer
Terms: Understanding of client general controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

18) Which of the following is not a general control?
A) computer performed validation tests of input accuracy
B) equipment failure causes error messages on monitor
C) separation of duties between programmer and operators
D) adequate program run instructions for operating the computer
Answer
Terms: General control
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

19) Controls which are built in by the manufacturer to detect equipment failure are called:
A) input controls.
B) data integrity controls.
C) hardware controls.
D) manufacturer’s controls.
Answer
Terms: Controls built in by manufacturer to detect equipment failure
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

20) Which of the following best describes the test data approach?
A) auditors process their own test data using the client’s computer system and application program
B) auditors process their own test data using their own computers that simulate the client’s computer system
C) auditors use auditor-controlled software to do the same operations that the client’s software does, using the same data files
D) auditors use client-controlled software to do the same operations that the client’s software does, using auditor created data files
Answer
Terms: Control risk matrix
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
21) Controls which are designed to assure that the information processed by the computer is authorized, complete, and accurate are called:
A) input controls.
B) processing controls.
C) output controls.
D) general controls.
Answer
Terms: Controls designed to assure information processed by computer is authorized, complete, and accurate
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

22) Programmers should be allowed access to:
A) user controls.
B) general controls.
C) systems controls.
D) applications controls.
Answer
Terms: Programmers should be allowed access
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

23) Which of the following tests determines that every field in a record has been completed?
A) Validation
B) Sequence
C) Completeness
D) Programming
Answer
Terms: Tests to determine that every field in a record has been completed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

24) In an IT-intensive environment, most processing controls are:
A) input controls.
B) operator controls.
C) programmed controls.
D) documentation controls.
Answer
Terms: IT intensive environment and processing controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
25) Output controls are not designed to assure that data generated by the computer are:
A) accurate.
B) distributed only to authorized people.
C) complete.
D) used appropriately by management.
Answer
Terms: Output controls are not designed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

26) Auditors usually obtain information about general and application controls through:
A) interviews with IT personnel.
B) examination of systems documentation.
C) reading program change requests.
D) all of the above methods.
Answer
Terms: General and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

27) An internal control deficiency occurs when computer personnel:
A) participate in computer software acquisition decisions.
B) design flowcharts and narratives for computerized systems.
C) originate changes in customer master files.
D) provide physical security over program files.
Answer
Terms: Internal control deficiency
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

28) General controls have which of the following effects on the operating effectiveness of application controls?
A) nominal
B) pervasive
C) mitigating
D) worsening
Answer
Terms: General controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
29) When auditing a client that uses batch processing the problem with error detection is that:
A) transaction trails in a batch system are available only for a limited period of time.
B) there are time delays in processing transactions in a batch system.
C) errors in some transactions cause rejection of other transactions in the batch.
D) random errors are more likely in a batch system than in an online system.
Answer
Terms: Batch processing and problem with error detection
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

30) Which of the following computer-assisted auditing techniques inserts an audit module in the client’s application system to identify specific types of transactions?
A) parallel simulation testing
B) test data approach
C) embedded audit module
D) generalized audit software testing
Answer
Terms: Computer-assisted auditing techniques allows fictitious and real transactions
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

31) In an IT system, automated equipment controls or hardware controls are designed to:
A) correct errors in the computer programs.
B) monitor and detect errors in source documents.
C) detect and control errors arising from the use of equipment.
D) arrange data in a logical sequential manner for processing purposes.
Answer
Terms: Equipment or hardware controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

32) If a control total were to be computed on each of the following data items, which would best be identified as a hash total for a payroll IT application?
A) gross wages earned
B) employee numbers
C) total hours worked
D) total debit amounts and total credit amounts
Answer
Terms: Hash total for payroll IT application
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
33) Which of the following is not an application control?
A) preprocessing authorization of sales transactions
B) reasonableness test for unit selling price of sale
C) post-processing review of sales transactions by the sales department
D) logging in to the company’s information systems via a password
Answer
Terms: Application controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

34) Application controls vary across the IT system. To gain an understanding of internal control for a private company, the auditor must evaluate the application controls for every:
A) audit area.
B) material audit area.
C) audit area in which the client uses the computer.
D) audit area where the auditor plans to reduce assessed control risk.
Answer
Terms: Application controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

35) Which of the following is not a general control?
A) sSeparation of IT duties
B) systems development.
C) processing controls
D) hardware controls
Answer
Terms: General control
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

36) In comparing (1) the adequacy of the hardware controls in the system with (2) the organization’s methods of handling the errors that the computer identifies, the independent auditor is:
A) unconcerned with both (1) and (2).
B) equally concerned with (1) and (2).
C) less concerned with (1) than with (2).
D) more concerned with (1) than with (2).
Answer
Terms: Concern of adequacy of hardware controls and methods of handling errors that computer identifies
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills
37) The most important output control is:
A) distribution control, which assures that only authorized personnel receive the reports generated by the system.
B) review of data for reasonableness by someone who knows what the output should look like.
C) control totals, which are used to verify that the computer’s results are correct.
D) logic tests, which verify that no mistakes were made in processing.
Answer
Terms: Output controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

38) Briefly define general controls and application controls.

39) Identify the three categories of application controls, and give one example of each.
Answerpplication controls fall into three categories:
• Input controls. Key verification and check digits are examples of input controls.
• Processing controls. One example is a reasonableness test for the unit selling price of a sale.
• Output controls. One example is post-processing review of sales transactions by the sales department.
Terms: Three categories of application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

40) One category of general controls is physical and online security. Describe the control and give at least three examples of implementation of the control.
Answerccess to hardware is restricted; passwords and finger print recognition limit access to data files; encryption and firewalls protect data integrity from outside sources.
Terms: General control of physical and online security
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
41) Processing controls include the following tests:

Validation
Sequence
Data Reasonableness
Completeness

Describe what each control is designed to do:

42) What are the two software testing strategies that companies typically use? Which strategy is more expensive?

43) Discuss the four areas of responsibility under the IT function that should be segregated in large companies.

44) Identify the six categories of general controls and give one example of each.

45) Parallel testing is used when old and new systems are operated simultaneously in all locations.
A) True
B) False
Answer
Terms: Parallel testing
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

46) Programmers should design the formatting for transactions data.
A) True
B) False
Answer
Terms: Programmer’s responsibilities
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

47) In IT systems, if general controls are effective, it increases the auditor’s ability to rely on application controls to reduce control risk.
A) True
B) False
Answer
Terms: Effective general controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
48) Parallel testing is more expensive than pilot testing.
A) True
B) False
Answer
Terms: Parallel testing
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

49) The effectiveness of automated controls depends solely on the competence of the personnel performing the controls.
A) True
B) False
Answer
Terms: Effectiveness of automated controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

50) Knowledge of both general and application controls is crucial for auditors in understanding how accounting information is recorded and reported.
A) True
B) False
Answer
Terms: Knowledge of general and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
Topic: Public

51) Logic tests and completeness tests are examples of application controls.
A) True
B) False
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

52) Auditors normally link controls and deficiencies in general controls to specific transaction-related audit objectives.
A) True
B) False
Answer
Terms: General controls linked to specific transaction-related audit objectives
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
53) Output controls focus on preventing errors during processing.
A) True
B) False
Answer
Terms: Output controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

54) Processing controls is a category of application controls.
A) True
B) False
Answer
Terms: Processing controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

55) Controls that relate to a specific use of the IT system, such as the processing of sales or cash receipts, are called application controls.
A) True
B) False
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

56) IT controls are classified as either input controls or output controls.
A) True
B) False
Answer
Terms: IT controls, input controls, and output controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

57) Tests of controls are normally performed only if the auditor believes the client’s internal control may be effective.
A) True
B) False
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
Learning Objective 12-4

1) The audit procedure which is least useful in gathering evidence on significant computer processes is:
A) documentation.
B) observation.
C) test decks.
D) generalized audit software.
Answer
Terms: Audit procedure least useful in gathering evidence
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

2) When the client uses a computer but the auditor chooses to use only the non-IT segment of internal control to assess control risk, it is referred to as auditing around the computer. Which one of the following conditions need not be present to audit around the computer?
A) Application controls need to be integrated with general controls.
B) The source documents must be available in a non-machine language.
C) The documents must be filed in a manner that makes it possible to locate them.
D) The output must be listed in sufficient detail to enable the auditor to trace individual transactions.
Answer
Terms: Client uses computer but auditor chooses to use non-IT segment of internal control to assess control risk
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

3) An auditor’s flowchart of the client’s IT system is a graphical representation that depicts the auditor’s:
A) program for tests of controls.
B) understanding of the system of how the IT system functions.
C) understanding of the types of errors that are probable given the present system.
D) documentation of the study and evaluation of the system.
Answer
Terms: Auditor flowchart of client IT system
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

4) Programmers should do all but which of the following?
A) Test programs for proper performance.
B) Evaluate representational faithfulness of transaction data input.
C) Develop flowcharts for new applications.
D) Programmers should perform each of the above.
Answer
Terms: Programmers should do
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
5) Which of the following audit procedures used to obtain an understanding of the client’s general controls would the auditor use to identify program changes in application software?
A) interviews with IT personnel
B) examination of system documentation
C) reviews of detailed questionnaires completed by the IT staff
D) review of the client’s IT architecture
Answer
Terms: Audit procedure to obtain understanding of client general controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

6) The process of assessing control risk considering only non IT controls is known as?
A) the single-stage audit.
B) the test deck approach.
C) auditing around the computer.
D) generalized audit software (GAS).
Answer
Terms: Assessing control risk considering only non-IT controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

7) Companies with non-complex IT environments often rely on desktops and networked servers to perform accounting system functions. Which of the following is not an audit consideration in such an environment?
A) limited reliance on automated controls
B) unauthorized access to master files
C) vulnerability to viruses and other risks
D) excess reliance on automated controls
Answer
Terms: Audit consideration in companies with non-complex IT environments
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

8) General controls in smaller companies are usually less effective than in more complex IT environments.
A) True
B) False
Answer
Terms: General controls in smaller companies
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
9) When the auditor decides to “audit around the computer” to obtain an understanding of the client’s internal controls related to the IT system.
A) True
B) False
Answer
Terms: Audit around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

10) “Auditing around the computer” is acceptable only if the auditor has access to the client’s data in a machine-readable language.
A) True
B) False
Answer
Terms: Auditing around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

11) “Auditing around the computer” is most appropriate when the client has not maintained detailed output or source documents in a form readable by humans.
A) True
B) False
Answer
Terms: Auditing around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
12) When a client uses desktops and networked servers for the accounting functions, the auditor should normally rely only on non-IT controls or may take a substantive approach to the audit.
A) True
B) False
Answer
Terms: Client uses desktop and network servers, auditor relies on non-IT controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

Learning Objective 12-5

1) The auditor’s objective in determining whether the client’s automated controls can correctly handle valid and invalid transactions as they arise is accomplished through the:
A) test data approach.
B) generalized audit software approach.
C) microcomputer-aided auditing approach.
D) generally accepted auditing standards.
Answer
Terms: Client control can correctly handle valid and invalid transactions
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills
2) The audit approach in which the auditor runs his or her own program on a controlled basis to verify the client’s data recorded in a machine language is:
A) the test data approach.
B) called auditing around the computer.
C) the generalized audit software approach.
D) the microcomputer-aided auditing approach.
Answer
Terms: Audit approach where auditor runs own program on a controlled basis
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

3) When performing a parallel simulation the auditor may use generalized audit software (GAS). Which of the following is not seen as an advantage to using GAS?
A) Auditors can learn the software in a short period of time
B) Can be applied to a variety of client’s after detailed customizations
C) Can be applied to a variety of client’s with minimal adjustments to the software
D) Greatly accelerates audit testing over manual procedures
Answer
Terms: Parallel simulation
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

4) When using the test data approach:
A) test data should include data that the client’s system should accept or reject.
B) application programs tested must be virtually identical to those used by employees.
C) select data may remain in the client system after testing.
D) none of the above statements is correct.
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

5) An auditor who is testing IT controls in a payroll system would most likely use test data that contain conditions such as:
A) time tickets with invalid job numbers.
B) overtime not approved by supervisors.
C) deductions not authorized by employees.
D) payroll checks with unauthorized signatures.
Answer
Terms: IT controls in payroll system and use of test data
Diff: Challenging
Objective: LO 12-5
AACSB: Reflective thinking skills
6) Describe three computer auditing techniques available to the auditor.
Answeromputer auditing techniques available to the auditor are:
• Test data approach. Using this approach, the auditor develops different types of transactions that are processed under his or her own control using the client’s computer programs on the client’s IT equipment.
• Parallel simulation. Using parallel simulation, the auditor writes a computer program that replicates some part of the client’s application system. The client’s data is then processed using the auditor’s computer program. The auditor then compares the output generated by his or her program with that generated by the client’s program to test the correctness of the client’s program. Generalized audit software may be used.
• Embedded audit module. Using this approach, the auditor inserts an audit module in the client’s application system to capture transactions with characteristics that are of interest to the auditor.
Terms: Computer auditing techniques
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

7) Discuss the advantages and benefits of using generalized audit software.
Answerdvantages and benefits of using generalized audit software include:
• they are developed in such a manner that most of the audit staff can be trained to use the program even if they have little formal IT education.
• a single program can be applied to a wide range of tasks without having to incur the cost or inconvenience of developing individualized programs.
• generalize audit software can perform tests much faster and in more detail than using traditional manual procedures.
Terms: Advantages and disadvantages using generalized audit software
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

8) Auditors often use Generalized Audit Software during their testing of a client’s internal controls. For the following uses of the software provide a description and an example.

Verify extensions and footings
Print confirmation requests
Compare data on separate files

9) Match eight of the terms (a-n) with the definitions provided below (1-8):

a. Application controls
b. Auditing around the computer
c. Auditing through the computer
d. Error listing
e. General controls
f. Generalized audit software
g. Hardware controls
h. Input controls
i. Output controls
j. Parallel simulation
k. Parallel testing
l. Pilot testing
m. Processing controls
n. Test data approach

________ 1. The new and old systems operate simultaneously in all locations.

________ 2. Controls that relate to all parts of the IT system.

________ 3. Involves the use of a computer program written by the auditor that replicates some part of a client’s application system.

________ 4. A method of auditing IT systems which uses data created by the auditor to determine whether the client’s computer program can correctly process valid and invalid transactions.

________ 5. Controls such as review of data for reasonableness, designed to assure that data generated by the computer is valid, accurate, complete, and distributed only to authorized people.

________ 6. Controls that apply to processing of transactions.

________ 7. A new system is implemented in one part of the organization while other locations continue to rely on the old system.

________ 8. Controls such as proper authorization of documents, check digits, and adequate documentation, designed to assure that the information to be processed by the computer is authorized, complete, and accurate.

10) The test data approach requires the auditor to insert an audit module in the client’s application system to test how transaction data is processed.
A) True
B) False
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

11) The objective of the computer audit technique known as the test data approach is to determine whether the client’s computer programs can correctly process valid and invalid transactions.
A) True
B) False
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

12) Parallel simulation is used primarily to test internal controls over the client’s IT systems, whereas the test data approach is used primarily for substantive testing.
A) True
B) False
Answer
Terms: Parallel simulation
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

13) One common use of generalized audit software is to help the auditor identify weaknesses in the client’s IT control procedures.
A) True
B) False
Answer
Terms: Generalized audit software
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills
Learning Objective 12-6

1) A database management system:
A) allows clients to create databases that include information that can be shared across multiple applications.
B) stores data on different files for different purposes, but always knows where they are and how to retrieve them.
C) allows quick retrieval of data, but at a cost of inefficient use of file space.
D) allows quick retrieval of data, but it needs to update files continually.
Answer
Terms: Database management system
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

2) When auditing client’s using database management systems the auditor is principally aware of elevated risk due to:
A) multiple users can access and update accounting files.
B) the accounting information is only in one place.
C) the database administrator may lack appropriate accounting knowledge.
D) multiple users could all access the data simultaneously causing system shutdown.
Answer
Terms: Database management systems and elevated risk
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

3) General controls may include firewalls which are used to protect:
A) erroneous internal handling of data.
B) against insufficient documentation of transactions.
C) illogical programming commands.
D) unauthorized use of system resources.
Answer
Terms: General controls use firewalls to protect
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

4) What tools do companies use to limit access to sensitive company data?
A)
Encryption techniques Digital signatures Firewall
Yes Yes Yes

B)
Encryption techniques Digital signatures Firewall
Yes No No

C)
Encryption techniques Digital signatures Firewall
No Yes Yes

D)
Encryption techniques Digital signatures Firewall
Yes Yes No

Answer
Terms: Tools companies use to limit access to sensitive data
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

5) Rather than maintain an internal IT center, many companies outsource their basic IT functions such as payroll to an:
A) external general service provider.
B) external application service provider.
C) internal control service provider.
D) internal auditor.
Answer
Terms: Outsourced services
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

6) When the auditor is obtaining an understanding of a service center’s internal controls the auditor should:
A) use the same criteria used to evaluate the client’s internal controls.
B) use different criteria because the service center resides outside the company.
C) use the same criteria used to evaluate the client’s internal controls but omit tests of transactions.
D) use different criteria for the service center by including substantive tests of balances.
Answer
Terms: Service center’s internal controls
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

7) Many clients have outsourced the IT functions. The difficulty the independent auditor faces when a computer service center is used is to:
A) gain the permission of the service center to review their work.
B) find compatible programs that will analyze the service center’s programs.
C) determine the adequacy of the service center’s internal controls.
D) try to abide by the Code of Professional Conduct to maintain the security and confidentiality of client’s data.
Answer
Terms: Outsourced IT functions
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

8) Service auditors do not issue which of the following types of reports?
A) report on implemented controls
B) report on controls that have been implemented and tested for design effectiveness
C) report on controls that have been implemented and tested for operating effectiveness
D) each of the above is issued
Answer
Terms: Service auditors and types reports
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

9) What do auditing standards require when a company outsources some of their IT requirements to an Application Service Provider?

10) Firewalls can protect company data and software programs.
A) True
B) False
Answer
Terms: Firewalls protect company data
Diff: Easy
Objective: LO 12-6
AACSB: Reflective thinking skills

11) LANs link equipment within a single or small cluster of buildings and are used only for intercompany purposes.
A) True
B) False
Answer
Terms: LANs link equipment
Diff: Easy
Objective: LO 12-6
AACSB: Reflective thinking skills
12) When auditing a client whose information is processed by an outside service provider, it is not acceptable for the auditor to rely on the audit report of another independent auditor who has previously tested the internal controls of the service provider, rather than testing the service provider’s controls himself or herself.
A) True
B) False
Answer
Terms: Information processed by outside service provider
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 13 Overall Audit Plan and Audit Program

Learning Objective 13-1

1) Shown below (1 through 5) are the five types of tests which auditors use to determine whether financial statements are fairly stated. Which three are substantive tests?
1. risk assessment procedures
2. tests of controls
3. tests of transactions
4. analytical procedures
5. tests of details of balances
A) 1, 2, and 3.
B) 3, 4, and 5.
C) 2, 3, and 5.
D) 2, 3, and 4.
Answer
Terms: Three types of substantive tests which auditors use
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

2) Collectively, procedures performed to obtain an understanding of the entity and its environment, including internal controls, represent the auditor’s:
A) audit strategy.
B) tests of controls.
C) risk assessment procedures.
D) tests of transactions.
Answer
Terms: Procedures performed to obtain understanding of entity and environment, including internal controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

3) Which of the following would not be considered further audit procedures?
A) tests of controls
B) substantive analytical procedures
C) tests of details of balances
D) risk assessment procedures
Answer
Terms: Not considered a further audit procedure
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

4) Which of the following procedures would most likely be performed in response to the auditor’s assessment of the risk of monetary misstatements in the financial statements?
A) Ratio analysis
B) Tests of controls
C) Tests of details of balances
D) Risk assessment procedures
Answer
Terms: Procedure performed in response to auditor’s assessment of risk of monetary misstatement
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

5) Which of the following further audit procedures are used to determine whether all six transaction related audit objectives have been achieved for each class of transactions?
A) tests of controls
B) risk assessment procedures
C) substantive tests
D) preliminary analytical procedures
Answer
Terms: Further audit procedures to determine whether all six transaction related audit objectives have been achieved
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

6) You are auditing Rodgers and Company. After performing substantive analytical procedures you conclude that, for the accounts tested, the client’s balance appears reasonable. This may indicate that:
A) details test of balances can be eliminated for those accounts.
B) certain test of balances procedures may be eliminated for those accounts.
C) control tests may be eliminated for those accounts.
D) control tests may be reduced for those accounts.
Answer
Terms: After performing substantive analytic procedures
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

7) The purpose of tests of controls is to provide reasonable assurance that the:
A) accounting treatment of transactions and balances is valid and proper.
B) internal control procedures are functioning as intended.
C) entity has complied with GAAP disclosure requirements.
D) entity has complied with requirements of quality control.
Answer
Terms: Purpose of tests of controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

8) In the context of an audit of financial statements, substantive tests are audit procedures that:
A) may be eliminated under certain conditions.
B) are designed to discover significant subsequent events.
C) are designed to test for dollar misstatements.
D) will increase proportionately with the auditor’s reliance on internal control.
Answer
Terms: Substantive tests are audit procedures
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

9) Which of the following is true?
A) tests of details of balances focus on the ending balances for accounts in the client’s ending trial balance
B) tests of details of balances focus on the transactions during the period
C) tests of details of balances focus on the auditor’s understanding of internal controls
D) tests of details of balances focus on comparisons of recorded amounts to expectations developed by the auditor
Answer
Terms: Tests of details of balances focus on
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

10) A system walkthrough is primarily used to:
A) test balances.
B) test details of transactions.
C) gain an understanding of internal controls.
D) determine acceptance of the client.
Answer
Terms: System walkthrough
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

11) Risk assessment procedures are performed by auditors during an audit in order to:
A) determine the risk of material misstatement in the financial statements.
B) determine the amount of testing of internal control.
C) determine the extent of testing of details of balances.
D) determine the extent of testing of transactions.
Answer
Terms: Risk assessment procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills
Topic: Public

12) Tests of controls are directed toward the control’s:
A) efficiency.
B) effectiveness.
C) efficiency and effectiveness.
D) cost benefit ratio.
Answer
Terms: Tests of controls directed toward
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

13) A procedure designed to test for monetary misstatements directly affecting the correctness of financial statement balances is a:
A) test of controls.
B) substantive test.
C) test of attributes.
D) monetary-unit sampling test.
Answer
Terms: Procedure designed to test for monetary misstatements directly affecting correctness of financial statements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

14) Which of the following is not a direct result of performing analytical procedures?
A) identify areas of potential misstatements
B) reduce detailed audit tests
C) understand the client’s business
D) identify specific errors in the accounts
Answer
Terms: Not a direct result of performing analytical procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

15) The primary emphasis in most tests of details of balances is on the:
A) balance sheet accounts.
B) revenue accounts.
C) cash flow statement accounts.
D) expense accounts.
Answer
Terms: Primary emphasis in most tests of details of balances
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

16) Which of the following statements is not true?
A) Analytical procedures emphasize the overall reasonableness of transactions and balances.
B) Tests of controls are concerned with evaluating whether controls are sufficiently effective to justify reducing control risk and thereby reducing analytical review procedures.
C) Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the general ledger.
D) Tests of details of balances emphasize the ending balances in the general ledger.
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

17) Many auditors perform extensive analytical procedures on audits because:
A) they are required by GAAS.
B) they pinpoint errors in accounts.
C) they indicate areas of potential risk and misstatement.
D) they are required for tests of controls.
Answer
Terms: Auditors perform extensive analytical procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

18) When controls are deemed ineffective and assessed control risk is at the maximum for a private company, which of the following would normally be true?
A) no emphasis placed on the controls
B) relatively little emphasis placed on the controls
C) moderate emphasis placed on the controls
D) heavy emphasis placed on the controls
Answer
Terms: Controls deemed ineffective and assessed control risk is at maximum
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

19) Which of the following is ordinarily designed to detect material dollar errors on the financial statements?
A) Tests of controls
B) Analytical review procedures
C) Computer controls
D) Tests of details of balances
Answer
Terms: Designed to detect material dollar errors on the financial statements
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

20) List each of the five types of audit tests and list at least two types of evidence that may be obtained from each type of test.

21) Describe the five types of audit tests. Identify which of the five types are substantive tests, and which are used to reduce assessed control risk.

22) Discuss the purposes of (1) substantive tests of transactions, (2) tests of controls, and (3) tests of details of balances. Give an example of each.

23) There are three stages of the audit in which analytical procedures are performed. Identify each of these three stages and, for each stage, discuss the purpose of performing analytical procedures in that stage. Also indicate in which stage(s) analytical procedures are required by current professional auditing standards.
Answernalytical procedures are performed in the audit planning stage to help the auditor decide the other evidence needed to satisfy sufficient competent evidence requirements. Analytical procedures can also be performed as substantive tests in the testing phase of the audit. Analytical procedures are performed in the audit completion phase as a final test of reasonableness. Auditing standards require that analytical procedures be performed in the planning and completion phases of every audit.
Terms: Analytical procedures in stages of audit
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

24) There are seven types of audit evidence: physical examination, confirmation, documentation, observation, inquiries of the client, reperformance, and analytical procedures. For each of the following types of audit tests, indicate the type(s) of evidence that can be obtained through the test: (1) tests of controls, (2) substantive tests of transactions, (3) analytical procedures, and (4) tests of details of balances.

25) One difference between the procedures used to obtain an understanding of internal control and procedures used to test those controls is that tests of controls are more extensive.
A) True
B) False
Answer
Terms: Procedures to understand internal controls vs. tests of controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

26) Tests of controls provide evidence about the likelihood for misstatements in a client’s financial statements.
A) True
B) False
Answer
Terms: Tests of controls; Misstatements in client’s financial statements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

27) An exception in a test of control provides only an indication of the likelihood of monetary misstatements in the financial statements because tests of controls do not reveal whether monetary misstatements have actually occurred.
A) True
B) False
Answer
Terms: Exception in test of control; Indication of likelihood of monetary misstatements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

28) An exception in a substantive test of transactions provides an indication of the likelihood of monetary misstatements in the financial statements because substantive tests of transactions do reveal whether monetary misstatements have actually occurred.
A) True
B) False
Answer
Terms: Exception in substantive test of transactions
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

29) When analytical procedures are performed during substantive testing, they are typically more focused and extensive than when performed as part of audit planning.
A) True
B) False
Answer
Terms: Analytical procedures performed during substantive testing
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

30) Tests of controls should be performed after substantive tests of transactions.
A) True
B) False
Answer
Terms: Tests of controls and substantive tests of transactions
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

31) Substantive tests of transactions focus on the changes in the beginning and ending of the year balances, particularly for the balance sheet.
A) True
B) False
Answer
Terms: Substantive tests of transactions
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills
32) If tests of controls reveal that controls are sufficiently effective to justify reducing control risk, the auditor is justified in reducing substantive audit tests.
A) True
B) False
Answer
Terms: Tests of controls and control risk
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

33) Analytical procedures are normally designed at the account level, whereas tests of controls and substantive tests of transactions are normally designed at the transaction-related objective level.
A) True
B) False
Answer
Terms: Analytical procedures designed at the account level
Diff: Challenging
Objective: LO 13-1
AACSB: Reflective thinking skills

34) Procedures to obtain an understanding of internal control may suffice for tests of controls when the auditor is assessing control risk in a well defined transaction cycle that has not contained material misstatements in prior audits.
A) True
B) False
Answer
Terms: Procedures to obtain an understanding of internal control
Diff: Challenging
Objective: LO 13-1
AACSB: Reflective thinking skills

Learning Objective 13-2

1) In order to promote audit efficiency the auditor considers cost in selecting audit tests to perform. Which of the following audit tests would be the most costly?
A) Analytical Procedures
B) Risk Assessment Procedures
C) Tests of Controls
D) Tests of Details of Balances
Answer
Terms: Most costly audit test
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

2) An exception or deficiency found in a test of controls:
A) indicates a financial statement misstatement.
B) indicates that a financial statement misstatement may be likely.
C) indicates that the financial statements are misstated.
D) indicates that an adverse opinion is warrarnted on the Audit of Internal Control.
Answer
Terms: Exception or deficiency in test of controls
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

3) If no material differences are found using analytical procedures and the auditor concludes that misstatements are not likely to have occurred:
A) other substantive tests may be reduced.
B) it will be necessary to increase the tests of balances.
C) it will not be necessary to perform tests of balances.
D) it will be necessary to increase the tests of transactions.
Answer
Terms: If no material differences are found using analytical procedures
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

4) Which of the following audit tests is usually the most costly to perform?
A) Analytical procedures
B) Tests of controls
C) Tests of balances
D) Substantive tests of transactions
Answer
Terms: Most costly audit test
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

5) An increased extent of tests of controls is most likely to occur when:
A) it is a first-year audit.
B) the auditor is doing a “fraud audit.”
C) controls are effective and the preliminary control risk assessment is low.
D) controls are ineffective and the preliminary control risk assessment is high.
Answer
Terms: Increased extent of tests of controls most likely to occur
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

6) When an auditor believes that analytical procedures indicate a reasonable possibility of misstatement, the auditor usually would:
A)
Perform additional tests of controls Decide to modify tests of details of balances
Yes Yes

B)
Perform additional tests of controls Decide to modify tests of details of balances
No No

C)
Perform additional tests of controls Decide to modify tests of details of balances
Yes No

D)
Perform additional tests of controls Decide to modify tests of details of balances
No Yes

Answer
Terms: Analytical procedures indicate reasonable possibility of misstatement
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

7) If the results of the tests of controls, substantive tests of transactions, and analytical procedures are not consistent with the predictions, tests of details of balances will be:
A) eliminated.
B) increased.
C) unaffected.
D) changed.
Answer
Terms: Results of tests of controls, substantive tests of transactions, and analytical procedures
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

8) The auditor would design which of the following audit tests to detect possible monetary errors in the financial statements?
A) Control tests
B) Analytical procedures
C) Risk assessment procedures
D) Tests of operating effectives of controls over revenue and cash
Answer
Terms: Audit tests to detect possible monetary errors in the financial statements
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

9) The reliance the auditor places on substantive tests in relation to the reliance placed on internal control varies in a relationship that is ordinarily:
A) parallel.
B) inverse.
C) direct.
D) equal.
Answer
Terms: Reliance auditor places on substantive tests and internal controls
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

10) A deficiency uncovered in the audit of internal control is explained by which of the following in relation to a financial statement misstatement?
A) the amount of the misstatement
B) the likelihood of the misstatement
C) the amount, likelihood, and classification of the misstatement
D) the amount and the classification of the misstatement
Answer
Terms: Deficiency uncovered in audit of internal control
Diff: Challenging
Objective: LO 13-2
AACSB: Reflective thinking skills

11) Which of the following is not a valid basis for omitting an audit test in forming an opinion on the clients financial statements?
A) the difficulty and expense involved in testing a particular item
B) the relative risk involved
C) the degree of reliance on the relevant internal controls
D) the relationship between the cost of obtaining evidence and its usefulness
Answer
Terms: Not a valid basis for omitting an audit test in forming an opinion
Diff: Challenging
Objective: LO 13-2
AACSB: Reflective thinking skills

12) Three factors the auditor considers when assessing control risk are: the auditor’s belief concerning the effectiveness of internal controls, the results of tests of controls, and the cost-effectiveness of a reduced assessed control risk. Identify the combination of conditions for these three factors that is required before a reduction in substantive testing is permitted.
Answer reduction in substantive testing is permitted when (1) the auditor identifies specific controls he or she believes have been operating effectively during the period under audit, (2) the auditor believes it will be cost-effective to test those controls, and (3) the results of tests of controls indicate that the controls have indeed been operating effectively.
Terms: Three factors auditor considers when assessing control risk and conditions before reduction in substantive testing
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills
13) Tests of controls are generally more costly to perform than analytical procedures.
A) True
B) False
Answer
Terms: Cost of tests of controls vs. analytical procedures
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

14) Substantive tests of details of balances are the most costly type of audit test to perform.
A) True
B) False
Answer
Terms: Substantive tests of details of balances cost
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

15) Analytical procedures are the least costly type of audit test.
A) True
B) False
Answer
Terms: Analytical procedures cost
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

16) If inherent risk is increased to medium from low, tests of details of balances can be reduced.
A) True
B) False
Answer
Terms: Inherent risk; Details of balances
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

17) The extent of tests of details of balances cannot be reduced when transaction-related audit objectives have been satisfied by tests of controls or substantive tests of transactions.
A) True
B) False
Answer
Terms: Extent of details of balances; Transaction-related audit objectives; Tests of controls and substantive tests of transactions
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

18) Tests of controls and substantive tests of transactions are normally conducted simultaneously on the same transactions.
A) True
B) False
Answer
Terms: Not considered a further audit procedure
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

19) Under normal circumstances, there should be no variation in the audit evidence mix from cycle to cycle for a given audit engagement.
A) True
B) False
Answer
Terms: Variation in audit evidence in cycles
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

20) Analytical procedures are the most expensive type of audit test to perform because of the expertise and training required to properly use them.
A) True
B) False
Answer
Terms: Analytical procedures cost
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

21) The results of tests of controls and substantive tests of transactions affect the design of tests of details of balances.
A) True
B) False
Answer
Terms: Results of tests of controls affect design of tests of details of balances
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

22) If the auditor’s preliminary assessment of control risk is decreased from high to medium, tests of controls can be reduced.
A) True
B) False
Answer
Terms: Auditor’s preliminary assessment of control risk
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

Learning Objective 13-3

1) The most important consideration in developing the audit plan and audit program is the:
A) client’s size.
B) client’s industry.
C) audit firm’s available personnel.
D) audit risk model used in its planning form.
Answer
Terms: Most important consideration in developing the audit plan and audit program
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

2) Auditors who test manual controls that rely on IT-generated reports must consider:
A) the benefits of relying on IT-generated reports.
B) separation of duties related to the IT-generated reports.
C) the controls related to the accuracy of the information in the report.
D) whether the manual controls are approved by the audit committee.
Answer
Terms: Test manual controls that rely on IT-generated reports
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

3) Auditing standards recognize that in instances where a significant amount of audit evidence is in electronic form, it may not be possible to reduce detection risk to an acceptable level by performing only substantive tests.
A) True
B) False
Answer
Terms: Auditing standards; Evidence in electronic form reduces detection risk
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

4) In the audit of a public company, computer controls must be tested if they are considered to be key controls for reducing the likelihood of material misstatements in the financial statements.
A) True
B) False
Answer
Terms: Audit of public company testing of computer controls
Diff: Challenging
Objective: LO 13-3
AACSB: Reflective thinking skills
Topic: Public

5) Procedures to obtain an understanding of internal control may suffice for tests of controls when the auditor is assessing automated controls.
A) True
B) False
Answer
Terms: Procedures to obtain understanding of internal control; Tests of controls; Automated controls
Diff: Challenging
Objective: LO 13-3
AACSB: Reflective thinking skills

Learning Objective 13-4

1) The evidence mix includes risk assessment procedures.
A) True
B) False
Answer
Terms: Evidence mix and risk assessment procedures
Diff: Moderate
Objective: LO 13-1 and LO 13-4
AACSB: Reflective thinking skills

Learning Objective 13-5

1) A document that details what the auditor will do to gather sufficient, appropriate evidence is the:
A) audit strategy.
B) audit program.
C) audit procedure.
D) audit risk model.
Answer
Terms: Document that details what the audit will do to gather sufficient, appropriate evidence
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

2) Auditors follow a four step approach to reduce assessed control risk. Which of the following is not one of the four?
A) Apply transaction related audit objectives to a class of transactions.
B) Indentify accounts that have high inherent risk.
C) Identify key controls that reduce control risk.
D) For potential misstatements, design appropriate substantive tests of transactions.
Answer
Terms: Approach to reduce assessed control risk
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

3) When designing tests of controls and substantive tests an auditor is gathering evidence to satisfy the transaction related audit objectives. What are the four steps the auditor would normally follow to reduce assessed control risk?

4) What are the four steps auditors follow when they plan to reduce assessed control risk?

5) Discuss the relationship of each of the following to the extent of planned tests of details of balances: (1) tolerable misstatement, (2) inherent risk, (3) control risk, and (4) acceptable audit risk.

6) Auditing standards require a written audit program.
A) True
B) False
Answer
Terms: Auditing standards; Audit program
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

7) When designing an audit program for tests of details of balances, the auditor should make assumptions about inherent risk and control risk, and predictions concerning the outcome of tests of controls, substantive tests of transactions, and analytical procedures.
A) True
B) False
Answer
Terms: Designing audit program; Inherent risk and control risk; Tests of controls, substantive tests of transactions, and analytical procedures
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

8) When testing details of balances, most audit procedures satisfy only one balance-related objective, but more than one audit procedure should be used to test each objective.
A) True
B) False
Answer
Terms: Testing details of balances and audit procedures
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

9) Substantive tests of transactions and control tests are often conducted simultaneously.
A) True
B) False
Answer
Terms: Substantive tests of transactions and control tests
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

10) Auditing standards require that tests of controls be performed on every audit engagement.
A) True
B) False
Answer
Terms: Auditing standards require tests of controls
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

Learning Objective 13-6

1) Which of the following types of procedures will be performed in an audit of internal control over financial reporting?
A)
Procedures to obtain an understanding of internal control Ratio analysis
Yes Yes

B)
Procedures to obtain an understanding of internal control Ratio analysis
No No

C)
Procedures to obtain an understanding of internal control Ratio analysis
Yes No

D)
Procedures to obtain an understanding of internal control Ratio analysis
No Yes

Answer
Terms: Types of procedures performed in an audit of internal control
Diff: Moderate
Objective: LO 13-6
AACSB: Reflective thinking skills
Topic: Public

2) What type of test is used to obtain more types of evidence than any other?
A) Substantive tests of transactions
B) Tests of controls
C) Analytical procedures
D) Tests of details
Answer
Terms: Type of test used to obtain more types of evidence
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

3) Which audit tests involve physical examination and confirmation?
A) tests of controls
B) tests of transactions
C) tests of balances
D) analytical procedures
Answer
Terms: Audit tests that involve physical examination and confirmation
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills
4) Which of the following is generally not included in the “evidence mix”?
A) Tests of Controls
B) Substantive Tests of Transactions
C) Risk Assessment Procedures
D) Tests of details of balances
Answer
Terms: Evidence mix
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

5) Which of the following types of evidence is not available when using substantive tests of transactions?
A) Documentation
B) Confirmation
C) Inquiries of the client
D) Reperformance
Answer
Terms: Types of evidence not available when using substantive tests of transactions
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

6) Analytical procedures provide fewer types of evidence than any other type of audit test.
A) True
B) False
Answer
Terms: Analytical procedures and evidence
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

Learning Objective 13-7

1) Presentation and disclosure related audit objectives would be performed in which phase of the audit process?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Presentation and disclosure related audit objective performed in what phase of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
2) Transaction related audit objectives would most likely be performed in which phase of the audit process?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Transaction related audit objectives performed in what phase of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

3) Analytical procedures must be performed in:
A) the planning and test of control stages.
B) conjunction with tests of transactions and tests of details of balances.
C) the planning and completion stages.
D) the planning, test of control, and completion stages.
Answer
Terms: Analytical procedures must be performed
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

4) Which of the following tests commonly occur together?
A) substantive tests of transactions and tests of controls
B) substantive tests of transactions and obtaining an understanding of internal controls
C) analytical procedures and tests of controls
D) tests of controls and tests of details of balances
Answer
Terms: Tests that occur together
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

5) Tests of controls and substantive tests of transactions are an important determinant of the extent of the auditor’s use of tests of details of balances. Which of the following is true?
A) They are likely to be performed prior to the clients end of the fiscal year.
B) They are likely to eliminate the need for tests of details of balances.
C) They are likely to have no impact on the planned tests of details of balances.
D) They are likely to be used only in the audit of internal control.
Answer
Terms: Tests of controls and substantive tests of transactions
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
6) When the auditor has completed the tests of details of balances and enters phase 4 of the audit process, she must still perform audit procedures for which of the following?
A) contingent liabilities and employee compensation
B) contingent liabilities and subsequent events
C) subsequent events and contractual commitments
D) subsequent events and unrecorded liabilities
Answer
Terms: Audit procedures performed in phase 4 of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

7) Which of the following audit tests would be regarded as a test of controls?
A) Comparison of the inventory pricing to vendors’ invoices.
B) Tests of the signatures on canceled checks to board of directors’ authorizations.
C) Tests of the additions to property, plant, and equipment by physical inspections.
D) Review of the specific items making up the balance in a given general ledger account.
Answer
Terms: Tests of controls audit tests
Diff: Moderate
Objective: LO 13-7
AACSB: Analytic skills

8) Which of the following audit tests form the basis for an auditor’s report on internal control over financial reporting?
A) Analytical procedures
B) Tests of transactions
C) Tests of controls
D) Tests of details of balances
Answer
Terms: Audit tests that form basis for auditor’s report on internal control
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Topic: Public

9) After finishing the review phase of the study and evaluation of internal control in an audit, the auditor should perform tests of controls on:
A) those controls that the auditor wants and plans to rely upon.
B) those controls in which material weaknesses were identified.
C) those controls that have a material effect upon the financial statement balances.
D) a random sample of the controls that were reviewed.
Answer
Terms: After finishing the review phase of study and evaluation of internal control in an audit, auditor should perform
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
10) At what point in the audit process are tests of details most appropriately designed?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Audit process and test of details
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

11) Which of the following is/are performed in an audit of internal control over financial reporting?
A)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
Yes Yes No

B)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
Yes No No

C)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
No Yes Yes

D)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
No No Yes

Answer
Terms: Audit of internal control over financial reporting
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Topic: Public

12) Which of the following ultimately determines the specific audit procedures necessary to provide an independent auditor with a reasonable basis for the expression of an opinion?
A) the audit program
B) the auditor’s judgment
C) generally accepted auditing standards
D) the auditor’s working papers
Answer
Terms: Determines specific audit procedures
Diff: Challenging
Objective: LO 13-7
AACSB: Reflective thinking skills

13) In phase 4 of the audit, complete the audit and issue an audit report, there are five activities required. List below the activities.

14) In accumulating final evidence upon which to base an audit opinion, the auditor should perform four activities. List the activities below.

15) Discuss the major activities and procedures performed by the auditor in the plan and design of the audit approach.

16) The auditor must communicate significant deficiencies in internal control only after the entire audit is complete to ensure the auditor has a sufficient understanding of the circumstances surrounding the deficiency.
A) True
B) False
Answer
Terms: Auditor communicate significant deficiencies in internal control
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 14 Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions

Learning Objective 14-1

1) Which of the following is not an account affected by the sales and collection cycle?
A) Cash
B) Accounts receivable
C) Allowance for doubtful accounts
D) Sales of Accounts Receivables
Answer
Terms: Sales and collection cycle
Diff: Easy
Objective: LO 14-1
AACSB: Reflective thinking skills

2) The auditor’s objectives for the sales and cash collections activities when the client is primarily an e-commerce business as compared to a “bricks and mortar” business are:
A) unchanged.
B) expanded.
C) mitigated.
D) decreased.
Answer
Terms: Auditor objectives for sales and cash collections
Diff: Moderate
Objective: LO 14-1
AACSB: Analytic skills

3) The overall objective in the audit of the sales and collection cycle is to evaluate whether the account balances affected by the cycle are fairly presented in accordance with Accounting standards.
A) True
B) False
Answer
Terms: Objective in audit of sales and collection cycle; Account balances fairly presented
Diff: Easy
Objective: LO 14-1
AACSB: Reflective thinking skills

4) The sales and collection cycle applies to businesses that transfer goods to customers or provides services to businesses.
A) True
B) False
Answer
Terms: Sales and collection cycle
Diff: Moderate
Objective: LO 14-1
AACSB: Reflective thinking skills
Learning Objective 14-2

1) Which of the following is not one of the five classes of transactions included in the sales and collection cycle?
A) Sales returns and allowances
B) Write-off of uncollectible accounts
C) Bad debt expense
D) Interest Income
Answer
Terms: Class of transactions; Sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

2) What event initiates a transaction in the sales and collection cycle?
A) receipt of cash
B) delivery of product to a customer
C) identification of a new customer
D) customer request for goods
Answer
Terms: Initiates transaction in sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

3) A ________ is a document that indicates a request for merchandise by a customer.
A) sales invoice
B) vendor invoice
C) customer order
D) sales order
Answer
Terms: Document indicates request for merchandise
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

4) A ________ is a document that is matched with the customer order to assure that the correct quantity and type of goods are shipped.
A) sales order
B) customer order
C) vendor invoice
D) sales invoice
Answer
Terms: Document matched with customer order
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

5) What critical event must take place before goods can be shipped in order to assure payment can be reasonably expected?
A) determination of correct delivery address
B) credit approval
C) matching of shipping document with sales invoice
D) receipt of sales order from the customer
Answer
Terms: Event must take place in order to assure payment
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

6) Before goods are shipped on account, a properly authorized person must:
A) prepare the sales invoice.
B) approve the journal entry.
C) approve the customer’s credit.
D) verify that the unit price is accurate.
Answer
Terms: Goods shipped on account; Properly authorized person
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

7) A document prepared to initiate shipment of the goods sold by an independent shipper is the:
A) sales order.
B) bill of lading.
C) sales invoice.
D) customer order.
Answer
Terms: Document prepared to initiate shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

8) The document used to indicate to the customer the amount of a sale and payment due date is the:
A) sales invoice.
B) bill of lading.
C) purchase order.
D) sales order.
Answer
Terms: Document used to indicate amount of sale and payment due date
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

9) In the sales and collection cycle when is, generally, the earliest point at which revenue can be recognized?
A) sales approval
B) credit approval
C) cash collection
D) shipment of goods
Answer
Terms: Sales and collection cycle; revenue recognized
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

10) Most companies recognize sales revenue when:
A) sales are invoiced.
B) goods are received by the customer.
C) goods are shipped.
D) Both B and C are correct, depending upon the company’s revenue recognition policies.
Answer
Terms: Recognize sales revenue
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

11) Which of the following is not a business function within the “Sales” class of transactions?
A) processing customer orders
B) granting credit
C) processing and recording sales returns and allowances
D) shipping goods
Answer
Terms: Business function within the sales class of transactions
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

12) The total of the individual account balances in the accounts receivable subsidiary ledger should equal the:
A) total sales for the period.
B) balance of the sales account in the general ledger.
C) total sales less the total cash received for the period.
D) balance of the accounts receivable account in the general ledger.
Answer
Terms: Accounts receivable subsidiary ledger
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

13) In the accounts receivable subsidiary ledger the length of time the account has been due can be useful to the client and the auditor in preparing the:
A) trial balance.
B) working trial balance.
C) accounts receivable trial balance.
D) aged accounts receivable trial balance.
Answer
Terms: Accounts receivable subsidiary ledger
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

14) A document sent to each customer showing his or her beginning accounts receivable balance and the amount and date of each sale, cash payment received, any debit or credit memo issued, and the ending balance is the:
A) accounts receivable subsidiary ledger.
B) monthly statement.
C) remittance advice.
D) sales invoice.
Answer
Terms: Document sent to customer showing beginning accounts receivable balance
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

15) The document that accompanies the customer’s payment is the:
A) credit memo.
B) remittance advice.
C) vendor invoice.
D) monthly statement.
Answer
Terms: Document that accompanies customer’s payment
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

16) The document that requires adjustments to the customers subsidiary ledger account is the:
A) bill of lading.
B) sales invoice.
C) credit memo.
D) monthly statement.
Answer
Terms: Document that requires adjustment to the customer’s account
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

17) A document that initiates shipment of goods and indicates the description of the merchandise, the quantity shipped, and customer name and address is the:
A) bill of lading.
B) sales invoice.
C) picking ticket.
D) vendor invoice.
Answer
Terms: Document that initiates shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

18) The ________ is a contract between a carrier (e.g., a trucking company) and the seller of goods that dictates the details surrounding the shipment of goods.
A) bill of lading
B) sales invoice
C) picking ticket
D) remittance advice
Answer
Terms: Contract that dictates details for shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

19) Some companies have customers send payments directly to a post office box address maintained by a bank. This is called a(n) ________ system.
A) direct deposit
B) funds transfer
C) lockbox
D) interbank transfer
Answer
Terms: Payments sent to post office box
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

20) In designing audit procedures for the sales returns and allowances account, the auditor would primarily rely on the following accounts, except for:
A) sales returns and allowances transaction file.
B) accounts receivable master file.
C) cash receipts journal.
D) sales returns and allowances will be recorded in all of the above.
Answer
Terms: Designing audit procedures sales returns and allowances
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

21) For a firm that practices good internal controls in the sales and collections cycle, the function of indicating credit approval should be recorded on which of the following documents?
A) sales order
B) sales invoice
C) customer order
D) remittance advice
Answer
Terms: Good internal controls in sales and collection cycle; Credit approval
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

22) When posting items from the sales journal, details of the journal and journal totals are posted to which items?
A)
Details of the journal are posted to Journal totals are posted to
The sales account The general ledger

B)
Details of the journal are posted to Journal totals are posted to
The sales account The accounts receivable subsidiary ledger

C)
Details of the journal are posted to Journal totals are posted to
The accounts receivable master file The general ledger

D)
Details of the journal are posted to Journal totals are posted to
The accounts receivable account in the general ledger The sales account in the general ledger

Answer
Terms: Posting from sales journal; Details of journal and journal totals posted
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

23) Credit memos are normally issued for what purpose(s)?
A) To adjust the customers balance to the amount owed to the company.
B) To assist in the aging of accounts receivable.
C) To reduce customer frustration and sales losses.
D) To inform the customer of the balance due.
Answer
Terms: Credit memos
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

24) Who is generally responsible for opening receipts when a company uses a lockbox to speed the handling of cash receipts?
A) company personnel
B) temporary employees in the town where the lockbox is located
C) bank employees
D) company controller
Answer
Terms: Opening receipts; Lockbox
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

25) One key internal control to prevent fictitious transactions in the sales and collection cycle is:
A) assign a specific customer number for each customer in the computer files.
B) to account for the integrity of the numerical sequence of sales orders.
C) to include the sales price list of all products in the computer files.
D) having bank reconciliations prepared by one who is independent of the treasury function.
Answer
Terms: Internal control; Fictitious transactions in sales and collection cycle
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

26) Which of the following is the appropriate point at which the auditor deems authorization to be critical?
A)
Credit granting Price authorization Shipment of goods
Yes Yes Yes

B)
Credit granting Price authorization Shipment of goods
Yes No Yes

C)
Credit granting Price authorization Shipment of goods
No Yes No

D)
Credit granting Price authorization Shipment of goods
Yes No No

Answer
Terms: Point authorization deemed critical
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

27) Sales should be recorded, at the earliest, when:
A) the order is received.
B) the order is received and credit is approved.
C) credit is approved and it is verified that there is enough inventory to fill the order.
D) the shipment takes place.
Answer
Terms: Sales recorded
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

28) Which of the following would least concern an auditor regarding the lack of a specific authorization to conduct the sales transaction?
A) granting of credit
B) shipment of goods
C) determination of discounts
D) selling of goods for cash
Answer
Terms: Specific authorization to conduct sales transactions
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

29) Smith Manufacturing Company’s accounts receivable clerk has a friend who is also a Smith’s customer. The accounts receivable clerk has issued fictitious credit memos to his friend for goods supposedly returned. The most effective procedure for preventing this activity is to:
A) prenumber and account for all credit memorandums.
B) require receiving reports that provide evidence of returned inventory items to support all credit memorandums before they are approved.
C) have independent sales and accounts receivable departments.
D) mail monthly statements to customers.
Answer
Terms: Fictitious credit memos; Procedure to prevent activity
Diff: Moderate
Objective: LO 14-2
AACSB: Analytic skills

30) Explain each of the following types of documents and indicate the class of transactions in which they are commonly used.
1. Customer order
2. Shipping document
3. Remittance advice
4. Sales returns and allowance journal
5. Uncollectible account authorization form

31) You are an audit manager for Rodgers & Co. and have recently taken on as a client Manufacturing Company. You are in the initial stages of planning the audit and have decided to start gathering information about the Sales/Collection Cycle of the business. List below the classes of transactions that you need to gather audit evidence for in designing your audit procedures.

32) Customer billing is a critical process which auditors must understand. What are the most important aspects of billing and what are the related objectives?

33) Discuss the four business functions that result in sales transactions in a typical sales and collection cycle and, for each function, state the key documents and records involved.

34) Match seven of the terms for documents and records (a-k) with the descriptions provided below (1-7):

a. Customer order form
b. Sales order
c. Bill of lading
d. Sales invoice
e. Summary sales report
f. Accounts receivable master file
g. Monthly statement
h. Remittance advice
i. Prelisting of cash receipts
j. Credit memo
k. Uncollectible account authorization form

________ 1. A list prepared when cash is received by someone who has no responsibility for recording sales, accounts receivable, or cash, and has no access to the accounting records. It is used to verify whether cash received was recorded and deposited at the correct amounts and on a timely basis.

________ 2. A document indicating a reduction in the amount due from a customer because of returned goods or an allowance.

________ 3. A document prepared to initiate shipment of goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. It is a written contract between the carrier and seller of the receipt and shipment of goods.

________ 4. A document for communicating the description, quantity, and related information for goods ordered by a customer. This is frequently used to indicate credit approval and authorization for shipment.

________ 5. A document mailed to the customer and typically returned to the seller with the cash payment.

________ 6. A document used internally to indicate authority to write-off an account receivable as uncollectible.

________ 7. A document or electronic record indicating the description and quantity of goods sold, the price, freight charges, insurance, terms, and other relevant data.

35) A sales invoice is a document that usually indicates credit approval.
A) True
B) False
Answer
Terms: Sales invoice; Credit approval
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

36) Credit should be approved before a customer’s order is received.
A) True
B) False
Answer
Terms: Credit approved
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

37) Credit should be approved before goods are shipped to a customer.
A) True
B) False
Answer
Terms: Credit approved
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

38) The receipt of a customer order from a customer is the starting point for the entire sales and collection cycle.
A) True
B) False
Answer
Terms: Customer order; Starting point for sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

39) The preparation of a sales invoice is the final step in the sales and collection cycle.
A) True
B) False
Answer
Terms: Sales invoice; Final step in sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

40) A bill of lading is a special type of sales invoice used when goods are shipped interstate.
A) True
B) False
Answer
Terms: Bill of lading; Sales invoice
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

41) The shipping point is critical because it is the first point at which company assets are released to another party.
A) True
B) False
Answer
Terms: Shipping point critical; Assets released
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

42) A bill of lading is a written contract between the seller and the buyer.
A) True
B) False
Answer
Terms: Bill of lading; Written contract
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

43) In a lockbox system, bank employees are responsible for opening cash receipts and maintaining records of all payments made by customers at the lockbox address.
A) True
B) False
Answer
Terms: Lockbox system
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

44) Sales transactions are the result of the following five functions in the sales and collection cycle: processing customer orders, granting credit, shipping goods, billing customers, and recording sales.
A) True
B) False
Answer
Terms: Sales and collection cycle
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

45) The prelisting of cash receipts should be prepared by the individual who has primary responsibility for the recording of cash receipts.
A) True
B) False
Answer
Terms: Prelisting of cash receipts
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

46) A credit memo is a document used internally that indicates authority to write-off an account receivable as uncollectible.
A) True
B) False
Answer
Terms: Credit memos
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

47) When a company prepares multi-copy, prenumbered sales invoices at the time customer orders are received, there is a higher likelihood of failure to bill the customers than when sales invoices are prepared only after goods have been shipped.
A) True
B) False
Answer
Terms: Prepare prenumbered sales invoices
Diff: Moderate
Objective: LO 14-2
AACSB: Analytic skills

48) The auditor’s primary concern about authorization centers on shipment of goods to customers.
A) True
B) False
Answer
Terms: Primary concern about authorization
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

Learning Objective 14-3

1) When designing audit procedures, tracing of source documents to the customers subsidiary ledger and subsequently to the general ledger is done to satisfy what assertion?
A) valuation
B) cutoff
C) completeness
D) classification
Answer
Terms: Tracing of source documents; Assertion
Diff: Easy
Objective: LO 14-3
AACSB: Reflective thinking skills

2) Which of the following documents is not commonly associated with the “cash receipts” class of transactions?
A) Remittance advice
B) Sales order
C) Prelisting of cash receipts
D) Cash receipts journal or listing
Answer
Terms: Document; Cash receipts class of transactions
Diff: Easy
Objective: LO 14-3
AACSB: Reflective thinking skills

3) When sales invoices are automatically calculated and posted by a computer, the auditor may be able to reduce substantive tests of transactions for which, if any, assertion?
A) accuracy
B) existence
C) completeness
D) none of the above
Answer
Terms: Reduce substantive tests of transactions
Diff: Easy
Objective: LO 14-3
AACSB: Reflective thinking skills

4) In many audits, no substantive tests of transactions are made for the ________ assertion on the grounds that understatement of sales is not a concern.
A) accuracy
B) existence
C) completeness
D) none of the above
Answer
Terms: No substantive tests of transactions; Assertion; understatement of sales
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills
5) Which one the following procedures performed for the billing function provides evidence for the completeness assertion?
A) Making sure that all shipments have been billed.
B) Making sure that no shipment has been billed more than twice.
C) Making sure that each shipment is billed at the correct amount.
D) Making sure that each shipment is billed to the proper customer.
Answer
Terms: Procedures; Billing function; Completeness assertion
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

6) Which of the following procedures performed for the billing function may provide evidence that the accounts receivable subsidiary ledger is in agreement with the accounts receivable control account?
A) Making sure that all shipments have been billed.
B) Making sure that no shipment has been billed more than twice.
C) Making sure that each shipment is billed at the correct amount.
D) Making sure that each shipment is billed to the proper customer.
Answer
Terms: Procedure; Billing function; Accounts receivable subsidiary ledger in agreement with the accounts receivable control account
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

7) The document that the accounting staff will use as the primary basis for recording sales transactions and updating the customers accounts receivable subsidiary ledger is the:
A) sales order.
B) bill of lading.
C) sales journal.
D) sales invoice.
Answer
Terms: Document used as primary basis for recording sales transactions
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

8) In determining the level of audit efficiency, once the auditor has identified the key internal controls and identified any deficiencies in order to determine the level of control risk appropriate for a private company client, it is appropriate to decide whether:
A) substantive tests can be reduced sufficiently to justify costs of performing tests of controls.
B) substantive tests can be increased sufficiently to justify costs of performing tests of controls.
C) tests of controls can be increased sufficiently to justify costs of performing substantive tests.
D) tests of controls can be reduced sufficiently to justify costs of performing substantive tests.
Answer
Terms: Audit efficiency; Key internal controls; Deficiencies; Control risk
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills
9) Which one of the following statements is true? In deciding on substantive tests of transactions:
A) some procedures are commonly employed on every audit regardless of the circumstances.
B) all procedures are dependent on the adequacy of the controls and the results of the tests of controls.
C) results obtained in the prior year’s audit will not affect the procedures used this year.
D) the materiality of the item will not influence the choice of procedures used.
Answer
Terms: Substantive tests of transactions
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

10) To test for recorded sales for which there were no actual shipments, the auditor vouches from the:
A) bill of lading to the sales journal.
B) sales journal to the shipping documents.
C) sales journal to the accounts receivable subsidiary ledger.
D) bill of lading to the supporting customer order and sales order.
Answer
Terms: Test for recorded sales with no actual shipments
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

11) An effective procedure to test for unbilled shipments is to trace from the:
A) sales journal to the shipping documents.
B) shipping documents to the sales journal.
C) sales journal to the accounts receivable ledger.
D) sales journal to the general ledger sales account.
Answer
Terms: Procedure for unbilled shipments
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

12) The auditor traces items from the source documents to the journals in order to accumulate audit evidence that will satisfy the:
A) existence objective.
B) completeness objective.
C) ownership objective.
D) valuation objective.
Answer
Terms: Trace items from source documents to journals
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

13) In many audits of sales transactions substantive tests of transactions can be reduced in determining the completeness objective because:
A) understatements of assets and income are a greater concern than overstatements.
B) overstatements of assets and income are a greater concern than understatements.
C) it doesn’t matter if income is understated because the savings on income tax offsets the reduced revenue and net income is correct.
D) the unrecorded sales cause a reduction of accounts receivable; therefore, the ratios of the two financial statements will not be misleading.
Answer
Terms: Audit of sales transactions; Substantive tests of transactions; Completeness objective
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

14) To determine that sales are accurately recorded, the unit prices on the duplicate sales invoices are normally compared with:
A) the original invoices.
B) an approved master price list.
C) the amounts recorded in the sales journal for that transaction.
D) the amounts posted to the customer’s account in the accounts receivable master file.
Answer
Terms: Sales accurately recorded; Unit prices compared with
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

15) Prenumbered documents are intended to help:
A)
Prevent the failure to bill or record sales Prevent duplicate billings or recordings of sales
Yes Yes

B)
Prevent the failure to bill or record sales Prevent duplicate billings or recordings of sales
No No

C)
Prevent the failure to bill or record sales Prevent duplicate billings or recordings of sales
Yes No

D)
Prevent the failure to bill or record sales Prevent duplicate billings or recordings of sales
No Yes

Answer
Terms: Prenumbered documents
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills
16) Prenumbered documents will only be useful for control purposes if:
A) a different numerical sequence is used for each company.
B) the sequence is accounted for periodically.
C) employees are allowed to use documents out of numerical sequence.
D) the same numerical sequence is used each accounting period.
Answer
Terms: Prenumbered documents; Control purposes
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

17) ________ tests are for omitted transactions, while ________ tests are for nonexistent transactions.
A) Tracing, vouching
B) Vouching, tracing
C) Verifying, tracking
D) Tracking, verifying
Answer
Terms: Tests for omitted transactions and nonexistent transactions
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

18) Which one of the following best describes the auditors responsibilities regarding appropriate authorizations in the sales/collections cycle?
A) B, C, and D should all be of concern to the auditor.
B) Credit must be authorized before the sale.
C) Goods must be shipped after the authorization.
D) Prices must be authorized.
Answer
Terms: Authorizations in sales/collection cycle
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills

19) Which one of the following is of the least concern to the auditor when designing substantive tests of transactions for the sales/collection cycle?
A) Sales being included in the journal for which no shipment was made.
B) Sales to related parties, such as officers and subsidiaries.
C) Sales recorded more than once.
D) Shipments being made to nonexistent customers and recorded as sales.
Answer
Terms: Substantive tests of transactions for sales/collection cycle
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills
20) An auditor needs to determine whether all customers of an electric utility company are being billed. The auditor should test from the:
A) sales register to the accounts receivable ledger.
B) sales register to the meter department records.
C) accounts receivable ledger to the sales register.
D) meter department records to the sales register.
Answer
Terms: All customers being billed
Diff: Challenging
Objective: LO 14-3
AACSB: Analytic skills

21) Which one of the following would the auditor consider to be an incompatible operation if the cashier receives remittances from the mailroom?
A) The cashier prepares the daily deposit.
B) The cashier makes the daily deposit at a local bank.
C) The cashier posts the receipts to the accounts receivable subsidiary ledger cards.
D) The cashier endorses the checks.
Answer
Terms: Incompatible operation if cashier receives remittance; Separation of duties
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills

22) In designing substantive audit procedures for tests of transactions for sales the auditor needs to test for evidence of misstatements due to errors or fraud. Describe at least 2 potential errors (unintentional) and at least 1 intentional (fraud).

23) For each of the following potential misstatements, provide one potential audit test that could be used to detect the misstatement.
• Sales included in the journals for which there was no shipment
• Sale recorded more than once
• Shipments made to nonexistent customers and recorded as sales

24) Separation of duties in the sales/collection cycle should mandate that the credit-granting function be separate from the sales function.
A) True
B) False
Answer
Terms: Separation of duties in the sales/collection cycle; credit-granting function
Diff: Easy
Objective: LO 14-3
AACSB: Reflective thinking skills

25) Tracing from source documents to the journal is useful for testing the existence objective.
A) True
B) False
Answer
Terms: Tracing; Existence objective
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

26) Tests of controls should never be performed using the client’s computer system; that is, all tests of control should be performed either using the auditor’s computers or performed manually by the auditor.
A) True
B) False
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

27) Management’s assertions for sales and collection activities remain the same whether sales are generated through traditional or e-commerce activities.
A) True
B) False
Answer
Terms: Management’s assertions for sales and collection activities
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

28) Misstatements involving the completeness objective for sales lead to overstatements of assets and income.
A) True
B) False
Answer
Terms: Misstatements involving the completeness objective for sales
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills
29) Violations of the existence objective for sales are of greater concern to the auditor than violations of the completeness objective.
A) True
B) False
Answer
Terms: Violations of the existence objective for sales; violations of the completeness objective
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

30) An effective procedure to test the existence objective for sales is to vouch sales journal entries to copies of sales orders, shipping documents, and sales invoices.
A) True
B) False
Answer
Terms: Procedure to test the existence objective for sales
Diff: Moderate
Objective: LO 14-3
AACSB: Reflective thinking skills

31) For each significant internal control deficiency identified by the auditor, he or she should design one or more tests of controls to assess the extent of the deficiency and its effect on the financial statements.
A) True
B) False
Answer
Terms: Significant internal control deficiency; Tests of controls
Diff: Challenging
Objective: LO 14-3
AACSB: Analytic skills

32) For effective internal control, it is important that sales be recorded as soon after the customer order is received as possible to prevent the unintentional omission of transactions from the records and to make sure that sales are recorded in the proper period.
A) True
B) False
Answer
Terms: Effective internal control
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills

33) Footing the sales journal and tracing the totals to the general ledger are tests relating to the accuracy objective for sales.
A) True
B) False
Answer
Terms: Accuracy objective
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills
Learning Objective 14-4

1) Transaction-related audit objectives are essentially the same for processing credit memos as for sales with certain differences. Which of the following are two key differences?
A) Risk and emphasis on the completeness objective.
B) Materiality and emphasis on the accuracy objective.
C) Risk and emphasis on the classification objective.
D) Materiality and emphasis on the occurrence objective.
Answer
Terms: Transaction-related audit objectives; Credit memos
Diff: Challenging
Objective: LO 14-4
AACSB: Reflective thinking skills

2) The transaction-related audit objectives and the client’s methods of controlling misstatements are essentially the same for credit memos as for sales with the exception of two differences. What are the two differences from the auditor’s perspective?

3) When auditors evaluate sales returns and allowances, a primary emphasis is on the objective of occurrence.
A) True
B) False
Answer
Terms: Sales returns and allowances; Objective of occurrence
Diff: Easy
Objective: LO 14-4
AACSB: Reflective thinking skills

4) Sales returns and allowances are often ignored by auditors because they are often immaterial.
A) True
B) False
Answer
Terms: Sales returns and allowances; Immaterial
Diff: Moderate
Objective: LO 14-4
AACSB: Reflective thinking skills
5) When auditing sales returns and allowances, the emphasis is normally on testing the completeness objective.
A) True
B) False
Answer
Terms: Auditing sales returns and allowances; Completeness objective
Diff: Moderate
Objective: LO 14-4
AACSB: Reflective thinking skills

Learning Objective 14-5

1) When an employee who is authorized to make customer entries in the accounts receivable subsidiary ledger, purposefully enters cash received into the wrong customers account that employee may be suspected of:
A) kiting.
B) lapping.
C) floating.
D) shorting.
Answer
Terms: Employee authorized to make customer entries
Diff: Moderate
Objective: LO 14-5
AACSB: Analytic skills

2) An audit procedure that compares the name, amount, and dates shown on remittance advices, either paper of electronic via direct deposit, with cash receipts journal entries and with related duplicate deposit slips would be effective in detecting:
A) kiting.
B) lapping.
C) illicit write-offs of customers as uncollectible accounts.
D) sales without proper credit authorization.
Answer
Terms: Audit procedure compares names with cash receipts journal entries
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

3) To prevent fraud, management should deny cash access to anyone responsible for:
A)
Opening mail from
customers Entering sales
transactions Entering cash receipts transactions
Yes Yes Yes

B)
Opening mail from
customers Entering sales
transactions Entering cash receipts transactions
No NoYes Yes

C)
Opening mail from
customers Entering sales
transactions Entering cash receipts transactions
No Yes Yes

D)
Opening mail from
customers Entering sales
transactions Entering cash receipts transactions
Yes No No

Answer
Terms: Fraud; Cash access
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

4) The audit procedure referred to as proof of cash receipts is particularly useful to test:
A) time lags in making deposits.
B) whether all recorded cash receipts have been deposited in the bank.
C) whether there are cash receipts that have not been recorded in the journals.
D) the client’s reconciliation between cash receipts and bank deposits.
Answer
Terms: Audit procedure; Proof of cash receipts
Diff: Moderate
Objective: LO 14-5
AACSB: Analytic skills

5) Which of the following audit procedures would normally be best expected to test the completeness objective (assertion) for sales?
A) Compare shipping documents with sales records.
B) Apply gross profit rates to inventory disposed of during the period.
C) Trace payments received subsequent to the balance sheet date.
D) Send accounts receivable confirmation requests.
Answer
Terms: Audit procedures; Test completeness objective (assertion) for sales
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills
6) Proper separation of duties is useful to prevent various types of misstatements. Which of the following is not an essential separation of duties?
A) Persons having access to cash should also be responsible for recording sales, accounts receivable, and cash.
B) Separate the credit-granting function from the sales function.
C) Personnel doing internal comparisons should be independent of those entering the original data.
D) Anyone responsible for entering sales and cash receipts transactions information into the computer should be denied access to cash.
Answer
Terms: Separation of duties
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills

7) Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this fraud and be least likely to be detected by an auditor?
A) Understating the sales journal by not recording cash sales.
B) Overstating the accounts receivable control account by intentionally misstating prices charged for goods sold.
C) Overstating the accounts receivable subsidiary ledger by not recording payments made by customers.
D) Understating the cash receipts journal by purposely recording incorrect amounts.
Answer
Terms: Cash receipts from sales on account; Misappropriated; Fraud
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills

8) Which of the following would offer the best protection for a company that wishes to prevent a reoccurrence of a previously detected “lapping” problem with trade accounts receivable?
A) Segregate duties so that the bookkeeper in charge of the general ledger has no access to incoming mail.
B) Segregate duties so that no employee has access to both checks from customers and currency from daily cash receipts.
C) Have customers send payments directly to the company’s depository bank.
D) Request that customer’s payment checks be made payable to the company and addressed to the treasurer.
Answer
Terms: Prevent lapping problem
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills

9) Preparation of a proof of cash would not be useful in discovering differences between the actual and reported cash balances if the differences were due to:
A) deposits in transit.
B) collections on the company’s behalf by the bank which are deposited directly to the company’s account.
C) cash receipts that were not recorded in the relevant accounting records.
D) service charges.
Answer
Terms: Proof of cash
Diff: Challenging
Objective: LO 14-5
AACSB: Analytic skills

10) When assessing planned control risk for sales, the auditor is concerned about proper authorization at three key points. Discuss each of these three points.
Answerredit must be properly authorized before a sale takes place; goods should be shipped only after proper authorization; and prices including base terms, freight, and discounts must be properly authorized.
Terms: Assessing planned control risk; Proper authorization
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

11) The occurrence objective (assertion) is of primary importance when performing transaction testing for sales. List and discuss the three potential misstatements that audit procedures are designed to detect.

12) Explain what lapping means, and discuss the internal control deficiency that allows it to occur. Also discuss the procedures the auditor can perform to detect lapping.

13) You are part of the audit team that is auditing Hillsburg Hardware Co. and you have been assigned to the sales and collection business process. You are testing whether the cash received has been recorded in the cash receipts journal. (completeness objective /assertion). List two tests of controls and at least one test of transactions that you would do to satisfy yourself regarding the completeness assertion.

14) In planning the audit, an auditor takes 3 basic steps in determining the audit procedures to be performed for any business cycle or class of transactions in order to gather audit evidence concerning possible misstatement due to error or fraud. List those three basic steps below.

15) The most difficult type of cash embezzlement for the auditor to detect is when the cash is stolen before it can be recorded in the cash receipts journal.
A) True
B) False
Answer
Terms: Cash embezzlement
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

16) The most important audit concern in the processing and recording cash receipts function is not tracing the cash receipts from customers to their subsidiary ledger accounts.
A) True
B) False
Answer
Terms: Audit concern in processing and recording cash receipts function
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

Learning Objective 14-6

1) The auditor would expect that an account receivable from a customer would be written off by the client when which of the following occurs:
A) the customer files for bankruptcy.
B) the account is at least six months old.
C) a collection agency cannot inspire customer to pay the debt.
D) the client company concludes that an amount is no longer collectible.
Answer
Terms: Accounts receivable; Written off
Diff: Challenging
Objective: LO 14-6
AACSB: Reflective thinking skills

2) The auditor’s primary concern in performing audit procedures of the write-off of uncollectible accounts relates to the risk that the client writes offs customer accounts that have already been collected. The primary control for preventing this fraud is:
A) examining authorized credit memos.
B) examining the uncollectible account authorization form.
C) examining debit memos.
D) examining the vouchers payable register.
Answer
Terms: Audit procedures; Write-off of uncollectible accounts; Fraud
Diff: Challenging
Objective: LO 14-6
AACSB: Reflective thinking skills

3) Generally, audit evidence gathered from the sales and collection cycle is combined with evidence:
A) as the evidence accumulation process proceeds.
B) only when all fieldwork processes of the engagement are completed.
C) only after the audit of the sales and collection cycle is concluded.
D) after the conclusion of both the cash cycle and the sales and collection cycle.
Answer
Terms: Audit evidence; Sales and collection cycle
Diff: Challenging
Objective: LO 14-6
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 15 Audit Sampling for Tests of Controls and Substantive Tests of Transactions

Learning Objective 15-1

1) A sample in which the characteristics of the sample are the same as those of the population is a(n):
A) variables sample.
B) representative sample.
C) attributes sample.
D) random sample.
Answer
Terms: Sample in which characteristics of sample are same as population
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

2) When the auditor decides to select less than 100 percent of the population for testing, the auditor is said to use:
A) audit sampling.
B) representative sampling.
C) poor judgment.
D) estimation sampling.
Answer
Terms: Auditor selects less than 100 percent of population for testng
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

3) To determine if a sample is truly representative of the population, an auditor would be required to:
A) conduct multiple samples of the same population.
B) never use sampling because of the expense involved.
C) audit the entire population.
D) use systematic sample selection.
Answer
Terms: Sample truly representative of population
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

4) One of the ways to eliminate nonsampling risk is through:
A) proper supervision and instruction of the client’s employees.
B) proper supervision and instruction of the audit team.
C) the use of attributes sampling rather than variables sampling.
D) controls which ensure that the sample drawn is random and representative.
Answer
Terms: Ways to eliminate nonsampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills
5) Which one of the choices below is most correct regarding a cause of sampling risk?
A) ineffective use of audit procedures
B) testing less than the entire population
C) use of extensive tests of controls
D) the possibility that a properly-selected sample still may not be representative
Answer
Terms: Correct regarding sampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

6) An auditor can increase the likelihood that a sample is representative by using care in:
A)
Designing the sampling process Designing the sample selection
Yes Yes

B)
Designing the sampling process Designing the sample selection
No No

C)
Designing the sampling process Designing the sample selection
Yes No

D)
Designing the sampling process Designing the sample selection
No Yes

Answer
Terms: Increase likelihood that sample is representatigve
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

7) Which of the following is the risk that audit tests will not uncover existing exceptions in a sample?
A) Sampling risk
B) Nonsampling risk
C) Audit risk
D) Detection risk
Answer
Terms: Risk that audit tests will not uncover existing exceptions
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills
8) Which of the following is the risk that an auditor will reach an incorrect conclusion because a sample is not representative of the population?
A) Sampling risk
B) Nonsampling risk
C) Audit risk
D) Detection risk
Answer
Terms: Risk auditor will reach an incorrect conclusion
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

9) Sampling risk may be controlled by:
A)
Adjusting the sample size Always using random sampling
Yes Yes

B)
Adjusting the sample size Always using random sampling
No No

C)
Adjusting the sample size Always using random sampling
Yes No

D)
Adjusting the sample size Always using random sampling
No Yes

Answer
Terms: Sampling risk controlled by
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

10) Which of the following statements is most correct?
A) A sample of all items of a population will eliminate sampling risk, but increase nonsampling risk.
B) The use of an appropriate sample selection technique ensures a representative sample.
C) The auditor’s failure to recognize an exception is a significant cause of sampling risk.
D) The use of inappropriate audit procedures is a significant cause of nonsampling risk.
Answer
Terms: Sample selection; Sampling and nonsampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills
11) Which of the following statements best expresses the impact that the performance of audit procedures has on statistical vs. nonstatistical sampling?
A) Audit procedures on the sample item will vary as a result of using either statistical or nonstatistical sampling.
B) The audit procedures will be the same for either statistical or nonstatistical sampling but they must be performed differently for each.
C) Statistical sampling requires quantitative audit procedures, whereas nonstatistical sampling requires judgmental audit procedures.
D) Audit procedures on the sample item will not vary as a result of using either statistical or nonstatistical sampling.
Answer
Terms: Statistical vs. nonstatistical sampling
Diff: Challenging
Objective: LO 15-1
AACSB: Reflective thinking skills

12) Briefly explain why auditors utilize audit sampling.
Answeruditors use sampling techniques primarily because it is generally impractical to audit all transactions or balances. Consequently, auditors must design strategies to select items from the population that are likely to be representative of the remaining unaudited population items. In addition, auditors often use sampling techniques because of economic realities. That is, clients generally do not want to incur the substantial fees associated with auditing every transaction or balance.
Terms: Audit sampling
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

13) Discuss what is meant by “sampling risk” and “nonsampling risk”.

14) Discuss what is meant by “nonsampling risk.”

15) Discuss two causes of nonsampling risk. Also discuss ways the auditor can control nonsampling risk.

16) Sampling risk results from the auditor’s failure to recognize exceptions in transaction data.
A) True
B) False
Answer
Terms: Sampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

17) Even when nonsampling risk is zero, there is always a possibility that a sample is not representative of the population.
A) True
B) False
Answer
Terms: Nonsampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

18) If a particular internal control is not followed by the client exactly 6% of the time, and the auditor’s tests of that control find three control violations in a sample of 50, the sample is considered to be representative.
A) True
B) False
Answer
Terms: Sample considered to be representative
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills

19) In practice, auditors do not know whether a sample is representative, even after all testing is complete.
A) True
B) False
Answer
Terms: Representative sample
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills
20) One way to control sampling risk is to increase sample size.
A) True
B) False
Answer
Terms: Control sampling risk is with sample size
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills

21) A sample of all items in a population will have a zero sampling risk.
A) True
B) False
Answer
Terms: Sample of all items in a population will have zero sampling risk
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills

22) It is virtually impossible to reduce sampling risk to zero.
A) True
B) False
Answer
Terms: Sampling risk
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills

Learning Objective 15-2

1) Which of the following is not true for nonstatistical sampling?
A) applies mathematical rules that allows auditors to quantify sampling risk
B) auditors select items for the sample that they believe would provide them the most information
C) reach conclusion about the population on a judgmental sample
D) often called judgmental sampling
Answer
Terms: Nonstatistical sampling
Diff: Easy
Objective: LO 15-2
AACSB: Reflective thinking skills

2) When the auditor goes through a population and selects items using nonprobalistic selection methods, without regard to their size, source, or other distinguishing characteristics, it is called:
A) block sample selection.
B) haphazard selection.
C) systematic sample selection.
D) statistical selection.
Answer
Terms: Nonprobabilistic selection methods
Diff: Easy
Objective: LO 15-2
AACSB: Reflective thinking skills
3) When auditors wish to evaluate a sample statistically, an acceptable selection method is:
A) systematic sample selection.
B) judgmental selection.
C) haphazard selection.
D) block sample selection.
Answer
Terms: Sample statistically
Diff: Easy
Objective: LO 15-2
AACSB: Reflective thinking skills

4) Which of the following statement is most correct with concerning the quantification of sampling risk?
A) Sampling risk cannot be quantified.
B) Sampling risk can be quantified only when non-probabilistic selection techniques are used to select the sample.
C) Sampling risk can be quantified only when probabilistic selection techniques are used to select the sample.
D) None of the above.
Answer
Terms: Quantification of sampling risk
Diff: Easy
Objective: LO 15-2
AACSB: Reflective thinking skills

5) The auditor may use which of the following criteria when using the directed sample selection technique?
A) Items most likely to contain misstatements.
B) Items containing selected population characteristics.
C) Large dollar coverage.
D) Any of the above.
Answer
Terms: Criteria with directed sample selection technique
Diff: Easy
Objective: LO 15-2
AACSB: Reflective thinking skills

6) Which of the following statements is most correct with respect to the evaluation of non-probabilistic sample results?
A) It is acceptable to make non-probabilistic evaluations only when probabilistic sample selection is used.
B) It is acceptable to make non-probabilistic evaluations only if the auditor cannot quantify sampling risk.
C) It is never acceptable to evaluate a non-probabilistic sample using statistical methods.
D) All of the above are correct.
Answer
Terms: Evaluation of non-probabilistic sample results
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills
7) Which of the following statements is a valid criticism of non-statistical sampling?
A) Many audit tests, such as footing of journals, must be performed outside a statistical sampling context.
B) The cost of performing random selection or testing often exceeds the benefits.
C) Non-statistical sampling does not differ substantially from statistical sampling methods.
D) Conclusions may be drawn in more precise ways when using statistical sampling methods.
Answer
Terms: Criticism of non-statistical sampling
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

8) Which of the following statements is not correct regarding probabilistic and non-probabilistic sample selection?
A) In probabilistic selection, every population item has a known chance of being selected.
B) It is not acceptable to make non-probabilistic evaluations using probabilistic selection.
C) Probabilistic selection is required for all statistical sampling methods.
D) Both methods are acceptable and commonly used.
Answer
Terms: Probabilistic and non-probabilistic sample selection
Diff: Challenging
Objective: LO 15-2
AACSB: Reflective thinking skills

9) Non-probabilistic selection methods are not based on mathematical probabilities; therefore:
A) the extent to which a sample is representative of the population may be difficult to determine.
B) they are discouraged by the AICPA.
C) they are not allowed by the Statements on Auditing Standards.
D) they are not as effective as statistical sampling.
Answer
Terms: Non-probabilistic selection methods
Diff: Challenging
Objective: LO 15-2
AACSB: Reflective thinking skills

10) Which of the following statements regarding block sampling is least likely to be true?
A) Block sampling is the selection of several items in sequence.
B) It is acceptable to use block sampling for tests of transactions only if a reasonable number of blocks is used.
C) Only one block should be selected to increase the probability of a representative sample.
D) Once the first item in the block is selected, the remainder of the block is chosen automatically.
Answer
Terms: Block sampling
Diff: Challenging
Objective: LO 15-2
AACSB: Reflective thinking skills
11) An advantage of using statistical sampling techniques is that such techniques:
A) mathematically measure risk.
B) eliminate the need for judgmental decisions.
C) define the values of precision and reliability required to provide audit satisfaction.
D) have been established in the courts to be superior to judgmental sampling.
Answer
Terms: Advantage of using statistical sampling techniques
Diff: Challenging
Objective: LO 15-2
AACSB: Reflective thinking skills

12) Auditors who prefer statistical to nonstatistical sampling believe that the principal advantage of statistical sampling flows from its ability to:
A) quantify sampling risk.
B) promote a more legally defensible procedural approach.
C) define the precision required to provide audit satisfaction.
D) establish conclusive audit evidence with decreased audit effort.
Answer
Terms: Advantage of statistical sampling over nonstatistical sampling
Diff: Challenging
Objective: LO 15-2
AACSB: Reflective thinking skills

13) Describe the differences between statistical and nonstatistical sampling in terms of (1) the sample selection methods used, and (2) quantification of sampling risk.

14) You are designing the audit plan for Mathews & Company. You are a strong proponent for statistical sampling over nonstatistical sampling. Make your case.

15) Directed sample selection is the selection of each item in the sample based on some judgment criteria established by the auditor. Discuss three commonly used criteria.

16) It is equally acceptable under professional auditing standards for auditors to use either statistical or nonstatistical sampling methods.
A) True
B) False
Answer
Terms: Equally acceptable to use statistical or nonstatistical sampling methods
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

17) When using nonstatistical sampling, the sample must be a probabilistic one.
A) True
B) False
Answer
Terms: Nonstatistical sampling; sample must be probabilistic
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

18) The use of haphazard sample selection is encouraged under professional auditing standards.
A) True
B) False
Answer
Terms: Haphazard sample selection
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

19) Directed sample selection, block sample selection, and haphazard sample selection are three types of probabilistic sample selection methods.
A) True
B) False
Answer
Terms: Probabilistic sample selections; Directed sample selection, block sample selection and haphazard selections
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills
Learning Objective 15-3

1) A sample in which every possible combination of items in the population has an equal chance of constituting the sample is a:
A) random sample.
B) statistical sample.
C) judgment sample.
D) representative sample.
Answer
Terms: Sample in which every possible combination has equal chance of constituting sample
Diff: Easy
Objective: LO 15-3
AACSB: Reflective thinking skills

2) The process which requires the calculation of an interval and then selects the items based on the size of the interval is:
A) statistical sampling.
B) random sample selection.
C) systematic sample selection.
D) computerized sample selection.
Answer
Terms: Process which requires calculation of an interval
Diff: Easy
Objective: LO 15-3
AACSB: Reflective thinking skills

3) In systematic sample selection, the population size is divided by the number of sample items desired in order to determine the:
A) sampling interval.
B) tolerable exception rate.
C) computed upper exceptions rate.
D) mean.
Answer
Terms: Systematic sample selection
Diff: Easy
Objective: LO 15-3
AACSB: Reflective thinking skills
4) Which of the following methods of sample selection is appropriately used when selecting a random sample?
A)
Auditor’s judgmental
selection of items Use of computer-generated random numbers Use of random number
ables
Yes No Yes

B)
Auditor’s judgmental
selection of items Use of computer-generated random numbers Use of random number
ables
No Yes Yes

C)
Auditor’s judgmental
selection of items Use of computer-generated random numbers Use of random number
ables
Yes No No

D)
Auditor’s judgmental
selection of items Use of computer-generated random numbers Use of random number
ables
No Yes No

Answer
Terms: Methods of sample selection in selecting a random sampl
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

5) Correspondence is established between the random number table and the population by:
A) identifying each item in the population with a unique number.
B) deciding the number of digits to use in the random number table and their association with the population numbering system.
C) defining which digits the auditor uses in a column and the method of reading the table.
D) selecting a random starting point on the table.
Answer
Terms: Correspondence between random number table and population
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

6) Which of the following statements is not correct?
A) It is acceptable to pick a starting point on a random number table by using a “blind stab” method.
B) It is impossible to draw a six-digit random number from a table that is separated into columns of five digits.
C) The only reason for selecting a random starting point on a random number table is to eliminate the predictability of the sample.
D) When selecting a three-digit number from a table that is separated into columns of five digits, it is permissible to use the first three digits, the middle three digits, or the last three digits.
Answer
Terms: Random number tables
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills
7) The advantage of systematic sample selection is that:
A) it is easy to use.
B) there is limited possibility of it being biased.
C) it is unnecessary to determine if the population is arranged randomly.
D) it automatically selects items material to the financial statements.
Answer
Terms: Advantage of systematic sample selection
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

8) In performing a review of a client’s cash disbursements, an auditor uses systematic sample selection with a random start. The primary disadvantage of this technique is population items:
A) may occur twice in the sample.
B) must be reordered in a systematic pattern before the sample can be drawn.
C) may occur in a systematic pattern, thus negating the randomness of the sample.
D) must be replaced in the population after sampling to permit valid statistical inference.
Answer
Terms: Disadvantage of systematic sample selection with random start
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

9) Which of the following is an advantage of systematic sample selection over random number sampling?
A) It provides a stronger basis for statistical conclusions.
B) It enables the auditor to use the more efficient “sampling with replacement” tables.
C) There may be correlation between the location of items in the population, the feature of sampling interest, and the sampling interval.
D) It does not require establishment of correspondence between random numbers and items in the population.
Answer
Terms: Advantage of systematic sample selection over random number sampling
Diff: Challenging
Objective: LO 15-3
AACSB: Reflective thinking skills

10) What is the key advantage and disadvantage associated with systematic sample selection? How must auditors address this disadvantage?

11) Describe each of the four types of sample selection methods commonly associated with statistical audit sampling.

12) When selecting a sample, random numbers may be obtained either with replacement or without replacement. Although both selection methods are theoretically sound, auditors rarely use replacement sampling.
A) True
B) False
Answer
Terms: Selecting same with random numbers
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

13) Although systematic sample selection is easy to use, its primary disadvantage is that it is not a probabilistic sampling method.
A) True
B) False
Answer
Terms: Systematic sample selection; probabilistic sampling method
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills
Learning Objective 15-4

1) Which of the following occurrences would be least likely to warrant further audit attention for the auditor?
A) Deviations from client’s established control procedures.
B) Deviations from client’s budgeted values.
C) Monetary misstatements in populations of transaction data.
D) Monetary misstatements in populations of account balance details.
Answer
Terms: Warrant further audit attention for auditor
Diff: Easy
Objective: LO 15-4
AACSB: Reflective thinking skills

2) What types of exceptions are auditors most concerned with when evaluating populations of accounting data?

3) The auditor may estimate the “estimated population exception rate” by taking a small preliminary sample from the current year’s data or by using the prior year’s experience with the client.
A) True
B) False
Answer
Terms: Estimated population exception rate
Diff: Challenging
Objective: LO 15-4
AACSB: Reflective thinking skills

4) When a small preliminary sample is used to estimate the population exception rate, it (the preliminary sample) cannot be included in the ultimate sample.
A) True
B) False
Answer
Terms: Population exception rate; Small preliminary sample
Diff: Challenging
Objective: LO 15-4
AACSB: Reflective thinking skills
Learning Objective 15-5

1) The risk which the auditor is willing to take in accepting a control as being effective when the true population exception rate is greater than a tolerable rate is the:
A) finite correction factor.
B) tolerable exception rate.
C) acceptable risk of assessing control risk too low.
D) estimated population exception rate.
Answer
Terms: Risk auditor is willing to take in accepting a control as being effective
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

2) The exception rate the auditor will permit in the population and still be willing to reduce the assessed level of control risk is called the:
A) tolerable exception rate.
B) estimated population exception rate.
C) acceptable risk of overreliance.
D) sample exception rate.
Answer
Terms: Exception rate auditor will permit and still be willing to reduce assessed level of control risk
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

3) If the auditor decides to assess control risk at the moderate level in a private company audit, when in previous years the auditor set control risk at the maximum level, then tests of controls for the current year would be:
A) increased in number.
B) reduced in number.
C) not performed.
D) unchanged from prior planned settings.
Answer
Terms: Assess control risk
Diff: Easy
Objective: LO 15-5
AACSB: Analytic skills

4) When the computed upper exception rate is greater than the tolerable exception rate, it is necessary for the auditor to take specific action. Which of the following courses of action would be most difficult to justify?
A) Reduce the tolerable exception rate so as to accept the sample results.
B) Expand the sample size and perform more tests.
C) Revise the assessed control risk.
D) Write a letter to management which outlines the control deficiencies.
Answer
Terms: Computed upper exception rate is greater than tolerable exception rate
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills
5) Which of the following would have the least impact in determining sample size for tests of controls?
A) Expected population exception rate.
B) Risk of assessing control risk too low.
C) Tolerable exception rate.
D) Population size.
Answer
Terms: Least impact on determining sample size for tests of controls
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

6) Which of the following represents the best description of the tolerable exception?
A) The highest exception rate the auditor will permit in the control being tested and still conclude it is operating effectively.
B) The highest exception rate the auditor expects to find in the population.
C) The number of exceptions found in the sample divided by the sample size.
D) The highest estimated exception rate in a population at a given ARACR.
Answer
Terms: Tolerable exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

7) Which of the following is most correct when using audit sampling for exception rates?
A) auditor is concerned with the lowest rate
B) auditor is concerned with the highest rate
C) auditor is concerned with the average on previous audits
D) doesn’t impact the auditors decision
Answer
Terms: Auditing sampling for exception rates
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

8) The highest estimated exception rate in the population at a particular acceptable risk of assessing control risk too low is:
A) the upper exception rate.
B) estimated population exception rate.
C) the computed upper exception rate.
D) the tolerable exception rate.
Answer
Terms: Highest estimated exception rate in population; Acceptable risk of assessing control risk too low
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
9) You are testing controls over accounts receivable and are determining if the appropriate credit authorization was made by an authorized person. Your sample size is 40 and your computed upper deviation rate is 5%. On the first 10 items sampled you have found 8 deviations. You would most likely:
A) continue with the other 30 items.
B) revisit the sample size calculations.
C) increase the tolerable deviation rate.
D) stop the test and re-set control risk for accounts receivable.
Answer
Terms: Sample size, computed upper deviation and actual deviations
Diff: Moderate
Objective: LO 15-5
AACSB: Analytic skills

10) The exception rate that the auditor will permit in the population and still be willing to use the preliminary control risk assessment is called the:
A) acceptable exception rate.
B) estimated population exception rate.
C) sample exception rate.
D) tolerable exception rate.
Answer
Terms: Exception rate; Preliminary control risk assessment
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

11) The auditor’s best estimate of the population exception rate is the:
A) current year’s sample exception rate.
B) tolerable exception rate.
C) prior year’s sample exception rate.
D) computed upper exception rate.
Answer
Terms: Estimate of population exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

12) Place the following steps in their proper order:
1. Analyze exceptions
2. Select the sample
3. Define attributes and exception conditions
4. State the objectives of the audit test
5. Specify the tolerable exception rate
A) 1, 3, 2, 4, 5.
B) 4, 3, 1, 2, 5.
C) 4, 3, 5, 2, 1.
D) 1, 2, 3, 4, 5.
Answer
Terms: Auditing sampling steps
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
13) If an auditor judgmentally selects a sample of one hundred items from a population and finds two exceptions, the auditor:
A) can conclude that the sample exception rate is 2%.
B) can conclude that the population exception rate is 2%.
C) can calculate the highest exception rate expected in the population.
D) cannot make any conclusions about either the sample or the population.
Answer
Terms: Sample selected from population and found exceptions
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

14) In testing controls, an overreliance on internal controls that reduces substantive tests and increases the likelihood of not detecting a material misstatement occurs because:
A) true deviation in the population was less than the sample.
B) true deviation in the population was greater than the sample.
C) auditor judgment was flawed.
D) it is inherent in the audit risk model.
Answer
Terms: Testing controls; Overreliance on internal controls
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
15) You are determining the significance of the following: you set a 5% risk of assessing control risk to low and your computation of the upper deviation risk is 7%. What could you conclude?
A) There is a 95% chance the deviation rate is the population is less than 5%.
B) There is a 5% chance the deviation rate in the population is less than 7%.
C) There is a 95% chance the deviation rate in the population exceeds 95%.
D) There is a 5% chance the deviation rate in the population exceeds 7%.
Answer
Terms: Risk of assessing control risk low and computation of upper deviation risk
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

16) Which of the following is the exception rate that the auditor expects to find before testing?
A) Sample exception rate.
B) Estimated population exception rate.
C) Computed exception rate.
D) Tolerable exception rate.
Answer
Terms: Exception rate auditor expects to find before testing
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
17) Which of the following is not a term related to evaluating results in audit sampling until after a sample is tested and evaluated?
A) Sample exception rate.
B) Estimated population exception rate.
C) Computed upper exception rate.
D) Exception.
Answer
Terms: Term not related to evaluating results in audit sampling
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

18) The relationship of tolerable exception rate (TER) to sample size is:
A) direct (larger TER = larger sample).
B) inverse (larger TER = smaller sample).
C) variable (sometimes larger, sometimes smaller).
D) not determinable.
Answer
Terms: Relationship of tolerable exception rate (TER) to sample size
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

19) Which of the following must be set prior to testing a sample?
A) Sample exception rate.
B) Achieved upper precision limit.
C) Computed exception rate.
D) Tolerable exception rate.
Answer
Terms: Set prior to testing sample
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

20) The relationship of acceptable risk of accessing control risk too low (ARACR) to sample size is:
A) variable (sometimes larger, sometimes smaller).
B) direct (larger ARACR = larger sample).
C) inverse (larger ARACR = smaller sample).
D) nonexistent.
Answer
Terms: Relationship of acceptable risk of assessing control risk too low (ARACR) to sample size
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
21) The sample exception rate equals:
A) the number of exceptions in the population divided by the sample size.
B) the number of items in the population multiplied by the number of exceptions in the sample.
C) the number of exceptions in the sample divided by the sample size.
D) the number of exceptions in the population divided by the population size.
Answer
Terms: Sample exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

22) Before the population can be considered acceptable based on the acceptable risk of assessing control risk too low, the computed upper exception rate must be:
A) greater than or equal to the tolerable exception rate.
B) greater than the tolerable exception rate.
C) less than or equal to the tolerable exception rate.
D) less than the tolerable exception rate.
Answer
Terms: Population considered acceptable based on acceptable risk of assessing control risk too low; Upper exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

23) An auditor uses statistical sampling for attributes in internal control testing. She would most likely reduce the planned reliable on the control tested when:
A) the sample deviation rate plus the adjustment for sampling risk exceeded the tolerable deviation rate.
B) the sample deviation rate plus the adjustment for sampling risk equaled the tolerable deviation rate.
C) the tolerable deviation rate less the adjustment for sampling risk exceeded the expected population deviation rate.
D) the tolerable deviation rate plus the adjustment for sampling risk was less than the expected population deviation rate.
Answer
Terms: Statistical sampling for attributes; Reduce planned reliance on control tested
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
24) The acceptable risk of assessing control risk too low is:
A)
The risk that the auditor is willing to take of accepting a control as
ineffective when it is effective The risk that the auditor is willing to take of accepting a control as effective when it is ineffective
Yes Yes

B)
The risk that the auditor is willing to take of accepting a control as
ineffective when it is effective The risk that the auditor is willing to take of accepting a control as effective when it is ineffective
No No

C)
The risk that the auditor is willing to take of accepting a control as
ineffective when it is effective The risk that the auditor is willing to take of accepting a control as effective when it is ineffective
Yes No

D)
The risk that the auditor is willing to take of accepting a control as
ineffective when it is effective The risk that the auditor is willing to take of accepting a control as effective when it is ineffective
No Yes

Answer
Terms: Acceptable risk of assessing control risk too low
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

25) When using statistical sampling, the auditor would most likely require a smaller sample if the:
A) population increases.
B) desired reliability decreases.
C) desired precision interval narrows.
D) expected exception rate increases.
Answer
Terms: Statistical sampling; Auditor requires smaller sample
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

26) Whenever auditors use sampling, they risk making incorrect conclusions about the population. For audit sampling of tests of transactions this risk is known as:
A) acceptable risk of assessing control risk too low.
B) acceptable risk of assessing transaction testing as too low.
C) risk that the sample is not representative of the population.
D) risk that the sample conclusions cannot be useful because of non-probability sampling.
Answer
Terms: Sampling and the risk of making incorrect conclusions about the population
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills
27) When deciding on the acceptable risk of assessing control risk too low, the auditor needs to:
A) rely on his/her professional judgment.
B) err on the side of conservatism.
C) consult the professional standards.
D) follow SEC guidelines.
Answer
Terms: Acceptable risk of assessing control risk too low
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills

28) The difference between the tolerable exception rate and the estimated population exception rate is called:
A) accuracy of the initial sample estimate.
B) inflation factor of the initial sample estimate.
C) precision of the initial sample estimate.
D) reliability of the initial sample estimate.
Answer
Terms: Difference between tolerable exception and estimated population exception rate
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills

29) If the result obtained from a particular sample for control and substantive tests of transactions is critical to the formation of an audit opinion, which of the following is the most important to the auditor in concluding of the appropriateness and sufficiency of evidence gathered?
A) Acceptable risk of assessing control risk too low.
B) Estimated population exception rate.
C) Tolerable exception rate.
D) Size of the population.
Answer
Terms: Control and substantive tests of transactions; Important in concluding appropriateness and sufficiency of evidence
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills

30) The tolerable rate of exceptions for tests of controls is generally:
A) lower than the expected rate of errors in the related accounting records.
B) higher than the expected rate of errors in the related accounting records.
C) identical to the expected rate of errors in the related accounting records.
D) unrelated to the expected rate of errors in the related accounting records.
Answer
Terms: Tolerable rate of exceptions for tests of controls
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills
31) Which of the following results in a larger sample size?
A) decrease the desired confidence level and decrease the tolerable deviation rate
B) increase the desired confidence level and decrease the tolerable deviation rate
C) decrease the desired confidence level and increase the tolerable deviation rate
D) increase the desired confidence level and increase the tolerable deviation rate
Answer
Terms: Results in larger sample size
Diff: Moderate
Objective: LO 15-1 and LO 15-5
AACSB: Reflective thinking skills

32) An auditor plans to examine a sample of 40 canceled checks for a countersignature which is prescribed in the client’s control procedures manual. Two of the checks in sample cannot be located by the company or the auditor. The auditor would most likely:
A) treat the missing checks as a deviation when evaluating the results of the sample.
B) draw a conclusion on a sample size of 38.
C) substitute two more checks to get to a sample size of 40.
D) recalculate the sample excluding the original 40 checks.
Answer
Terms: Missing canceled checks in population
Diff: Moderate
Objective: LO 15-4 and LO 15-5
AACSB: Analytic skills
Topic: Public

33) You are determining the appropriate sample size to test accounts receivable. What three factors are the most important to consider?

34) Explain the effect on sample size of increasing each of the following: (1) tolerable exception rate, (2) estimated population exception rate, (3) acceptable risk of assessing control risk too low, and (4) population size.

35) The prior year’s sample exception rate is the auditor’s best estimate of the exception rate in the population for the current year.
A) True
B) False
Answer
Terms: Sample exception rate
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

36) The tolerable exception rate is the rate that the auditor will permit in the population and still be willing to conclude a control is effective.
A) True
B) False
Answer
Terms: Tolerable exception rate
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

37) The only way to know with certainty whether a sample is representative is to subsequently audit the entire population.
A) True
B) False
Answer
Terms: Know with certainty whether sample is representative is to audit entire population
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

38) Acceptable risk of assessing control risk too low is the risk that the auditor is willing to take in accepting a control as effective when the true population exception rate is greater than the estimated population exception rate.
A) True
B) False
Answer
Terms: Acceptable risk of assessing control risk
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

39) ARACR is normally lower for a public company audit than a private company audit.
A) True
B) False
Answer
Terms: ARACR – Acceptable risk of assessing control risk
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
Topic: Public
40) The conjoined sample exception rate is the auditor’s “best estimate” of the actual exception rate in the entire population.
A) True
B) False
Answer
Terms: Sample exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

41) When the computed upper exception rate is greater than the tolerable exception rate in attributes sampling, one possible appropriate course of action is to increase sample size.
A) True
B) False
Answer
Terms: Computed upper exception rate and tolerable exception rate
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

42) Tolerable exception rate (TER) is inversely related to sample size.
A) True
B) False
Answer
Terms: Tolerable exception rate and sample size relationship
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

43) The higher the assessed control risk, the lower will be the acceptable risk of assessing control risk too low.
A) True
B) False
Answer
Terms: Control risk assessment
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills

44) In nonstatistical sampling, the calculated sampling error is the difference between the tolerable exception rate and the sample exception rate.
A) True
B) False
Answer
Terms: Nonstatistical sampling; Calculated sampling error; Difference between tolerable exception rate and sample exception rate
Diff: Challenging
Objective: LO 15-5
AACSB: Reflective thinking skills
Learning Objective 15-6

1) Rodgers CPA believes that the rate of client billing errors is 4% and has established a tolerable deviation rate of 6%. In auditing client invoices Rodgers should use:
A) stratified sampling.
B) classical sampling.
C) proportional sampling.
D) attributes sampling.
Answer
Terms: Auditing client invoices
Diff: Easy
Objective: LO 15-6
AACSB: Analytic skills

2) Attributes sampling would be an appropriate method to use on which one of the following procedures in an audit program?
A) Review sales transactions for large and unreasonable amounts.
B) Observe whether the duties of the accounts receivable clerk are separate from handling cash.
C) Examine a sample of duplicate sales invoices for credit approval by the credit manager.
D) Review the aged schedule of accounts receivable to determine if receivables from officers are included.
Answer
Terms: Attributes sampling
Diff: Easy
Objective: LO 15-6
AACSB: Reflective thinking skills

3) As the auditor you are assessing the proper sample size to use in testing controls. When using attributes sampling which of the following is most correct?
A) A 10% change in population size will have the least effect on sample size.
B) A 10% change in the tolerable deviation rate will have the least effect on sample size.
C) A 10% change in the expected deviation rate will have the least effect on sample size.
D) A 10% change in the tolerable will have the least effect on sample size
Answer
Terms: Attributes sampling
Diff: Moderate
Objective: LO 15-6
AACSB: Reflective thinking skills

4) In attributes sampling, an estimate of the expected population exception rate is necessary to plan the sample size. The relationship of expected population exception rate (EPER) to sample size is:
A) direct (small EPER = small sample).
B) inverse (small EPER = large sample).
C) a variable (sometimes small, sometimes large) dependent on other factors present.
D) indeterminate.
Answer
Terms: Attributes sampling; Expected population exception rate and sample size
Diff: Moderate
Objective: LO 15-6
AACSB: Reflective thinking skills
5) If an auditor, planning to use statistical sampling, is concerned with the number of a client’s sales invoices that contain mathematical errors, the auditor would most likely utilize which sampling technique?
A) Random sampling with replacement
B) Sampling for attributes
C) Ssampling for variables
D) Stratified random sampling
Answer
Terms: Statistical sampling; Number of invoices containing mathematical errors
Diff: Challenging
Objective: LO 15-6
AACSB: Reflective thinking skills

6) For which of the following audit procedures would audit sampling not be appropriate?
A) Review sales transactions for large and unusual amounts.
B) Examine a sample of duplicate sales invoices for credit approval.
C) Compare the quantity on duplicate sales invoices with the quantity on related shipping documents.
D) Audit sampling is appropriate for each of the above procedures.
Answer
Terms: Audit sampling not appropriate for which audit procedure
Diff: Moderate
Objective: LO 15-5 and LO 15-6
AACSB: Reflective thinking skills

7) Match eight of the terms (a-k) with the definitions provided below (1-8):

a. Haphazard selection
b. Attributes sampling
c. Block sample selection
d. Judgmental sampling
e. Non-probabilistic sample selection
f. Probabilistic sample selection
g. Random sample
h. Representative sample
i. Statistical sampling
j. Systematic sample selection
k. Sampling distribution

________ 1. The use of mathematical measurement techniques to calculate formal statistical results and quantify sampling risk.

________ 2. A non-probabilistic method of sample selection in which items are selected in measured sequences.

________ 3. A sample whose characteristics are the same as those of the population.

________ 4. A statistical, probabilistic method of sample evaluation that results in an estimate of the proportion of items in a population containing a characteristic of interest.

________ 5. A non-probabilistic method of sample selection in which items are chosen without regard to their size, source, or other distinguishing characteristics.

________ 6. An auditor selects items such that each population item has a known probability of being included in the sample.

________ 7. A frequency distribution of the results of all possible samples of a specified size that could be obtained from a population containing some specific parameters.

________ 8. A sample in which every possible combination of elements in the population has an equal chance of constituting the sample.

8) There are 14 steps to attributes sampling, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss the three steps that comprise the “evaluate the results” section.

9) There are 14 steps to attributes sampling, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. In the planning section there are 9 steps, beginning with “state the audit objective” and ending with “determine the initial sample size”. Name and discuss at least 3 steps between the ones listed above.

1) A principal advantage of statistical methods of attributes sampling over nonstatistical methods is that they provide a scientific basis for establishing the:
A) risk of assessing control risk too low.
B) tolerable exception rate.
C) expected population exception rate.
D) sample size.
Answer
Terms: Advantage of statistical methods of attributes sampling
Diff: Moderate
Objective: LO 15-7
AACSB: Reflective thinking skills

2) In using sampling distribution for attributes, which one of the following must be known to evaluate the sample results?
A) Estimated dollar value of the population.
B) Standard exception of the values in the population.
C) Actual exception rate of the attribute in the population.
D) Sample size.
Answer
Terms: Estimation sampling for attributes
Diff: Moderate
Objective: LO 15-7
AACSB: Reflective thinking skills

3) When audit procedures have been completed for an attributes sampling application, the auditor must generalize from the sample to the population. Which of the following statements would be incorrect regarding this process?
A) The auditor would use an attributes sampling table to determine the computed upper exception rate.
B) The computed upper exception rate is the highest exception rate in the population that the auditor is willing to accept.
C) It would be wrong for the auditor to conclude that the population exception rate is exactly the same as the sample exception rate.
D) In selecting the table corresponding to the risk of overreliance, it should be the same as the ARACR used for determining the initial sample size.
Answer
Terms: Attributes sampling application
Diff: Challenging
Objective: LO 15-7
AACSB: Reflective thinking skills

4) What is an auditor’s evaluation of a statistical sample for attributes when a test of 100 documents results in four exceptions if the tolerable exception rate is 5%, the expected population exception rate is 3%, and the allowance for sampling risk is 2%?
A) Accept the sample results as support for planned reliance on the control because the tolerable rate less the allowance for sampling risk equals the expected population exception rate.
B) Modify planned reliance on the control because the sample exception rate plus the allowance for sampling risk exceeds the tolerable rate.
C) Modify planned reliance on the control because the tolerable rate plus the allowance for sampling risk exceeds the expected population exception rate.
D) Accept the sample results as support for planned reliance on the control because the sample deviation rate plus the allowance for sampling risk exceeds the tolerable rate.
Answer
Terms: Statistical sample for attributes; Tolerable exception rate, expected population exception rate and allowance for sampling risk
Diff: Challenging
Objective: LO 15-7
AACSB: Reflective thinking skills

5) In the evaluation of the results of an attributes sample, the fact that the exception rate in the sample was 2% rather than the estimated population exception rate of 4% would cause the computed upper exception rate to:
A) be less than the tolerable exception rate.
B) equal the tolerable exception rate.
C) exceed the tolerable exception rate.
D) cannot be determined from the information given.
Answer
Terms: Attributes sample; Exception rate in sample, estimated population exception rate, and computed upper exception rate
Diff: Challenging
Objective: LO 15-7
AACSB: Reflective thinking skills

6) If the size of the sample to be used in a test of attributes is not determined by using statistical concepts, but the sample is chosen in accordance with random selection procedures:
A) no inferences can be drawn from the sample.
B) the auditor has committed a nonsampling error.
C) the auditor may or may not achieve the tolerable exception rate at the acceptable risk of assessing control risk too low.
D) the auditor will have to evaluate results using the principles of discovery sampling.
Answer
Terms: Size of sample used in test of attributes
Diff: Challenging
Objective: LO 15-7
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 16 Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

1) The net realizable value of accounts receivable is equal to:
A) gross accounts receivable less allowance for uncollectible accounts.
B) gross accounts receivable less bad debt expense.
C) gross accounts receivable less returns and allowances.
D) gross accounts receivable less sales discounts.
Answer
Terms: Revenue recognition
Diff: Easy
Objective: LO 16-1
AACSB: Reflective thinking skills

2) The two primary classes of transactions in the sales and collection cycle are:
A) sales and sales discounts.
B) sales and cash receipts.
C) sales and sales returns.
D) sales and accounts receivable.
Answer
Terms: Classes of transactions; Sales and collection cycle
Diff: Easy
Objective: LO 16-1
AACSB: Reflective thinking skills

3) The appropriate and sufficient evidence to be obtained from tests of details must be decided on an:
A) efficiency basis.
B) effectiveness basis.
C) audit objectives basis.
D) none of the above.
Answer
Terms: Tests of details
Diff: Easy
Objective: LO 16-1
AACSB: Reflective thinking skills

4) For most audits, inherent risk for accounts receivable is moderate or low except for which balance-related audit objectives?
A) Timing and realizable value.
B) Completeness and existence.
C) Existence and accuracy.
D) Realizable value and cutoff.
Answer
Terms: Inherent risk; Balance-related audit objectives
Diff: Easy
Objective: LO 16-1
AACSB: Reflective thinking skills
5) For sales, the occurrence transaction-related audit objective affects which of the following balance-related audit objective?
A) Existence
B) Completeness
C) Rights
D) Detail tie-in
Answer
Terms: Sales transaction-related audit objective
Diff: Moderate
Objective: LO 16-1
AACSB: Reflective thinking skills

6) For cash receipts, the occurrence transaction-related audit objective affects which of the following balance-related audit objective?
A) Existence
B) Completeness
C) Rights
D) Detail tie-in
Answer
Terms: Cash receipts transaction-related objective
Diff: Moderate
Objective: LO 16-1
AACSB: Reflective thinking skills

7) Favorable results from analytical procedures may reduce the extent to which the auditor needs to test details of balances.
A) True
B) False
Answer
Terms: Analytical procedures; Test details of balances
Diff: Easy
Objective: LO 16-1
AACSB: Reflective thinking skills

8) For sales, the completeness transaction-related audit objective affects the existence balance-related audit objective.
A) True
B) False
Answer
Terms: Completeness transaction-related audit objective; Existence balance-related audit objective
Diff: Moderate
Objective: LO 16-1
AACSB: Reflective thinking skills
9) For cash receipts, the occurrence transaction-related audit objective affects the completeness balance-related audit objective.
A) True
B) False
Answer
Terms: Cash receipts; Occurrence transaction-related audit objective; Completeness balance-related audit objective
Diff: Moderate
Objective: LO 16-1
AACSB: Reflective thinking skills

10) The accounts receivable balance-related audit objective net realizable value is not affected by assessed control risk for sales or cash receipts.
A) True
B) False
Answer
Terms: Accounts receivable balance-related audit objective net realizable value; Assessed control risk
Diff: Moderate
Objective: LO 16-1
AACSB: Reflective thinking skills

Learning Objective 16-2

1) Which of the following types of receivables would not deserve the special attention of the auditor?
A) Accounts receivables with credit balances.
B) Accounts that have been outstanding for a long time.
C) Receivables from related parties.
D) Each of the above would receive special attention.
Answer
Terms: Receivables; Special attention
Diff: Easy
Objective: LO 16-2
AACSB: Reflective thinking skills

2) Analytical procedures are substantive tests and, if the results of the analytical procedures are favorable, the auditor would normally:
A) reduce the extent of tests of details of balances.
B) reduce the extent of tests of controls.
C) reduce the tests of transactions.
D) reduce all of the other tests.
Answer
Terms: Analytical procedures; Substantive tests
Diff: Moderate
Objective: LO 16-2
AACSB: Reflective thinking skills
3) In performing your audit you noticed that often times goods are shipped that are not matched with the corresponding sales invoice. This control deficiency could cause:
A) understatement of revenues and overstatement of inventory.
B) overstatement of revenues and understatement of inventory.
C) understatement of revenues and inventory.
D) overstatement of revenues and inventory.
Answer
Terms: Control deficiency
Diff: Moderate
Objective: LO 16-2
AACSB: Reflective thinking skills

4) An auditor selects a sample of shipping documents in order to determine if the related sales invoices were prepared. This test would gather evidence concerning which audit objective?
A) Completeness
B) Detail tie-in
C) Occurrence
D) Realizable value
Answer
Terms: Evidence; Audit objected
Diff: Moderate
Objective: LO 16-2
AACSB: Analytic skills

5) The understatement of sales and accounts receivable is best uncovered by:
A) confirming receivables.
B) reviewing the aged trial balance.
C) test of transactions for shipments made but not recorded.
D) reconciling the accounts receivable general ledger account with the schedule of accounts receivable.
Answer
Terms: Understatement of sales and accounts receivable
Diff: Challenging
Objective: LO 16-2
AACSB: Analytic skills

6) An auditor learns that collections of accounts receivable during the first ten days of January were debited to cash and credited to accounts receivable as of December 31. The effect generally will be to:
A) overstate the current ratio with no effect on working capital at December 31.
B) overstate both working capital and the current ratio at December 31.
C) overstate working capital with no effect on the current ratio at December 31.
D) leave both working capital and the current ratio unchanged at December 31.
Answer
Terms: Collections of accounts receivable
Diff: Challenging
Objective: LO 16-2
AACSB: Analytic skills
7) Below are listed possible misstatements that could occur in the sales and collections cycle. Provide the analytical procedure that would be most useful in detecting the possible misstatement.

a. Overstatement of sales and accounts receivable
b. Uncollectible accounts receivable that have not been provided for
c. Overstatement of sales returns and allowances

1) The audit procedure of tracing sales invoices to shipping documents will provide the auditor evidence that:
A) billed sales were shipped.
B) shipments were recorded as receivables in the subsidiary ledger.
C) the accounts receivable master file and the accounts receivable subsidiary ledger reconcile.
D) goods shipped were billed to customers.
Answer
Terms: Tracing invoices; Evidence
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

2) Tests of which balance-related audit objective are normally performed first in an audit of the sales and collection?
A) Accuracy
B) Completeness
C) Rights
D) Detail tie-in
Answer
Terms: Tests of balance-related audit objective; Sales and collection
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills
3) A listing of the balances in the accounts receivable master file at the balance sheet date, by total balance outstanding and by the amount of time the component parts have been outstanding, is the:
A) customer list.
B) aged trial balance.
C) accounts receivable ledger.
D) schedule of accounts receivable.
Answer
Terms: Listing of balances in accounts receivable master file
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

4) Testing the information on the aged trial balance for detail tie-in is a necessary audit procedure, which would normally include:
A)
Test-footing the total column
and the columns depicting the
aging Comparing the total of the aged trial balance with the general ledger accounts receivable account
Yes Yes

B)
Test-footing the total column
and the columns depicting the
aging Comparing the total of the aged trial balance with the general ledger accounts receivable account
No No

C)
Test-footing the total column
and the columns depicting the
aging Comparing the total of the aged trial balance with the general ledger accounts receivable account
Yes No

D)
Test-footing the total column
and the columns depicting the
aging Comparing the total of the aged trial balance with the general ledger accounts receivable account
No Yes

Answer
Terms: Detail tie-in; Audit procedure
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills
5) Audit procedures designed to uncover credit sales made after the client’s fiscal year end that relate to the current year being audited provide evidence for which of the following audit objective?
A) realizable value
B) accuracy
C) cutoff
D) existence
Answer
Terms: Audit procedures to uncover credit sales
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

6) Cutoff misstatements occur when:
A)
The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks Subsequent period
transactions are
recorded in the
current period Current period
transactions are
recorded in the
subsequent period
Yes Yes No

B)
The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks Subsequent period
transactions are
recorded in the
current period Current period
transactions are
recorded in the
subsequent period
Yes No Yes

C)
The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks Subsequent period
transactions are
recorded in the
current period Current period
transactions are
recorded in the
subsequent period
No Yes Yes

D)
The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks Subsequent period
transactions are
recorded in the
current period Current period
transactions are
recorded in the
subsequent period
No Yes No

Answer
Terms: Cutoff misstatements
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

7) Cutoff misstatements occur:
A) either by error or fraud.
B) by error only.
C) by fraud only.
D) randomly without causes related to errors or fraud.
Answer
Terms: Cutoff misstatements
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

8) Which of the following is likely to be determined first when performing tests of details for accounts receivable?
A) Recorded accounts receivable exist.
B) Accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and agrees with the general ledger.
C) Accounts receivable are owned.
D) Existing accounts receivable are included.
Answer
Terms: Tests of details for accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

9) An auditor is performing a credit analysis of customers with balances over 60 days due. She is most likely obtaining evidence for which audit related objective?
A) realizable value
B) existence
C) completeness
D) occurrence
Answer
Terms: Audit-related objective
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

10) The most important test of details of balances to determine the existence of recorded accounts receivable is:
A) tracing details of sales invoices to shipping documents.
B) tracing the credits in accounts receivable to bank deposits.
C) tracing sales returns entries to credit memos issued and receiving room reports.
D) the confirmation of customers’ balances.
Answer
Terms: Test of details of balances; Existence of accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

11) Because of its central role in auditing of accounts receivable, which of the following would normally be one of the first items tested?
A) Accounts receivable master file
B) Customer file
C) Aged trial balance
D) Sales register
Answer
Terms: Central role in auditing accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

12) The correct accounting for accounts receivable accounts with credit balances, provided they are significant, would be:
A) written off.
B) moved to the debit side.
C) reclassified as accounts payable.
D) corrected by making adjusting entries.
Answer
Terms: Correct accounting for accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

13) Most tests of accounts receivable are based on what schedule, file, or listing?
A) Sales master file.
B) Aged accounts receivable trial balance.
C) Accounts receivable master file.
D) Accounts receivable general ledger account.
Answer
Terms: Tests of accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

14) If the client’s internal control for recording sales returns and allowances is evaluated as ineffective:
A) a larger sample may be needed to verify cutoff.
B) sampling is not appropriate.
C) all sales returns must be traced to supporting documentation.
D) all sales returns must be confirmed with the customer.
Answer
Terms: Internal control; Sales returns and allowances
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

15) A customer mails and records a check to a client for payment of an unpaid account on December 30. The client receives and records the amount on January 2. The records of the two organizations will be different on December 31. This represents:
A)
A cutoff misstatement A timing difference
Yes Yes

B)
A cutoff misstatement A timing difference
No No

C)
A cutoff misstatement A timing difference
Yes No

D)
A cutoff misstatement A timing difference
No Yes

Answer
Terms: Records will be different
Diff: Moderate
Objective: LO 16-3
AACSB: Analytic skills

16) Which of the following audit procedures would not likely detect a client’s decision to pledge or factor accounts receivable?
A) A review of the minutes of the board of directors’ meetings.
B) Discussions with the client.
C) Confirmation of receivables.
D) Examination of correspondence files.
Answer
Terms: Audit procedures; Pledge or factor accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

17) When do most companies record sales returns and allowances?
A) During the month in which the sale occurs.
B) During the accounting period in which the return occurs.
C) Whenever the customer contacts the company regarding the credit.
D) During the month after the sale occurs.
Answer
Terms: Record sales returns and allowances
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

18) Cutoff misstatements can occur for:
A)
Sales Sales returns and allowances
Yes Yes

B)
Sales Sales returns and allowances
No No

C)
Sales Sales returns and allowances
Yes No

D)
Sales Sales returns and allowances
No Yes

Answer
Terms: Cutoff misstatements
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

19) The most important aspect of evaluating the client’s method of obtaining a reliable cutoff is to:
A) perform extensive detailed testing of cutoff.
B) evaluate the client’s control procedures around cutoff.
C) confirm a sample of transactions near period end with customers.
D) confirm transaction with customers.
Answer
Terms: Reliable cutoff
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

20) Which of the following audit procedure would normally be included in the audit plan when auditing the allowance for doubtful accounts?
A) Send positive confirmations.
B) Inquire of the client’s credit manager.
C) Send negative confirmations.
D) Examine sales invoices.
Answer
Terms: Auditing allowance for doubtful accounts
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

21) Generally accepted accounting principles require that revenue be reported net of sales returns and allowances:
A) if practical.
B) if required by industry practice.
C) if the amounts are material.
D) any of the above.
Answer
Terms: Generally accepted accounting principles
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

22) For which of the following accounts is cutoff least important?
A) Sales
B) Sales returns and allowances
C) Cash collections
D) Inventory
Answer
Terms: Cutoff
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

23) Which of the following most likely would be detected by a review of a client’s sales cutoff?
A) Excessive sales discounts
B) Unrecorded sales for the year
C) Unauthorized goods returned for credit
D) Lapping of year-end accounts receivable
Answer
Terms: Sales cutoff
Diff: Moderate
Objective: LO 16-3
AACSB: Analytic skills

24) How might the auditor determine whether a client has limited rights to accounts receivable?
A)
Review minutes from board of directors meetings Inquiries of the client
Yes Yes

B)
Review minutes from board of directors meetings Inquiries of the client
No No

C)
Review minutes from board of directors meetings Inquiries of the client
Yes No

D)
Review minutes from board of directors meetings Inquiries of the client
No Yes

Answer
Terms: Limited rights to accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills
25) You are reviewing sales to discover cutoff problems. If the client’s policy is to record sales when title to the merchandise passes to the buyer, then the books and records would contain errors if the December 31 entries were for sales recorded:
A) before the merchandise was shipped.
B) at the time the merchandise was shipped.
C) several days subsequent to shipment.
D) at a time after the point at which title passed.
Answer
Terms: Cutoff problems
Diff: Challenging
Objective: LO 16-3
AACSB: Analytic skills

26) A procedure to test for a cash receipts cutoff error is:
A) reconciling the bank statement.
B) performing a four-column proof-of-cash.
C) observing the counting of cash at the balance sheet date.
D) tracing recorded cash receipts to bank deposits on the bank statement of a different period.
Answer
Terms: Test for cash receipts cutoff
Diff: Challenging
Objective: LO 16-3
AACSB: Reflective thinking skills

27) Auditors often use analytical procedures in gathering audit evidence. For example, an unexplained decrease in the amount of accounts receivable may indicate:
A) Sales were overstated.
B) Inventory purchases were curtailed.
C) Cost of Goods sold was overstated.
D) Accounts Receivables were sold.
Answer
Terms: Analytical procedures; Audit evidence
Diff: Challenging
Objective: LO 16-3
AACSB: Analytic skills

28) For effective internal control, employees maintaining the accounts receivable subsidiary ledger should not also approve:
A) employee overtime wages.
B) credit granted to customers.
C) write-offs of customer accounts.
D) cash disbursements.
Answer
Terms: Internal control; Accounts receivable
Diff: Challenging
Objective: LO 16-3
AACSB: Reflective thinking skills
29) For most audits, a proper cash receipts cutoff is less important than the sales cutoff because the improper cutoff of cash:
A) is detected and correct when cash is separately audited.
B) is unlikely to have a material impact on the balance sheet or the income statement.
C) affects items on the balance sheet but does not affect net income.
D) rarely occurs given the control consciousness of most entities.
Answer
Terms: Cash receipts cutoff; Sales cutoff
Diff: Challenging
Objective: LO 16-3
AACSB: Reflective thinking skills

30) You are auditing Rodgers and Company and have noticed that accounts receivables have increased from the previous year because of financial problems with its customers. Your likely first response would be to:
A) expand tests regarding account balance collectability.
B) increase the allowance for uncollectible accounts for the client.
C) communicate to the client that credit policy must be reviewed.
D) increase the sample size of past due accounts.
Answer
Terms: Increased accounts receivable
Diff: Challenging
Objective: LO 16-3
AACSB: Analytic skills

31) An auditor selects a sample from the file of shipping documents to determine whether invoices were prepared. This test is performed to satisfy the audit objective of:
A) accuracy.
B) existence.
C) control.
D) completeness.
Answer
Terms: Sample of shipping documents; Audit objective
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

32) When performing tests of controls and tests of transactions for sales, the auditor generally defines the population as:
A) all accounts receivable transactions for the year.
B) all sales invoices for the year.
C) all cash receipts transactions for the year.
D) all sales invoices less sales return credit memos.
Answer
Terms: Tests of controls and tests of transactions; Population
Diff: Challenging
Objective: LO 16-3
AACSB: Reflective thinking skills
33) Describe how the auditor tests the accuracy objective for accounts receivable.
Answeronfirmation of accounts selected from the trial balance is the most common test of details of balances for the accuracy of accounts receivable. When customers do not respond to confirmation requests, auditors examine supporting documents in the same way as described for the existence objective. Auditors perform tests of the debits and credits to individual customers’ balances by examining supporting documentation for shipments and cash receipts.
Terms: Auditors test the accuracy objective for accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

34) Cutoff misstatements can occur for sales, sales returns, and cash receipts. List below the threefold approach an auditor performs for each account above to determine the reasonableness of the cutoff.

35) Discuss the audit procedures performed when testing the detail tie-in objective for accounts receivable, and explain why this objective is ordinarily tested before any other objectives for accounts receivable.

36) Assuming the client’s internal controls are adequate, describe how the auditor can verify proper cutoff of sales transactions.
Answerssuming the client’s internal controls are adequate, the auditor can verify proper cutoff of sales transactions by obtaining the shipping document number for the last shipment made at the end of the period and comparing this number with current and subsequent period recorded sales.
Terms: Adequate internal controls; Cutoff of sales transactions
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills
37) Tests of detail tie-in are normally conducted last in the audit of the sales and collections cycle.
A) True
B) False
Answer
Terms: Tests of detail tie-in; Sales and collections cycle
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

38) The criterion used by most merchandising and manufacturing clients for determining when revenue recognition takes place is whether title to the goods has passed.
A) True
B) False
Answer
Terms: Revenue recognition
Diff: Easy
Objective: LO 16-3
AACSB: Reflective thinking skills

39) The balance-related audit objectives of realizable value and rights are not affected by assessed control risk.
A) True
B) False
Answer
Terms: Balance-related audit objectives; Realizable value and rights; Assessed control risk
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

40) Tests of the presentation and disclosure-related objectives are generally done as part of the completion phase of the audit.
A) True
B) False
Answer
Terms: Tests of presentation and disclosure-related objectives; Completion phase of audit
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

41) Confirmation of accounts receivable provide evidence related to the existence, accuracy and cutoff objectives.
A) True
B) False
Answer
Terms: Confirmation of accounts receivable; Existence, accuracy, and cutoff objectives
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills
42) Confirmation is the most common test of details of balances for the accuracy of accounts receivable.
A) True
B) False
Answer
Terms: Confirmation; Test of details of balances
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

43) Tests of the realizable value balance-related audit objective are for the purpose of evaluating the allowance for doubtful accounts.
A) True
B) False
Answer
Terms: Tests of realizable value balance-related audit objective
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

44) For most audits, a proper cash receipts cutoff is less important than either the sales or the sales returns and allowances cutoff.
A) True
B) False
Answer
Terms: Cash receipts cutoff; Sales or sales returns and allowances cutoff
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

Learning Objective 16-4

1) Which of the following is the principle “weakness” of using negative confirmations for your tests of details of balances for accounts receivable?
A) can only be used for large balance accounts
B) cannot not be used when account balances “bunch” around a mean value
C) conclusions drawn from receiving no reply may not be correct
D) response rates are generally too low to draw any conclusions
Answer
Terms: Negative confirmations; Tests of details of balances of accounts receivable
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills
2) Communication addressed to the debtor requesting him or her to confirm whether the balance as stated on the communication is correct or incorrect is a:
A) representation letter.
B) negative confirmation.
C) bank confirmation.
D) positive confirmation.
Answer
Terms: Confirm balance
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills

3) A type of positive confirmation known as a blank confirmation:
A) requests the recipient to fill in the amount of the balance.
B) is considered less reliable than the regular positive confirmation.
C) generates as high a response rate as the regular positive confirmation form.
D) is used when the auditor is confirming several small balances.
Answer
Terms: Positive confirmation; Blank confirmation
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills

4) The most effective audit evidence gathered for accounts receivable is the:
A) detail tie-in of the records.
B) analysis of the allowance for doubtful accounts.
C) confirmation of accounts receivable.
D) examination of sales invoices.
Answer
Terms: Accounts receivable audit evidence
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

5) The audit procedure that provides the auditor with the most appropriate evidence when performing test of details of balances for accounts receivable is:
A) confirmations.
B) recalculation of the aged receivables and uncollectible accounts.
C) tracing credit memos for returned merchandise to receiving room reports.
D) tracing from shipping documents to journals to the accounts receivable ledger.
Answer
Terms: Tests of balances for accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
6) When should auditors not perform alternative procedures in testing the accounts receivable balance?
A) When customers do not return positive confirmation requests.
B) When customers do not return negative confirmation requests.
C) When confirmations are deemed to be ineffective as an audit procedure.
D) When confirmations are too costly to use.
Answer
Terms: Alternative procedures in testing accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

7) A positive confirmation is more reliable evidence than a negative confirmation because:
A) fewer confirmations can be sent out.
B) the auditor has a document which can be used in court.
C) the debtor’s lack of response indicates agreement with the stated balance.
D) follow-up procedures are performed if a response is not received from the debtor.
Answer
Terms: Positive confirmation; Negative confirmation
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

8) When positive confirmations are used, auditing standards require follow-up procedures for confirmations not returned by the customer. Which of the following would not be considered an alternative procedure?
A) Send a second confirmation request.
B) Examine subsequent cash receipts to determine if the receivable has been paid.
C) Examine shipping documents to verify that the merchandise was shipped.
D) Examine customer’s purchase order and the duplicate sales invoice to determine that the merchandise was ordered.
Answer
Terms: Positive confirmations follow-up procedures
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

9) The positive (as opposed to the negative) form of receivables confirmation may be preferred when:
A) internal control surrounding accounts receivable is considered to be effective.
B) there is reason to believe that a substantial number of accounts may be in dispute.
C) a large number of small balances are involved.
D) there is reason to believe a significant portion of the requests will be made.
Answer
Terms: Positive confirmation
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
10) An auditor should perform alternative procedures to substantiate the existence of accounts receivable when:
A) no reply to a positive confirmation request is received.
B) no reply to a negative confirmation request is received.
C) collectability of the receivables is in doubt.
D) pledging of the receivables is probable.
Answer
Terms: Auditor perform alternative procedures to substantiate existence of accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

11) Confirmation of accounts receivable balances normally provides evidence concerning the:
A) valuation of the balances.
B) rights of the balances.
C) existence of the balances.
D) completeness of the balances.
Answer
Terms: Confirmation of accounts receivable balances
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

12) If the auditor decides not to confirm accounts receivable, the auditor should:
A) always use alternative procedures to audit the accounts receivable.
B) include copies of customer statements in the audit files.
C) document the reasons for such a decision in the audit files.
D) include copies of customer sales invoices in the audit files.
Answer
Terms: Confirm accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

13) The most reliable evidence from confirmations is obtained when they are sent:
A) as close to the balance sheet date as possible.
B) at various times throughout the year to different segments of the sample, so that the entire sample is representative of account balances scattered throughout the year.
C) several months before the year-end, so the auditor will have adequate time to perform alternate procedures if they are required.
D) at various times throughout the year to the same group in the sample, so that the sample will not have a time bias.
Answer
Terms: Reliable evidence from confirmations
Diff: Challenging
Objective: LO 16-4
AACSB: Reflective thinking skills
14) An auditor would be least likely to use confirmations in connection with the examination of:
A) inventories.
B) long-term debt.
C) property, plant, and equipment.
D) stockholders’ equity.
Answer
Terms: Confirmations
Diff: Challenging
Objective: LO 16-4
AACSB: Reflective thinking skills

15) Auditing standards require the confirmation of accounts receivable in normal circumstances. What are the three exceptions to this requirement?

16) Describe the differences between positive and negative confirmations. Which type is generally viewed as more reliable?

17) Discuss the alternative procedures an auditor can perform to test the existence objective for accounts receivable when customers do not respond to confirmation requests.

18) Discuss the advantages and disadvantages of using negative accounts receivable confirmations rather than positive confirmations.

19) Briefly describe the circumstances in which it is acceptable to use negative confirmation requests.

20) Describe each of the following types of confirmations:
• Positive confirmation
• Blank confirmation
• Invoice confirmation
• Negative confirmation

21) What are the major factors affecting sample size for confirming accounts receivable?

22) When an auditor uses negative confirmations, several factors must be considered. What are those factors?

23) Tests of details of balances must be designed for each balance-related audit objective.
A) True
B) False
Answer
Terms: Tests of details of balances; Balance-related audit objective
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills

24) Tests of details of balances focus on testing the year-end balances of balance sheet accounts.
A) True
B) False
Answer
Terms: Tests of details of balances
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

25) Accounts receivable need not be confirmed if they are immaterial to the financial statements.
A) True
B) False
Answer
Terms: Accounts receivable confirmed
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
26) Blank confirmations are considered less reliable than standard positive confirmations.
A) True
B) False
Answer
Terms: Blank confirmations; Standard positive confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

27) Negative confirmations are less expensive, and less reliable, than positive confirmations.
A) True
B) False
Answer
Terms: Negative confirmations; Positive confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

28) It is common to use a combination of positive and negative confirmations by sending the latter to accounts with large balances and the former to those with small balances.
A) True
B) False
Answer
Terms: Positive confirmations; Negative confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

29) If auditors consider confirmations of accounts receivable to be ineffective evidence because response rates will be very low, they need not confirm accounts receivable.
A) True
B) False
Answer
Terms: Confirmations of accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

30) The type of receivables confirmation is a major factor affecting sample size, with negative confirmations normally requiring a larger sample than positive confirmations.
A) True
B) False
Answer
Terms: Negative confirmations; Positive confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
31) When sending confirmations during most audits of accounts receivable, the emphasis is often on confirming larger and older accounts.
A) True
B) False
Answer
Terms: Confirmations of accounts receivable
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

32) When a customer disagrees with the amount shown on an account receivable confirmation, the auditor should not ask the client to reconcile the difference.
A) True
B) False
Answer
Terms: Accounts receivable confirmation
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

33) Auditors must maintain control of confirmations until they are returned from the customer.
A) True
B) False
Answer
Terms: Control of confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

34) When a customer does not return an accounts receivable confirmation, it is acceptable, without performing alternative procedures, to assume the amount is 100% overstated when generalizing from the sample to the population.
A) True
B) False
Answer
Terms: Alternative procedures; Accounts receivable confirmation
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

Learning Objective 16-5

1) Match seven of the terms (a-k) with the definitions provided below (1-7):

a. Accounts receivable balance-related audit objectives
b. Aged trial balance
c. Alternative procedures
d. Blank confirmation form
e. Cutoff misstatements
f. Evidence planning worksheet
g. Negative confirmation
h. Positive confirmation
i. Realizable value of accounts receivable
j. Timing difference in an account receivable confirmation
k. Invoice confirmation

________ 1. The follow-up of a positive confirmation not returned by the debtor with the use of documentation evidence to determine whether the recorded receivable exists and is collectible.

________ 2. A letter, addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect and, if incorrect, by what amount.

________ 3. Misstatements that take place as a result of current period transactions being recorded in a subsequent period, or subsequent period transactions being recorded in the current period.

________ 4. A form used to help the auditor decide whether planned detection risk for tests of details of balances should be low, medium, or high for each balance-related audit objective.

________ 5. A letter, addressed to the debtor, requesting a response only if the recipient disagrees with the amount of the stated account balance.

________ 6. A reported difference in a confirmation from a debtor that is determined to be a timing difference between the client’s and debtor’s records and therefore not a misstatement.

________ 7. A listing of the balances in the accounts receivable master file at the balance sheet date broken down according to the amount of time that has passed between the date of sale and the balance sheet date.

Auditing and Assurance Services, 14e (Arens)
Chapter 17 Audit Sampling for Tests of Details and Balances

Learning Objective 17-1

1) Both sampling and nonsampling risks are associated with:
A)
Tests of controls. Substantive tests of transactions.
Yes Yes

B)
Tests of controls. Substantive tests of transactions.
No No

C)
Tests of controls. Substantive tests of transactions.
Yes No

D)
Tests of controls. Substantive tests of transactions.
No Yes

Answer
Terms: Sampling and nonsampling risks
Diff: Easy
Objective: LO 17-1
AACSB: Reflective thinking skills

2) Tests for rates of occurrence are appropriately used in all but which of the following situations?
A)
Testing of internal
controls Substantive testing of transactions Substantive testing of
details of balances
Yes Yes Yes

B)
Testing of internal
controls Substantive testing of transactions Substantive testing of
details of balances
No Yes Yes

C)
Testing of internal
controls Substantive testing of transactions Substantive testing of
details of balances
Yes Yes No

D)
Testing of internal
controls Substantive testing of transactions Substantive testing of
details of balances
No No Yes

Answer
Terms: Tests for rates of occurrence
Diff: Easy
Objective: LO 17-1
AACSB: Reflective thinking skills
3) The most important difference among tests of controls, substantive tests of transactions, and tests of details of balances lies in what the auditor wants to measure. Explain what each type of test attempts to measure.

Learning Objective 17-2

1) When selecting a sample size for substantive tests of balances which factor, other factors being equal, would result in a larger sample?
A) smaller tolerable misstatement
B) small expected misstatements
C) greater tolerable misstatement
D) greater expected misstatement
Answer
Terms: Selecting sample size for substantive tests of balance
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

2) The auditors principal objective when using a sample of tests of details of balances is whether the:
A) account balance being audited is fairly stated.
B) transactions being audited are free of misstatements.
C) controls being tested are operating effectively.
D) transactions and account balances being audited are fairly stated.
Answer
Terms: Principal objective when using sample of tests of details of balances
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

3) What is the purpose of applying stratified sampling to a population?
A)
To avoid items that may
contain misstatements To emphasize certain items
and deemphasize others
Yes Yes

B)
To avoid items that may
contain misstatements To emphasize certain items
and deemphasize others
No No

C)
To avoid items that may
contain misstatements To emphasize certain items
and deemphasize others
Yes No

D)
To avoid items that may
contain misstatements To emphasize certain items
and deemphasize others
No Yes

Answer
Terms: Purpose of stratified sampling of populations
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

4) If an auditor desires a greater level of assurance in auditing a balance, the acceptable risk of incorrect acceptance:
A) is reduced.
B) is increased.
C) is not changed.
D) may be reduced or increased depending upon other circumstances.
Answer
Terms: Greater level of assurance; Acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

5) In estimating the population misstatement, the first step in projecting from the sample to the population is to:
A) make a point estimate.
B) revise the upper error bound.
C) calculate the precision interval.
D) determine the population mean.
Answer
Terms: Estimating population misstatement; First step in projecting sample to population
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
6) Tolerable misstatement is used to:
A)
Determine sample size Select the sample. Evaluate results.
Yes Yes No

B)
Determine sample size Select the sample. Evaluate results.
No Yes No

C)
Determine sample size Select the sample. Evaluate results.
No No Yes

D)
Determine sample size Select the sample. Evaluate results.
Yes No Yes

Answer
Terms: Tolerable misstatement
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

7) The word below that best explains the relationship between required sample size and the acceptable risk of incorrect acceptance is:
A) inverse.
B) direct.
C) proportional.
D) indeterminate.
Answer
Terms: Relationship between required sample size and acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

8) The final step in the evaluation of the audit results is the decision to:
A) accept the population as fairly stated or to require further action.
B) determine sampling error and calculate the estimated total population error.
C) project the point estimate.
D) determine the error in each sample.
Answer
Terms: Final step in evaluation of audit results
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
9) Which of the following does not have to be considered in determining the initial sample size of a test of details?
A) tolerable misstatement
B) acceptable risk of incorrect rejection
C) estimate of misstatements in the population
D) acceptable audit risk
Answer
Terms: Not considered in determining initial sample size of test of details
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

10) If an auditor concludes that internal controls are likely to be effective, the preliminary assessment of control risk can be reduced, leading to which of the following impacts on the acceptable risk of incorrect acceptance?
A) reduction in
B) increase in
C) elimination of
D) increase or decrease
Answer
Terms: Auditor concludes internal controls are effective; Reduction of preliminary assessment of control risk; Impact on acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

11) If acceptable audit risk is increased, acceptable risk of incorrect acceptance should be:
A) increased.
B) reduced.
C) unaffected.
D) modified.
Answer
Terms: Acceptable audit risk is increased, acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

12) You are auditing Raji and Company. You discover an item of inventory with an audited value of $5,000 with a recorded amount of $3,000. If this is the only error you discover the projected misstatement for the sample would be:
A) $5,000
B) $2,000
C) $3,000
D) $4,000
Answer
Terms: Projected misstatement for sample for audited value and recorded amount
Diff: Moderate
Objective: LO 17-2
AACSB: Analytic skills
13) The acceptable risk of incorrect acceptance is most related to:
A) audit efficiency.
B) audit results.
C) audit effectiveness.
D) audit estimation.
Answer
Terms: Acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

14) In monetary-unit sampling, the relationship between tolerable misstatement size and required sample size is:
A) direct.
B) inverse.
C) varied.
D) indeterminable.
Answer
Terms: Monetary-unit sampling; Relationship between tolerable misstatement size and required sample size
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

15) The risk the auditor is willing to take of accepting a balance as correct when the true misstatement in the balance under audit is greater than the tolerable misstatement is:
A) the upper bound.
B) the tolerable risk.
C) the acceptable risk of incorrect acceptance.
D) the lower bound.
Answer
Terms: Risk auditor is willing to take of accepting a balance as correct when the true misstatement in the balance under audit is greater than the tolerable misstatement
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

16) As the amount of misstatements expected in the population approaches tolerable misstatement, the planned sample size will:
A) decrease.
B) increase.
C) vary based on characteristics of the population.
D) be unaffected.
Answer
Terms: Effect on planned sample size of amount of misstatements expected in population approached tolerable misstatement
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
17) An auditor using nonstatistical sampling cannot formally measure sampling error and therefore must subjectively consider the possibility that the true population misstatement exceeds a tolerable amount. Which of the following factors should be considered by the auditor in making this assessment?
A)
The dollar difference between the point estimate and tolerable misstatement. The extent to which items in the population have been audited 100 percent.
Yes Yes

B)
The dollar difference between the point estimate and tolerable misstatement. The extent to which items in the population have been audited 100 percent.
No No

C)
The dollar difference between the point estimate and tolerable misstatement. The extent to which items in the population have been audited 100 percent.
Yes No

D)
The dollar difference between the point estimate and tolerable misstatement. The extent to which items in the population have been audited 100 percent.
No Yes

Answer
Terms: Nonstatistical sampling; Auditor subjectively consider possibility of true population misstatements
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

18) The appropriate assumption to make regarding the overall percent of error in those population items containing an error is:
A) determined using random number tables.
B) set after a quantitative analysis of client’s internal control system.
C) based on the auditor’s personal judgment in the circumstances.
D) based on statistical analysis using confidence limits.
Answer
Terms: Assumption made regarding overall percent of error in population
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

19) When errors are found in a sample, auditors in practice generally make the assumption:
A) of a 100% assumption for all errors.
B) that the population errors are larger than the sample errors.
C) that the population errors are smaller than the sample errors.
D) that the actual sample errors are representative of the population errors.
Answer
Terms: Errors found in sample assumption
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
20) Which of the following does not need to be considered when the auditor generalizes from the sample to the population?
A)
Acceptable risk of incorrect acceptance. Acceptable risk of incorrect rejection.
Yes Yes

B)
Acceptable risk of incorrect acceptance. Acceptable risk of incorrect rejection.
No No

C)
Acceptable risk of incorrect acceptance. Acceptable risk of incorrect rejection.
Yes No

D)
Acceptable risk of incorrect acceptance. Acceptable risk of incorrect rejection.
No Yes

Answer
Terms: Not considered when auditor generalizes from sample to populations
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

21) The client’s trial balance has a balance of $410,000 for merchandise inventory. As the auditor you are willing to accept a balance that is within $20,000 of either side of the recorded balance. You compute a 95% confidence interval of $395,000 to $425,000. You could therefore:
A) reject the trial balance amount.
B) accept the trial balance amount.
C) increase the sample size to assure more precision.
D) use alternative audit procedures to satisfy yourself as to the correct balance.
Answer
Terms: Confidence interval decisions
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

22) While performing a substantive test of details during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was not materially misstated. It was, in fact, materially misstated. This situation illustrates the risk of:
A) incorrect rejection.
B) incorrect acceptance.
C) assessing control risk too low.
D) assessing control risk too high.
Answer
Terms: Substantive test of details; Sample results support conclusion that recorded account balance was not materially misstated which it was materially misstated
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
23) While performing a substantive test of details during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was materially misstated. Which of the following is the least likely auditor reaction to this discovery?
A) Perform expanded audit tests in the relevant areas
B) Increase detection risk in the relevant areas
C) Increase the sample size
D) Take no action until tests of other audit areas are completed
Answer
Terms: Performing substantive test of details; Sample results support conclusion that account balance was materially misstated; Auditor reaction
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

24) When selecting a stratified sample, the sample size is:
A) determined for the unstratified population and then apportioned to each stratum.
B) determined for each stratum and selected from that stratum.
C) determined for each stratum and selected randomly from the entire unstratified population.
D) always larger than if unstratified sampling had been used.
Answer
Terms: Sample size for stratified sample
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

25) An auditor using nonstatistical sampling cannot:
A)
determine a point estimate for the population. mathematically measure the precision of the point estimate.
Yes Yes

B)
determine a point estimate for the population. mathematically measure the precision of the point estimate.
No No

C)
determine a point estimate for the population. mathematically measure the precision of the point estimate.
Yes No

D)
determine a point estimate for the population. mathematically measure the precision of the point estimate.
No Yes

Answer
Terms: Auditor using nonstatistical sampling
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills
26) What is the primary objective of using stratified sampling in auditing?
A) To increase the confidence level at which a decision will be reached from the results of the sample selected.
B) To determine the occurrence rate for a given characteristic in the population being studied.
C) To decrease the effect of variance in the total population.
D) To determine the precision range of the sample selected.
Answer
Terms: Primary objective of using stratified sampling in auditing
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills
27) In the application of statistical techniques to the estimation of dollar amounts, a preliminary sample is usually taken primarily for the purpose of estimating the population:
A) mode.
B) range.
C) median.
D) variability.
Answer
Terms: Application of statistical techniques to estimation of dollar amounts; Preliminary sample
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
The following information applies to the questions below:

An audit partner is developing an office-training program to familiarize his professional staff with statistical decision models applicable to the audit of dollar-value balances. He wishes to demonstrate the relationship of sample sizes to population size and variability and the auditor’s specifications as to precision and confidence level. The partner prepared the following table to show comparative population characteristics and audit specifications of two populations.

Characteristics of
population 1 relative
to population 2 Audit specifications of a sample from population 1 relative to a sample from population 2
Size Variability Specified precision Specified confidence level
Case 1 Equal Equal Equal Higher
Case 2 Equal Larger Tighter Equal
Case 3 Larger Equal Tighter Lower
Case 4 Smaller Smaller Equal Lower
Case 5 Larger Equal Equal Higher

28) Based on the information presented above, you are to indicate for the specified case from the table the required sample size to be selected from population 1 relative to the sample from population 2. In case 1, the required sample from population 1 is:
A) larger than the required sample size from population 2.
B) equal to the required sample size from population 2.
C) smaller than the required sample size from population 2.
D) indeterminate relative to the required sample size from population 2.
Answer
Terms: Sample sizes
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

29) Based on the information presented above, you are to indicate for the specified case from the table the required sample size to be selected from population 1 relative to the sample from population 2. In case 2, the required sample from population 1 is:
A) larger than the required sample size from population 2.
B) equal to the required sample size from population 2.
C) smaller than the required sample size from population 2.
D) indeterminate relative to the required sample size from population 2.
Answer
Terms: Sample sizes
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills
30) Based on the information presented above, you are to indicate for the specified case from the table the required sample size to be selected from population 1 relative to the sample from population 2. In case 3, the required sample from population 1 is:
A) larger than the required sample size from population 2.
B) equal to the required sample size from population 2.
C) smaller than the required sample size from population 2.
D) indeterminate relative to the required sample size from population 2.
Answer
Terms: Sample sizes
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

31) Based on the information presented above, you are to indicate for the specified case from the table the required sample size to be selected from population 1 relative to the sample from population 2. In case 4, the required sample from population 1 is:
A) larger than the required sample size from population 2.
B) equal to the required sample size from population 2.
C) smaller than the required sample size from population 2.
D) indeterminate relative to the required sample size from population 2.
Answer
Terms: Sample sizes
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

32) Based on the information presented above, you are to indicate for the specified case from the table the required sample size to be selected from population 1 relative to the sample from population 2. In case 5, the required sample from population 1 is:
A) larger than the required sample size from population 2.
B) equal to the required sample size from population 2.
C) smaller than the required sample size from population 2.
D) indeterminate relative to the required sample size from population 2.
Answer
Terms: Sample sizes
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills
33) There are 14 steps to audit sampling for details of balances, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss each of the steps included in the “evaluate the results” section for nonstatistical sampling.

34) Consider the steps in sampling for tests of details and for tests of controls. Explain the differences in applying sampling to these two types of tests.

35) Identify each of the seven factors that influence sample size for nonstatistical tests of details of balances, and state whether each factor is directly or inversely related to sample size.

36) There are 14 steps to audit sampling for details of balances, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss 5 of the 9 steps included in the “plan the sample” section for nonstatistical sampling.

37) When using nonstatistical sampling, the auditor must subjectively consider whether the true population misstatement exceeds a tolerable amount. This is done by considering five factors. One factor is the difference between the point estimate and tolerable misstatement. State the other four factors the auditor must consider.

38) Discuss each of the six possible courses of action the auditor can take when he or she has concluded that the population is misstated by more than a tolerable amount.

39) The primary factor affecting the auditor’s acceptable risk of incorrect acceptance is assessed as inherent risk when quantifying audit risk.
A) True
B) False
Answer
Terms: Factor affecting acceptable risk of incorrect acceptance
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

40) In evaluating sample results for tests of details, auditors must evaluate exceptions identified by the performance of audit procedures.
A) True
B) False
Answer
Terms: Evaluating sample results
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

41) Acceptable risk of incorrect acceptance is directly affected by acceptable audit risk.
A) True
B) False
Answer
Terms: Acceptable risk of incorrect acceptance and acceptable audit risk
Diff: Easy
Objective: LO 17-2
AACSB: Reflective thinking skills

42) Tolerable misstatement is inversely related to sample size.
A) True
B) False
Answer
Terms: Tolerable misstatements related to sample size
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

43) Acceptable risk of incorrect acceptance (ARIA) and sample size are inversely related; that is, as ARIA increases, sample size decreases.
A) True
B) False
Answer
Terms: Relation of acceptable risk of incorrect acceptance and sample size
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

44) Estimated misstatement in the population and sample size are inversely related; that is, as estimated misstatement increases, sample size decreases.
A) True
B) False
Answer
Terms: Relation of estimated misstatement in the population and sample size
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

45) The purpose of stratification is to permit auditors to emphasize certain aspects of a population and deemphasize others.
A) True
B) False
Answer
Terms: Purpose of stratification
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

46) An auditor using nonstatistical sampling cannot formally measure sampling error.
A) True
B) False
Answer
Terms: Nonstatistical sampling
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

47) Attributes sampling tables can be used to evaluate results of tests of details with Acceptable risk of assessing control risk too low (ARACR) being replaced with acceptable risk of incorrect acceptance (ARIA).
A) True
B) False
Answer
Terms: Attributes sampling tables; Acceptable risk of assessing control risk too low; Acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

48) When using nonstatistical sampling, the larger the sample size, the greater the auditor’s confidence that the point estimate is close to the true population value.
A) True
B) False
Answer
Terms: Nonstatistical sampling
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

49) Required sample size increases as the auditor’s tolerable misstatement for an account balance or class of transactions decreases.
A) True
B) False
Answer
Terms: Required sample size and tolerable misstatement
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills
50) The primary factor affecting the auditor’s decision about acceptable risk of incorrect acceptance (ARIA) is assessed inherent risk.
A) True
B) False
Answer
Terms: Acceptable risk of incorrect acceptance
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

51) The purpose of stratified sampling is to achieve a greater confidence level (lower risk of incorrect acceptance) for a given sample size.
A) True
B) False
Answer
Terms: Stratified sampling; Confidence level and sample size
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

52) Acceptable risk of assessing control risk too low (ARACR) and acceptable risk of incorrect acceptance (ARIA) are inversely related; that is, a decrease in ARACR is accompanied by an increase in ARIA.
A) True
B) False
Answer
Terms: Acceptable risk of assessing control risk too low and acceptable risk of incorrect acceptance
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

53) Acceptable audit risk (AAR) and acceptable risk of incorrect acceptance (ARIA) are inversely related; that is, as AAR increases, ARIA decreases.
A) True
B) False
Answer
Terms: Acceptable audit risk and acceptable risk of incorrect acceptance
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

54) Acceptable risk of incorrect acceptance (ARIA) is directly related to the computed precision interval in difference estimation; that is, as ARIA increases, the computed precision interval decreases.
A) True
B) False
Answer
Terms: Acceptable risk of incorrect acceptance; Computed precision interval
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

Learning Objective 17-3

1) Sampling used for tests of details of balances provides results in terms of:
A) exception rates.
B) percentages.
C) dollars.
D) expectation rates.
Answer
Terms: Sampling used for tests of details of balances
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

2) In monetary unit sampling, a sampling interval of 900 means that:
A) every 900th item will be selected.
B) every 900th dollar in the account will be sampled.
C) expected misstatement is 900.
D) tolerable misstatement is 900.
Answer
Terms: Monetary unit sampling; Sampling interval
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

3) Monetary-unit sampling is not particularly effective at detecting:
A) overstatements.
B) understatements.
C) errors in current assets.
D) errors in noncurrent assets.
Answer
Terms: Monetary unit sampling not effective at detecting
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

4) The auditor must consider the possibility that the true population misstatement is greater than the amount of misstatement that is tolerable when the auditor is performing:
A)
Nonstatistical sampling. Monetary-unit sampling.
Yes Yes

B)
Nonstatistical sampling. Monetary-unit sampling.
No No

C)
Nonstatistical sampling. Monetary-unit sampling.
Yes No

D)
Nonstatistical sampling. Monetary-unit sampling.
No Yes

Answer
Terms: Auditor must consider the possibility that the true population misstatement is greater than the amount of misstatement that is tolerable
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

5) The most commonly used method of statistical sampling for tests of details of balances is:
A) attributes sampling.
B) systematic sampling.
C) discovery sampling.
D) monetary-unit sampling.
Answer
Terms: Most commonly used method of statistical sampling for details of balances
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

6) When using monetary-unit sampling, the recorded dollar population is a definition of all the items in the:
A) population.
B) population which the auditor has included in the sample.
C) population which contain errors.
D) sample which contain errors.
Answer
Terms: Monetary-unit sampling; Recorded dollar population
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

7) Your audit sampling program states: the upper misstatement limit is $13,200 and the risk of incorrect acceptance is at the 95% confidence level. This means:
A) there is a 95% chance the actual misstatement is greater than $13,200.
B) there is a 5% chance the actual misstatement is less than $13,200.
C) there is a 95% chance the actual misstatement is less than $13.200.
D) there is a 5% chance the actual misstatement is greater than $13,200.
Answer
Terms: Upper misstatement limit; risk of incorrect acceptance; confidence level
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

8) An accounts receivable population contains a total of four customers. The accounts, the amounts, and the cumulative total are shown below. Monetary-unit sampling is to be used.
Account
Name Recorded
Amount Cumulative
Total
Blue $ 357 $ 357
Brown 281 638
Gray 60 698
Green 574 1,272

Based on the information above, the population size is:
A) 4.
B) 574.
C) 1,272.
D) $2,684.
Answer
Terms: Using monetary-unit sampling, population is
Diff: Moderate
Objective: LO 17-3
AACSB: Analytic skills

9) An auditor uses monetary unit sampling with a sampling interval of $20,000 and detects an item with a recorded amount of $10,000 with an audited value of $4,000. The projected misstatement of the sample is:
A) $12,000.
B) $6,000.
C) $10,000.
D) $3,000.
Answer
Terms: Monetary unit sampling projected misstatement of the sample
Diff: Moderate
Objective: LO 17-3
AACSB: Analytic skills

10) The auditor must deal with layers of the computed upper deviation rate from the attributes table because there are different error assumptions for each error. Assume a sample of 100 had found one error, and the computed upper deviation rate is shown in the following table:

Number
of Errors Upper Precision
Limit from Table
0 .023
1 .038

The precision limit for the layer with one error is:
A) 2.3%.
B) 3.8%
C) 6.1%.
D) 1.5%.
Answer
Terms: Computed upper deviation from the attributes table; Precision limit with one error
Diff: Moderate
Objective: LO 17-3
AACSB: Analytic skills

11) Which balance-related audit objective cannot be assessed using monetary unit sampling?
A) Accuracy
B) Completeness
C) Existence
D) All of the above can be assessed using monetary unit sampling.
Answer
Terms: Balance-related audit objective that cannot be assessed using monetary unit sampling
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

12) PPS samples can be obtained in an efficient manner using all but which of the following?
A) hand selection by the auditor
B) computer software
C) random number tables
D) systematic sampling techniques
Answer
Terms: PPS samples obtained
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

13) Which of the following items is not needed to apply MUS?
A)
A point estimate for misstatements. A sample size. An estimated error rate.
No Yes No

B)
A point estimate for misstatements. A sample size. An estimated error rate.
Yes No Yes

C)
A point estimate for misstatements. A sample size. An estimated error rate.
No Yes Yes

D)
A point estimate for misstatements. A sample size. An estimated error rate.
Yes No No

Answer
Terms: Items not needed to apply MUS
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

14) In monetary-unit sampling, the values of the estimated likely maximum misstatements are referred to as the:
A) point estimates.
B) precision intervals.
C) confidence intervals.
D) misstatement bounds.
Answer
Terms: Maximum misstatements in monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

15) When using monetary-unit sampling, evaluating the likelihood of unrecorded items in the population is:
A) unnecessary.
B) impossible.
C) possible but difficult.
D) an automatic outcome of the process.
Answer
Terms: Likelihood of unrecorded items in population in monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

16) The statistical methods used to evaluate monetary-unit samples:
A) neither exclude nor include units twice.
B) may permit the inclusion of a unit in the sample more than once.
C) do not permit a unit to be included in the sample more than once.
D) ignore the possibility that a unit may be included in a sample more than once.
Answer
Terms: Statistical methods used to evaluate monetary-unit samples
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

17) Which of the following is not a problem with monetary-unit selection?
A) Population items with a zero recorded balance.
B) Population items that should have a zero balance but do not.
C) Accounts with negative balances.
D) Accounts with small recorded balances that are significantly understated.
Answer
Terms: Not a problem with monetary-unit selection
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

18) There are many kinds of statistical estimates that an auditor may find useful, but basically every accounting estimate is either of a quantity or of an error rate. The statistical terms that roughly correspond to “quantities” and “error rate,” respectively, are:
A) attributes and variables.
B) variables and attributes.
C) constants and attributes.
D) constants and variables.
Answer
Terms: Statistical estimates
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

19) Which of the following is not a disadvantage of monetary-unit-sampling?
A) It may be difficult to select samples from large population without computer assistance.
B) The total misstatement bounds resulting when misstatements are found may be too low to be useful to the auditor.
C) The total misstatement bounds resulting when misstatements are found may be too high to be useful to the auditor.
D) Each of the above is a disadvantage.
Answer
Terms: Disadvantage of monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

20) Calculating the sample size using monetary-unit-sampling depends on which of the following factors?
A)
assumptions of the average percent of misstatement
for population items that contain misstatements recorded population value
Yes Yes

B)
assumptions of the average percent of misstatement
for population items that contain misstatements recorded population value
No No

C)
assumptions of the average percent of misstatement
for population items that contain misstatements recorded population value
Yes No

D)
assumptions of the average percent of misstatement
for population items that contain misstatements recorded population value
No Yes

Answer
Terms: Sample size and monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

21) Using statistical sampling to assist in verifying the year-end accounts payable balance, an auditor has accumulated the following data:

Number of
accounts Book
balance Balance
determined by
the auditor
Population: 4,000 $5,000,000 ?
Sample: 200 $250,000 $300,000

Projecting the misstatement to the population, the auditor’s estimate of year-end accounts payable balance would be:
A) $5,050,000.
B) $5,125,000.
C) $6,000,000.
D) $6,150,000.
Answer
Terms: Using statistical sampling project the misstatement to the population
Diff: Challenging
Objective: LO 17-3
AACSB: Analytic skills
22) Why do auditors find MUS appealing?
A) MUS increases the likelihood of selecting a balance of high and low dollar items.
B) MUS is easy to use in the audit environment.
C) MUS provides a nonstatistical, rather than a statistical, conclusion.
D) When misstatements are found, MUS rarely produces bounds in excess of materiality.
Answer
Terms: MUS appeal to auditors
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

23) Explain the decision rule used in monetary-unit sampling to determine whether the population value (account balance) is acceptable.

24) Explain why monetary-unit sampling, or probability proportional to size sampling, is not useful for detecting understatements.

25) Discuss the advantages and disadvantages of monetary-unit sampling over other sampling methods.
Answerdvantages of monetary-unit sampling:
• It automatically increases the likelihood of selecting high dollar items from the population being audited.
• It frequently reduces the cost of doing the audit testing because several sample items are tested at once.
• It is appealing to auditors because of its ease of application.
• It provides a statistical conclusion rather than a nonstatistical one, which aids auditors in making better and more defensible conclusions.

Disadvantages of monetary-unit sampling:
• The total misstatement bounds resulting when exceptions are found may be too high to be useful to the auditor.
• It is cumbersome to select probability proportional to size samples from large populations without computer assistance.
Terms: Advantages and disadvantages of monetary-unit sampling
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

26) How might auditors include negative balances when using monetary-unit sampling to evaluate a population?

27) There are seven steps to calculate adjusted misstatement bounds when both overstatement and understatement errors are discovered in monetary-unit sampling. Step one is “Determine misstatement for each sample item, keeping overstatements and understatements separate.” Discuss three of the remaining six steps.

28) The two primary types of sampling methods used for calculating dollar misstatements are attribute sampling and monetary unit sampling.
A) True
B) False
Answer
Terms: Primary types of sampling methods for calculating dollar misstatements
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

29) In monetary-unit sampling, the likelihood of high dollar items from the population being included in the sample is lower than the likelihood for small dollar items.
A) True
B) False
Answer
Terms: Monetary-unit sampling
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

30) When auditors apply MUS to a sample, the sample is selected using random sampling techniques.
A) True
B) False
Answer
Terms: MUS applied to a sample; Random sampling techniques
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

31) The use of monetary-unit sampling is most appropriate when the auditor expects to find many errors and when a monetary result is desired.
A) True
B) False
Answer
Terms: Monetary-unit sampling most appropriate
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

32) Overstatement and understatement amounts are dealt with separately and then combined when generalizing from the sample to the population when applying monetary unit sampling (MUS).
A) True
B) False
Answer
Terms: Monetary unit sampling; Overstatement and understatement amounts
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

33) Accounts with zero or negative year-end balances have no chance of being included in a standard probability proportional to size (PPS) sample.
A) True
B) False
Answer
Terms: Standard probability proportionate to size (PPS) sample
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

34) The statistical results when Monetary-Unit Sampling (MUS) is used are called exception bounds.
A) True
B) False
Answer
Terms: Monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

Learning Objective 17-4

1) You are auditing Nelson and Company and determined that the sample results support a conclusion that the account is materially misstated, when in fact it was not misstated. This illustrates the risk of:
A) incorrect acceptance.
B) incorrect rejection.
C) control risk too low.
D) control risk too high.
Answer
Terms: Sample results support conclusion that account is materially misstated, when in
Diff: Easy
Objective: LO 17-4
AACSB: Reflective thinking skills

2) The method used to measure the estimated total error amount in a population when there is both a recorded value and an audited value for each item in the sample is:
A) difference estimation.
B) mean-per-unit estimation.
C) ratio estimation.
D) monetary-unit sampling.
Answer
Terms: Method used to measure estimated total error amount in a population
Diff: Moderate
Objective: LO 17-4
AACSB: Reflective thinking skills

3) The auditor is concerned with the audited value rather than the error amount of each item in the sample when using:
A) difference estimation.
B) mean-per-unit estimation.
C) ratio estimation.
D) monetary-unit sampling.
Answer
Terms: Auditor concerned with audited value rather than error amount of each item
Diff: Moderate
Objective: LO 17-4
AACSB: Reflective thinking skills

4) Acceptable risk of incorrect rejection affects auditors’ action only when they conclude that a population is:
A) fairly stated.
B) acceptable.
C) materially misstated.
D) acceptable after certain adjustments.
Answer
Terms: Acceptable risk of incorrect rejection
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

5) If the auditor believes that there will be more than just a few exceptions discovered, and desires an accurate estimate of the dollar value of the exceptions, he or she will use:
A) attributes sampling.
B) monetary-unit sampling.
C) block sampling.
D) variables sampling.
Answer
Terms: Auditor desires accurate estimate of dollar value of exceptions and believes more than just a few exceptions will be discovered
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

6) The risk of incorrect rejection is important only when there is a ________ cost to increasing the sample size.
A) high
B) low
C) moderate
D) marginal
Answer
Terms: Risk of incorrect rejection
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

7) Stratified sampling is applicable to difference, mean-per-unit, and ratio estimation, but it is most commonly used with:
A) ratio estimation.
B) discovery sampling.
C) difference estimation.
D) mean-per-unit estimation.
Answer
Terms: Stratified sampling; Difference, mean-per-unit, and ratio estimation
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

8) Which of the following sampling plans would be designed to estimate a numerical measurement of a population, such as a dollar value?
A) Numerical sampling.
B) Discovery sampling.
C) Attributes sampling.
D) Variable sampling.
Answer
Terms: Sampling plan designed to estimate a numerical measurement of population
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

9) Use of the ratio estimation sampling technique to estimated dollar amounts is inappropriate when:
A) the total book value is known and corresponds to the sum of all the individual book values.
B) a book value for each sample item is unknown.
C) there are some observed differences between audited values and book values.
D) the audited values are nearly proportional to the book values.
Answer
Terms: Ratio estimation sampling techniques
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills

10) The major reason that the difference and ratio estimation methods would be expected to produce audit efficiency is that the:
A) beta risk may be completely ignored.
B) variability of the populations of differences or ratios is less than that of the populations of book values or audited values.
C) number of members of the populations of differences or ratios is smaller than the number of members of the population of book values.
D) calculations required in using difference or ratio estimation are less arduous and fewer than those required when using direct estimation.
Answer
Terms: Reason difference and ratio estimation are expected to produce audit efficiency
Diff: Challenging
Objective: LO 17-4
AACSB: Reflective thinking skills
11) Which of the following is not a type of statistical method that provides results in dollar terms?
A) Variables sampling
B) Attributes sampling
C) Monetary-unit sampling
D) Sampling with probability proportional to size
Answer
Terms: Not a type of statistical method that provides results in dollar terms
Diff: Easy
Objective: LO 17-3 and LO 17-4
AACSB: Reflective thinking skills

12) The confidence limits in variables sampling are similar to the monetary-unit sampling’s:
A) point estimate.
B) misstatement bounds.
C) standard deviation.
D) standard error of the mean.
Answer
Terms: Confidence limits in variable sampling similar to monetary-unit sampling
Diff: Moderate
Objective: LO 17-3 and LO 17-4
AACSB: Reflective thinking skills

13) Explain the decision rule used with difference estimation sampling to determine whether the population is acceptable.

14) Explain acceptable risk of incorrect acceptance and acceptable risk of incorrect rejection within the context of variables sampling.

15) Match six of the terms (a-l) with the definitions provided below (1-6):

a. Acceptable risk of incorrect acceptance
b. Acceptable risk of incorrect rejection
c. Difference estimation
d. Misstatement bounds
e. Monetary-unit sampling
f. Mean-per-unit estimation
g. Point estimate
h. Probability proportional to size sample selection
i. Ratio estimation
j. Statistical inferences
k. Stratified sampling
l. Variable sampling

________ 1. Conclusions drawn from sample results based on knowledge of sampling distributions.

________ 2. Sampling techniques for tests of details that use the statistical inference processes.

________ 3. The risk that the auditor is willing to take of concluding a balance is materially misstated when it is, in fact, fairly stated.

________ 4. A statistical sampling method that provides upper and lower misstatement bounds expressed in monetary amounts.

________ 5. A method of variables sampling in which the auditor estimates the population misstatement by multiplying the average misstatement in the sample by the total number of population items and also calculates sampling risk.

________ 6. The risk that the auditor is willing to take of accepting a balance as correct when the true misstatement in the balance is greater than tolerable misstatement.

16) Acceptable risk of incorrect rejection is the statistical risk that the auditor has concluded that a population is materially misstated when it is not.
A) True
B) False
Answer
Terms: Acceptable risk of incorrect rejection
Diff: Easy
Objective: LO 17-4
AACSB: Reflective thinking skills
17) Difference estimation frequently results in smaller sample sizes than any other variables sampling method.
A) True
B) False
Answer
Terms: Difference estimation
Diff: Moderate
Objective: LO 17-4
AACSB: Reflective thinking skills

Learning Objective 17-5

1) An important statistic to consider when using a statistical sampling audit plan is the population variability. The population variability is measured by the:
A) sample mean.
B) standard deviation.
C) standard error of the sample mean.
D) estimated population total minus the actual population.
Answer
Terms: Population variability
Diff: Challenging
Objective: LO 17-5
AACSB: Reflective thinking skills

2) There are four steps to generalize from the sample to the population using difference estimation sampling. Identify each of these four steps.

3) The nine steps in planning the sample are almost identical for nonstatistical sampling and difference estimation. However, there are three important differences. Discuss each of the three differences.

4) The sample size is inversely related to the computed precision interval in difference estimation; that is, as sample size increases, the computed precision interval decreases.
A) True
B) False
Answer
Terms: Sample size and computed precision interval in difference estimation
Diff: Moderate
Objective: LO 17-5
AACSB: Reflective thinking skills

5) In difference estimation sampling, the confidence limits are calculated by combining the point estimate of the total misstatements and the computed precision interval at the desired confidence level.
A) True
B) False
Answer
Terms: Difference estimation sampling; Confidence limits
Diff: Moderate
Objective: LO 17-5
AACSB: Reflective thinking skills

6) The population standard deviation of the misstatements from the sample is inversely related to the computed precision interval in difference estimation; that is, as the standard deviation increases, the computed precision interval decreases.
A) True
B) False
Answer
Terms: Difference estimation; Population standard deviation of the misstatements; Computed precision interval
Diff: Challenging
Objective: LO 17-5
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 18 Audit of the Acquisition and Payment Cycle: Tests of Controls and Substantive Tests of Transactions, and Accounts Payable

Learning Objective 18-1

1) The overall objective in the audit of the acquisition and payment cycle is:
A) to ensure the reliability of the affected accounts.
B) to ensure the accuracy of the affected accounts.
C) to evaluate whether the affected accounts are fairly stated in accordance with accounting standards.
D) to evaluate whether fraudulent payments were made.
Answer
Terms: Overall objective of audit of acquisition and payment cycle
Diff: Easy
Objective: LO 18-1
AACSB: Reflective thinking skills

2) During your audit of Williams Company you are trying to determine whether all accounts payable were recorded in the proper period. Which assertion are you gathering evidence for?
A) Occurrence
B) Completeness
C) Cutoff
D) Rights and Obligations
Answer
Terms: Overall objective of audit of acquisition and payment cycle
Diff: Easy
Objective: LO 18-1
AACSB: Reflective thinking skills

3) The acquisition and payment cycle consists of one class of transactions.
A) True
B) False
Answer
Terms: Acquisition and payment cycle and class of transactions
Diff: Easy
Objective: LO 18-1
AACSB: Reflective thinking skills

4) The cash account is not part of the acquisitions and payment cycle.
A) True
B) False
Answer
Terms: Cash account and acquisitions and payment cycle
Diff: Easy
Objective: LO 18-1
AACSB: Reflective thinking skills

5) The acquisition and payment cycle is highly controlled and not well-structured in most companies.
A) True
B) False
Answer
Terms: Acquisitions and payment cycle
Diff: Easy
Objective: LO 18-1
AACSB: Reflective thinking skills

Learning Objective 18-2

1) What typically initiates the acquisitions and payment cycle?
A) issuance of a purchase requisition or request for purchase of goods/services
B) issuance of payment to vendor
C) approval of a new vendor
D) purchase requisition
Answer
Terms: Initiates acquisition and payment cycle
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

2) What typically ends the acquisitions and payment cycle?
A) issuance of a purchase requisition or request for purchase of goods/services
B) issuance of a payment to a vendor
C) approval of a new vendor
D) purchase requisition
Answer
Terms: Ends acquisition and payment cycle
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

3) Which of the following accounts is not included in the acquisitions class of transactions?
A) Inventory
B) Prepaid expenses
C) Purchase discounts
D) Accounts payable
Answer
Terms: Account not included in acquisition class of transactions
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

4) A document indicating a reduction in the amount owed to a vendor because of returned goods is:
A) a debit memo.
B) a credit memo.
C) a receiving report.
D) a contractual adjustment form.
Answer
Terms: Document indicating a reduction in the amount owed to a vendor for returned goods
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

5) A document used by organizations to establish a formal means of recording and controlling acquisitions which usually contains a package of documents about the acquisition is the:
A) voucher.
B) purchase order.
C) receiving report.
D) purchase requisition.
Answer
Terms: Document used to establish formal means of recording and controlling acquisitions
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

6) The computer-generated file which records acquisitions, disbursements and allowances for each vendor is the:
A) Accounts payable master file.
B) Cash disbursements file.
C) Acquisitions transaction file.
D) Purchase approval file.
Answer
Terms: Computer-generated file which records acquisitions, disbursements and allowances for vendor
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

7) Which of the following business functions is not considered to be part of the acquisitions class of transactions?
A) Processing purchase orders
B) Recognizing liabilities
C) Receiving goods and services
D) Processing cash disbursements
Answer
Terms: Business function not a part of acquisitions class of transactions
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

8) Smaller privately held companies may not maintain an accounts payable master file by vendor. These companies pay on the basis of:
A) vendors’ monthly statements.
B) individual vendors’ invoices.
C) the accounts payable account in the general ledger.
D) dunning letters.
Answer
Terms: Accounts payable master file and small companies
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

9) After a purchase requisition is approved, a ________ must be initiated to purchase the goods or services.
A) purchase order
B) vendor order
C) call order
D) vendor invoice
Answer
Terms: Purchase requisition
Diff: Easy
Objective: LO 18-2
AACSB: Reflective thinking skills

10) A document generally received from the vendor which indicates a reduction in the amount owed due to the company granting an allowance is:
A) vendor invoice.
B) debit memo.
C) credit adjustment form.
D) credit memo.
Answer
Terms: Document received from vendor which indicates a reduction of amount owed
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

11) Absent disputed amounts and minor timing differences, the vendor’s statements should reconcile to the:
A) acquisition journal.
B) accounts payable master file.
C) cash disbursements amount for purchases.
D) vouchers payable amount for vendors.
Answer
Terms: Vendor’s statements should reconcile to
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

12) Describe for each function below their role in the acquisition and payment cycle:
Purchasing
Invoice Processing
Accounts Payable

13) Discuss each of the four business functions that comprise the acquisition and payment cycle.

14) Describe purchase requisitions and purchase orders. What is a key difference between the two documents?

15) Match seven of the terms for documents and records (a-m) used in the acquisitions and cash disbursement cycle with the descriptions provided below (1-7):

a. Purchase requisition
b. Purchase order
c. Receiving report
d. Acquisitions journal
e. Summary acquisitions report
f. Vendor’s invoice
g. Debit memo
h. Voucher
i. Accounts payable master file
j. Accounts payable trial balance
k. Vendor’s statement
l. Check
m. Cash disbursements journal

________ 1. A document indicating a reduction in the amount owed to a vendor because of returned goods or an allowance granted.

________ 2. A document that specifies the details of an acquisition transaction and amount of money owed to the vendor for an acquisition.

________ 3. A document prepared by the purchasing department indicating the description, quantity, and related information for goods and services that the company intends to purchase.

________ 4. A listing of the amount owed to each vendor at a point in time.

________ 5. A document used to establish a formal means of recording and controlling acquisitions; it includes a cover sheet and a package of relevant documents.

________ 6. A document used to request goods and services by an authorized employee.

________ 7. The listing or report that includes all cash payments for a given period.

16) The acquisition and payment cycle typically begins with the initiation of purchase requisition for goods and services from an authorized individual.
A) True
B) False
Answer
Terms: Acquisition and payment cycle begins with
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

17) A vendor invoice is normally prepared at the time tangible goods are received and indicates the description of goods, the quantity received, the date received, and other relevant data.
A) True
B) False
Answer
Terms: Vendor invoice
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

18) A document received from the vendor indicating such things as the description and quantity of goods and services received, price including freight, cash discount terms, and date of billing is called the voucher.
A) True
B) False
Answer
Terms: Voucher
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

19) An acquisitions transaction file is a computer generated file that includes all information entered into the system regarding acquisition transactions.
A) True
B) False
Answer
Terms: Acquisition transaction file
Diff: Moderate
Objective: LO 18-2
AACSB: Reflective thinking skills

20) Receiving reports are normally only used to document the receipt of goods and are not used to document the receipt of services.
A) True
B) False
Answer
Terms: Receiving reports
Diff: Challenging
Objective: LO 18-2
AACSB: Reflective thinking skills
Learning Objective 18-3

1) You have been assigned to the accounts payable transaction cycle as part of your auditing responsibilities. You have decided to vouch a sample of entries in the accounts payable master file to supporting documents. Which assertion is this test of controls most likely to support?
A) Accuracy
B) Classification
C) Completeness
D) Occurrence
Answer
Terms: Assertion for test of controls
Diff: Easy
Objective: LO 18-3
AACSB: Reflective thinking skills

2) An auditor is gathering evidence on the completeness assertion. To do so she performs a test to verify that all goods received by the company have been recorded properly. The document population for this test would consist of all:
A) Vendor Invoices
B) Purchase Orders
C) Receiving Reports
D) Cash Disbursements for Accounts Payables
Answer
Terms: Evidence on completeness assertion to verify all goods received are recorded properly
Diff: Easy
Objective: LO 18-3
AACSB: Reflective thinking skills

3) The accounts payable accounting clerk erroneously recorded the same purchase twice. Which of the following internal control tests would most likely act as a detective control?
A) recalculating the purchases journal
B) tracing from the purchases journal to the general ledger
C) vouching from the general ledger to the purchases journal
D) reconciling the vendor’s statements to the accounts payable subsidiary ledger
Answer
Terms: Internal control test to detect erroneous recording of purchase
Diff: Easy
Objective: LO 18-3
AACSB: Reflective thinking skills

4) An auditor has been assigned to perform tests of controls for a client’s cash disbursement system. Client files are kept electronically with no paper audit trail. In this case the auditor would need to rely on which of the following audit procedures?
A) Analytical procedures and Inquiry
B) Confirmations and Inquiry
C) Observation and Inquiry
D) Reperformance and Inquiry
Answer
Terms: Tests of controls for cash disbursement system; Audit procedures
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills
5) A written purchase order is a contractual document that is:
A) an offer to buy.
B) not enforceable if it is not in writing.
C) a binding agreement between purchaser and vendor.
D) an acceptance of a vendor’s catalog offer to sell.
Answer
Terms: Written purchase order is a legal contractual document
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

6) Which one of the following duties should not be assigned the purchases department?
A) finding the lowest cost vendor
B) reviewing vendors’ catalog descriptions and prices for standardized items
C) designing the purchase order form
D) authorizing the acquisition of goods
Answer
Terms: Duties not to be assigned to the purchases department
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

7) The accounts payable department usually has responsibility for approving acquisitions for payment by comparing the details on the:
A) vendor’s invoice and the receiving report.
B) vendor’s invoice and the purchase requisition.
C) purchase order, receiving report, and vendor’s invoice.
D) purchase requisition, purchase order, and receiving report.
Answer
Terms: Accounts payable department responsibility for approving acquisitions for payment by comparing details
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

8) A substantive test for accounts payable that would be used to provide evidence regarding the occurrence assertion would be to:
A) agree a sample of vouchers to authorized purchase orders.
B) recalculate the accuracy of the vouchers and the authorized purchase orders.
C) trace vouchers to the client’s purchases journal.
D) vouch a sample of vouchers from the cash disbursements register to accounts payable.
Answer
Terms: Substantive test of accounts payable to provide evidence regarding occurrence assertion
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills
9) A company’s internal control procedures over the acquisition cycle should prevent the preparation of a voucher for goods that have not yet been received. Which of the following is the best procedure to assure vouchers are not prepared for goods not received?
A) purchase order and vendor invoice are matched to the receiving report
B) compare goods received with goods ordered
C) perform sample test counts of items when received
D) compare the requisition for goods with the purchase order
Answer
Terms: Best internal control procedure over acquisition cycle
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

10) Which of the following is not a key control in the acquisition and payment cycle?
A) Authorization of purchases
B) Authorization of credit
C) Timely recording and independent review of transactions
D) Authorization of payments
Answer
Terms: Not a key control in acquisition and payment cycle
Diff: Easy
Objective: LO 18-3
AACSB: Reflective thinking skills

11) Proper authorization for acquisition is useful for management as an internal control procedure, because it:
A) ensures that goods/services are used efficiently by company employees.
B) ensures that goods/services were purchased from approved vendors.
C) ensures that goods/services were purchased according to company policy.
D) ensures that goods/services were purchased at the lowest possible price.
Answer
Terms: Proper authorization for acquisition
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

12) When a client uses perpetual inventory records, the tests of details of balances for inventory can be significantly reduced if the auditor believes the records are accurate. The controls over the acquisitions included in the records are normally tested as a part of the:
A) tests of controls.
B) tests of controls and tests of transactions.
C) tests of details of balances.
D) analytical procedures and tests of controls.
Answer
Terms: Tests of details of balances for inventory
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills
13) The auditor’s internal control objective to determine that “recorded acquisitions are for goods and services received” satisfies the audit objective of:
A) accuracy.
B) occurrence.
C) authorization.
D) completeness.
Answer
Terms: Internal control objective that recorded acquisitions are for goods and services received
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

14) Failure to record the acquisition of goods is a violation of which audit objective?
A) Accuracy
B) Occurrence
C) Authorization
D) Completeness
Answer
Terms: Failure to record acquisition is violation of which audit objective
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

15) The internal control that requires that “checks are prenumbered and accounted for” satisfies the objective of:
A) accuracy.
B) existence.
C) completeness.
D) posting and summarization.
Answer
Terms: Internal control that requires that checks are prenumbered and accounted for
Diff: Easy
Objective: LO 18-3
AACSB: Reflective thinking skills

16) Because of the importance of tests of controls and substantive tests of transactions for acquisitions and cash disbursements, it is common in this audit area to use:
A) block sampling.
B) variables sampling.
C) attributes sampling.
D) probability proportional to size sampling.
Answer
Terms: Tests of controls and substantive tests of transactions for acquisitions and cash disbursements
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills
17) Which of the following tests of controls is least useful in assessing the transaction-related audit objective related to occurrence?
A) Examine documents in voucher package for occurrence.
B) Examine supporting documents for indication of approval.
C) Account for sequence of vouchers.
D) Attempt to input transactions with valid and invalid vendors.
Answer
Terms: Tests of controls for transaction-related audit objectives related to occurrence
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

18) You are performing the audit of Jenkins and Company. Your tests of controls and tests of transactions for accounts payable demonstrate that the controls are operating effectively. This would normally allow you to:
A) eliminate the need for substantive testing of balances for accounts payable.
B) reduce the need for substantive testing of balances for accounts payable.
C) reduce control tests in other transactions cycles.
D) increase the need for substantive testing of balances for accounts payable.
Answer
Terms: Tests of controls and tests of transactions demonstrate controls are operating effectively
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

19) An auditor is using audit sampling to test transactions in the acquisition and payment cycle. She would normally set the tolerable exception rate at what level?
A) low
B) medium
C) high
D) indeterminate
Answer
Terms: Test of transactions in the acquisition and payment cycle; Tolerable exception
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

20) Which of the following is the most effective control procedure to detect vouchers that were prepared for the payment of goods that were not received?
A) Count goods upon receipt in storeroom.
B) Match purchase order, receiving report, and vendor’s invoice for each voucher in accounts payable department.
C) Compare goods received with goods requisitioned in receiving department.
D) Verify vouchers for accuracy and approval in internal audit department.
Answer
Terms: Most effective control procedure to detect vouchers that were prepared, and payment for goods not received
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills
21) Which of the following should sign checks under conditions of effective internal control?
A) Treasurer
B) Purchasing agent
C) Accounts payable clerk
D) Person preparing the checks
Answer
Terms: Effective internal controls; Responsible for signing checks
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

22) In an examination of vendor statements or vendor confirmations when doing substantive tests of balances the auditor needs to perform the following:
A) reconciliation with the accounts payable master file.
B) reconciliation with vendor invoices.
C) reconciliation with purchase orders.
D) reconciliation with receiving reports.
Answer
Terms: Substantive tests of balances with vendor statements or vendor confirmations
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

23) Internal controls that are likely to prevent the client from including as a business expense those transactions that primarily benefit management or other employees rather than the entity being audited satisfy the control objective that:
A) acquisitions are correctly valued.
B) existing acquisitions are recorded.
C) acquisitions are correctly classified.
D) recorded acquisitions are for goods and services received.
Answer
Terms: Internal controls for asset acquisitions
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

24) A company failed to record an acquisition of merchandise and its related liability, but the merchandise was included in ending inventory. The effect on the financial statements was to:
A) understate both assets and liabilities.
B) understate net income and owners’ equity.
C) understate assets and owners’ equity.
D) understate liabilities, and overstate both net income and owners’ equity.
Answer
Terms: Effect on financial statements if company failed to record acquisition of merchandise and related liability but included in ending inventory
Diff: Challenging
Objective: LO 18-3
AACSB: Analytic skills
25) The test of transactions which requires one to “reconcile recorded cash disbursements with the cash disbursements on the bank statement” satisfies the objective of:
A) occurrence.
B) completeness.
C) accuracy.
D) posting and summarization.
Answer
Terms: Test of transactions to reconcile recorded cash disbursement with those on bank statement
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

26) For effective internal control purposes, the vouchers payable department generally should:
A) obliterate the quantity ordered on the receiving department copy of the purchase order.
B) stamp, perforate, or otherwise cancel supporting documentation after payment is mailed.
C) establish the agreement of the vendor’s invoice with the receiving report and purchase order.
D) ascertain that each requisition is approved as to price, quantity, and quality by an authorized employee.
Answer
Terms: Effective internal control, vouchers payable department
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

27) An auditor performs a test to determine whether all merchandise for which the client was billed was received. The population for this test consists of all:
A) merchandise received.
B) vendors’ invoices.
C) canceled checks.
D) receiving reports.
Answer
Terms: Auditor performs test to determine whether all merchandise for which client was billed was received
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

28) Matching the supplier’s invoice, the purchase order, and the receiving report prior to preparing the voucher would normally be the responsibility of the:
A) warehouse receiving function.
B) purchasing function.
C) general accounting function.
D) treasury function.
Answer
Terms: Responsibility for matching supplier’s invoice with the purchase order and receiving report
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills
29) A CPA learns that his client has paid a vendor twice for the same shipment, once based upon the original invoice and once based upon the monthly statement. A control procedure that should have prevented this duplicate payment is:
A) attachment of the receiving report to the disbursement report.
B) prenumbering of disbursement vouchers.
C) use of a limit or reasonableness test.
D) prenumbering of receiving reports.
Answer
Terms: Control procedure that prevents duplicate payment on invoice
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

30) With respect to a small company’s system of purchasing supplies, an auditor’s primary concern should be to obtain satisfaction that supplies ordered and paid for have been:
A) requested by and approved by authorized individuals who have no incompatible duties.
B) used in the course of business and solely for business purposes during the year under audit.
C) received, counted, and checked to quantities and amounts on purchase orders and invoices.
D) properly recorded as assets and systematically amortized over the estimated useful life of the supplies.
Answer
Terms: Auditor’s primary concern in system of purchasing supplies for supplies ordered and paid for
Diff: Challenging
Objective: LO 18-3
AACSB: Analytic skills

31) Authorization for accepting goods in the receiving department should be based on:
A) Vendor Invoice.
B) Requisition Request.
C) Purchase order from the purchasing department.
D) Vendor Statement.
Answer
Terms: Authorization for accepting goods
Diff: Easy
Objective: LO 18-2 and LO 18-3
AACSB: Reflective thinking skills

32) What are the three important controls over cash disbursements?

33) Discuss the key internal controls that should be present in the processing purchase orders function in the acquisitions and payment cycle.

34) Discuss the key internal controls that should be present in the receiving goods and services function in the acquisitions and payment cycle.

35) How do auditors determine the extent of testing of internal controls in the acquisition and payment cycle?

36) Listed below are some management assertions made for the acquisition and payment cycle. For each one give an example of how the auditor by using the documents normally found in the process can apply an auditing procedure to test the assertion.
Completeness
Timing
Accuracy

37) When auditing the acquisitions and cash disbursements cycle, it is usually more efficient for the auditor to reduce the extent of tests of controls and rely primarily on substantive tests of transactions and on tests of details of balances, provided the auditor has determined control risk low.
A) True
B) False
Answer
Terms: Auditing acquisitions and cash disbursements cycle, control risk determined low
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

38) Failure to record the acquisition of goods directly affects the balance in Accounts payable and may result in an understatement of ending inventory.
A) True
B) False
Answer
Terms: Failure to record acquisition of goods
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

39) If tests of controls and substantive tests of transactions related to perpetual inventory records reveal controls over perpetuals are effective, the auditor is justified in reducing the extent of tests of details of inventory.
A) True
B) False
Answer
Terms: Tests of controls and substantive tests of transactions
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

40) Because of the importance of tests of controls and substantive tests of transactions for acquisitions and cash disbursements, attributes sampling is commonly used when testing the acquisitions and cash disbursements cycle.
A) True
B) False
Answer
Terms: Importance of tests of controls and substantive tests of transactions; Attributes sampling
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

41) A substantive test of transactions commonly used to test the completeness objective for acquisitions is “Trace from a file of receiving reports to the acquisitions journal.”
A) True
B) False
Answer
Terms: Substantive test of transactions to test completeness objective for acquisitions
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

42) The audit procedure “Test clerical accuracy by footing the journals and tracing postings to general ledger and to accounts payable and inventory master files” is used to test the posting and summarization objective for acquisitions.
A) True
B) False
Answer
Terms: Audit procedure to test clerical accuracy to test posting and summarization objective
Diff: Moderate
Objective: LO 18-3
AACSB: Reflective thinking skills

43) Auditors are normally more concerned about violations of the completeness objective for acquisitions than about violations of the occurrence objective for acquisitions.
A) True
B) False
Answer
Terms: Auditor more concerned with violation of completeness objective than occurrence objective for acquisitions
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills
44) The use of statistical sampling is less common for the audit of accounts payable than for accounts receivable because it is more difficult to define the population and determine the population size in accounts payable.
A) True
B) False
Answer
Terms: Use of statistical sampling less common for audit of accounts payable
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

45) The internal control “Vouchers are prenumbered and accounted for” relates most closely to the occurrence objective for acquisitions.
A) True
B) False
Answer
Terms: Internal control; Vouchers prenumbered; Occurrence objective
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

46) The audit procedure “Examine canceled check for authorized signature, proper endorsement, and cancellation by the bank” is used to test the occurrence objective for cash disbursements.
A) True
B) False
Answer
Terms: Audit procedure for occurrence objective for cash disbursements
Diff: Challenging
Objective: LO 18-3
AACSB: Reflective thinking skills

Learning Objective 18-4

1) Auditors need to distinguish between accounts payable and accrued liabilities in designing the appropriate control and substantive tests. A liability is properly accounted for as an account payable if:
A) the amount is known and owed as of the balance sheet date.
B) the amount can be estimated and is owed at the balance sheet date.
C) the amount is known at the balance sheet date and owed by the end of the next fiscal year.
D) the amount is estimated and owed within 90 days of the balance sheet date.
Answer
Terms: Liability is properly accounted for as accounts payable
Diff: Moderate
Objective: LO 18-4
AACSB: Reflective thinking skills
2) One type of audit procedure the auditor uses to test accounts payable is a substantive analytical procedure. Describe why the auditor uses substantive analytical procedures for accounts payable and provide an example.

3) Discuss the key internal controls that should be present in the “recognizing the liability” function in the acquisitions and payment cycle.

4) Describe the methodology for designing tests of details of balances for accounts payable.

5) Companies would normally recognize an account payable when the goods are received by the company.
A) True
B) False
Answer
Terms: Normally recognize accounts payable
Diff: Easy
Objective: LO 18-4
AACSB: Reflective thinking skills

Learning Objective 18-5

1) The overall objective in the audit of accounts payable is to determine whether accounts payable:
A) is fairly stated and properly disclosed.
B) is overstated.
C) is understated.
D) is accurately stated.
Answer
Terms: Overall objective of audit of accounts payable
Diff: Easy
Objective: LO 18-5
AACSB: Reflective thinking skills

Learning Objective 18-6

1) At what point do most companies recognize liabilities in the acquisition and payment cycle when the goods are shipped FOB Destination?
A) the issuance of a purchase order
B) receipt of acknowledgement of order by vendor
C) receipt of goods or services
D) the receipt of a vendor invoice
Answer
Terms: Companies recognize liabilities in acquisition and payment cycle; FOB destination
Diff: Easy
Objective: LO 18-6
AACSB: Reflective thinking skills
2) Cutoff procedures for inventory purchased should be designed by companies to assure the company that:
A) inventory owned by the company has been received.
B) inventory included in the year end inventory count has been paid.
C) inventory received before year end was recorded before year end.
D) inventory was correctly valued at year end.
Answer
Terms: Cutoff procedures for inventory purchased
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

3) You are the in-charge auditor and are designing audit procedures for accounts payable. Which of the following management assertions would you normally be most concerned about?
A) Occurrence
B) Accurancy
C) Completeness
D) Existence
Answer
Terms: Audit procedures for accounts payable; Management assertions
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

4) The main focus taken by the auditor in verifying liability balances is on the discovery of:
A) understated liabilities.
B) overstated liabilities.
C) unrecorded liabilities.
D) overstated or extraneous liabilities.
Answer
Terms: Main focus in verifying liability balances
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

5) By tracing receiving reports issued at and before year-end to vendors’ invoices and making sure they are included in accounts payable, the auditor is testing for:
A) theft of merchandise by employees.
B) unrecorded obligations.
C) lapping.
D) kiting.
Answer
Terms: Tracing receiving reports issued at and before year-end to vendors’ invoices
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills
6) The extent of a search for unrecorded liabilities largely depends on:
A) materiality and inherent risk.
B) materiality and control risk.
C) materiality only.
D) inherent risk only.
Answer
Terms: Unrecorded liabilities
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

7) A document review of which of the following is most likely to yield evidence of any unrecorded liabilities?
A) Receiving reports
B) Vendor Memorandums
C) Unpaid accounts payable
D) Sales invoices out of sequence
Answer
Terms: Document review for unrecorded liabilities
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

8) When the client’s physical inventory occurs before the last day of the year, it is still necessary to perform an accounts payable cutoff at the time of the count. In addition, the auditor must verify whether all acquisitions taking place between the count and the end of the year were added to:
A) the physical inventory.
B) Accounts Payable.
C) Accounts Payable and Cost of Goods Sold.
D) the physical inventory and Accounts Payable.
Answer
Terms: Accounts payable cutoff; Physical inventory before last day of year
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

9) Peprah Company pays its accounts payable 45 days after receipt of the goods or services. In this case which audit procedure should be used to detect any unrecorded liabilities?
A) examine cash disbursements for several weeks after the balance sheet date
B) reconcile purchase orders to requisition orders
C) reconcile purchase orders to receiving reports
D) reconcile purchase orders to vendor invoices
Answer
Terms: Audit procedure for unrecorded liabilities
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills
10) Cutoff information for inventory acquisitions should be obtained during:
A) the interim period prior to year-end.
B) the interim period immediately following year-end.
C) the physical observation of inventory.
D) either the interim period prior to or immediately following year-end.
Answer
Terms: Cutoff information for inventory acquisitions
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills

11) The auditor has decided to use accounts payables confirmations when testing substantive testing for balances. Which two management assertions is she testing?
A) Existence and Completeness
B) Existence and Occurrence
C) Existence Only
D) Completeness Only
Answer
Terms: Accounts payable confirmations; Substantive testing for balances
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

12) In searching for unrecorded liabilities the purpose of the audit procedure to “examine underlying documentation for subsequent cash disbursements” is to:
A) uncover liabilities on the balance sheet which should not have been recorded until a subsequent period.
B) find the documentation relating to a cash disbursement.
C) uncover payments made in a subsequent accounting period for liabilities that existed at the balance sheet date.
D) uncover cash disbursements recorded in a subsequent accounting period which should be recorded in this period.
Answer
Terms: Unrecorded liabilities
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

13) To test for cutoff errors which overstate liabilities, the auditor should trace, to vendors’ invoices, the receiving reports issued:
A) after year-end.
B) before year-end.
C) the last day of the fiscal year.
D) both before and after year-end.
Answer
Terms: Test for cutoff errors which overstate liabilities
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills
14) In determining that the accounts payable cutoff is correct, it is essential that the cutoff tests be coordinated with the:
A) confirmation of payables.
B) tests on long-term liabilities.
C) observation of inventory.
D) cash count.
Answer
Terms: Accounts payable cutoff test coordinated with
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

15) An inventory acquisition is received late in the afternoon of December 31 after the physical inventory is completed. If the acquisition is included in accounts payable and purchases, but excluded from inventory, the result:
A) is an understatement of net earnings.
B) is an overstatement of net earnings.
C) is an overstatement of working capital.
D) is an overstatement of owner’s equity.
Answer
Terms: Inventory acquisition received after year end, but included in accounts payable and purchases
Diff: Challenging
Objective: LO 18-6
AACSB: Analytic skills

16) When an acquisition is on an FOB origin basis, the inventory and related accounts payable must be recorded in the current period if the goods were:
A) received prior to the balance sheet date.
B) shipped prior to the balance sheet date.
C) both shipped and received prior to the balance sheet date.
D) paid for in advance.
Answer
Terms: Acquisition of inventory on FOB basis
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

17) When assets are being verified, auditors focus much of their attention on making sure that the accounts are not overstated. Alternatively, auditors focus their efforts on understatement when auditing liabilities. What is the primary reason for this difference in focus?
A) Auditors’ legal liability
B) GAAP
C) GAAS requirements
D) All of the above
Answer
Terms: Basis for testing of asset accounts for overstatement and testing of liabilities for understatement
Diff: Challenging
Objective: LO 18-3 and LO 18-6
AACSB: Reflective thinking skills
18) Auditors examine supporting documentation for cash disbursements subsequent to the balance sheet date in order to determine whether the cash disbursement was for a current period liability.
Describe at least two audit procedures the auditor would perform to provide evidence that the cash disbursement was made for a current period liability.

19) Describe the audit procedures typically used to test for out-of-period liabilities (also referred to as the search for unrecorded accounts payable).

20) The balance-related audit objective realizable value is not applicable when auditing Accounts payable.
A) True
B) False
Answer
Terms: Balance-related audit objective of realizable value
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills
21) When auditing Accounts payable, the auditor is more concerned about the possibility of understatements than overstatements.
A) True
B) False
Answer
Terms: Auditing accounts payable, auditor concerned with understatement
Diff: Moderate
Objective: LO 18-6
AACSB: Reflective thinking skills
22) To test for overstatement cutoff amounts when auditing Accounts payable, the auditor should trace receiving reports issued before year-end to related vendors’ invoices to make sure they are not recorded as Accounts payable.
A) True
B) False
Answer
Terms: Test for overstatement cutoff amounts in Accounts Payable
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

23) When performing tests of controls or substantive tests of transactions for acquisitions, vendors’ invoices are more useful than vendors’ statements.
A) True
B) False
Answer
Terms: Vendors’ invoices more useful than vendors’ statements
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

24) When verifying the correct balance in Accounts payable, vendors’ invoices are more useful than vendors’ statements.
A) True
B) False
Answer
Terms: Vendors’ invoices more useful than vendors’ statements
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills

25) Auditors primarily emphasize the understatement of liabilities in the audit of Accounts payable because they are concerned about potential legal liability.
A) True
B) False
Answer
Terms: Auditors emphasize understatement of liabilities because of potential legal liability
Diff: Challenging
Objective: LO 18-6
AACSB: Reflective thinking skills
Learning Objective 18-7

1) In the course of your audit over the acquisitions cycle you need to determine whether the client billings from vendors were received by the client. You have decided to perform a sample test. The population for the sample would be comprised of:
A) Vendor Invoices.
B) Receiving reports.
C) Cash Disbursements.
D) Accounts Payable Subsidiary Ledger for Vendors.
Answer
Terms: Population for sample to test billings from vendors received by client
Diff: Easy
Objective: LO 18-7
AACSB: Reflective thinking skills

2) Which of the following is most reliable for verifying the correct balance of accounts payable?
A) Vendors’ invoices
B) Vendors’ statements
C) Confirmations
D) Bills of lading
Answer
Terms: Most reliable for verifying correct balance of accounts payable
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills

3) Vendors’ statements and vendors’ invoices are both relatively reliable evidence because they:
A) come directly to the auditor without being in client’s possession.
B) originate from a third party.
C) validate the effectiveness of the control system.
D) are compared to and reconciled with sales invoices.
Answer
Terms: Reliable evidence; Vendors’ statements and vendors’ invoices
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills

4) The auditor is performing tests of transactions for individual accounts payable transactions with vendors. Which document provides more reliable information about individual transactions with vendors?
A) Receiving report
B) Vendors Invoices
C) Vendor Statements
D) Purchase Orders
Answer
Terms: Tests of transactions for accounts payable; Reliable evidence
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills
5) Auditor confirmation of accounts payable balances at the balance sheet date may not need to be performed by the auditor because:
A) this is a duplication of cutoff tests.
B) there is likely to be other reliable external evidence available to support the balances.
C) accounts payable balances at the balance sheet date may not be paid before the audit is completed.
D) correspondence with the audit client’s attorney will reveal all legal action by vendors for nonpayment.
Answer
Terms: Confirmation of accounts payable
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills

6) Under which of the following circumstances would it be advisable for the auditor to confirm accounts payable with creditors?
A) Internal accounting control over accounts payable is adequate, and there is sufficient evidence on hand to minimize the risk of a material misstatement.
B) Confirmation response is expected to be favorable, and accounts payable balances are of immaterial amounts.
C) Creditor statements are not available and internal control over payables is unsatisfactory.
D) The majority of accounts payable balances are with associated companies.
Answer
Terms: Confirm accounts payable with creditors
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills

7) The auditor is performing substantive tests of balances for accounts payable. What documentation would provide the best evidence for the ending balance?
A) Vendor Invoices
B) Vendor Statements
C) Receiving reports
D) Purchase orders
Answer
Terms: Best evidence for substantive tests of balances for accounts payable
Diff: Moderate
Objective: LO 18-7
AACSB: Reflective thinking skills

8) The auditor gets highly reliable evidence about individual transactions by examining:
A) vendors’ invoices.
B) vendors’ statements.
C) confirmations of accounts payable balances.
D) detailed inventory counting instructions.
Answer
Terms: Auditor gets highly reliable evidence about individual transactions
Diff: Challenging
Objective: LO 18-7
AACSB: Reflective thinking skills

9) Which of the following documents is best for verifying the correct balance in accounts payable?
A) Bills of lading
B) Confirmations
C) Vendors’ invoices
D) Vendors’ statements
Answer
Terms: Document best for verifying correct balance in accounts payable
Diff: Challenging
Objective: LO 18-7
AACSB: Reflective thinking skills

10) You are performing an audit of Hawk Company. In evaluating the accounts payable balance you are concerned with the completeness assertion. Which of the following audit procedures best satisfy your concern?
A) send confirmations to only vendors with large balances
B) send confirmations to vendors with large, active, zero balance accounts and a representative sample of all others
C) send confirmations to vendors chosen from sample stratified by the dollar balance
D) send confirmations to all vendors
Answer
Terms: Accounts payable and completeness assertion
Diff: Challenging
Objective: LO 18-7
AACSB: Reflective thinking skills

11) Discuss the circumstances in which it is desirable to send confirmation requests to the client’s vendors.

12) A vendor’s statement is unreliable and auditors rarely use it.
A) True
B) False
Answer
Terms: Vendor’s statement reliability
Diff: Easy
Objective: LO 18-7
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 19 Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts

Learning Objective 19-1

1) Which of the following accounts is not associated with the acquisition and payment cycle?
A) Common stock
B) Property, plant and equipment
C) Accrued property taxes
D) Income tax expense
Answer
Terms: Acquisition and payment cycle
Diff: Easy
Objective: LO 19-1
AACSB: Reflective thinking skills

2) Discuss the key internal controls related to the disposal of property, plant, and equipment.

3) The auditor should keep in mind that the amount in insurance expense is a residual amount.
A) True
B) False
Answer
Terms: Acquisition and payment cycle
Diff: Easy
Objective: LO 19-1
AACSB: Reflective thinking skills

Learning Objective 19-2

1) You are auditing the acquisition and payment cycle and the presence of excessive recurring losses on retired assets. You may conclude that:
A) insured values are greater than book values.
B) there are a large number of fully depreciated assets.
C) depreciation charges may by insuffient.
D) company has a policy of selling relatively new assets.
Answer
Terms: Acquisition and payment cycle; Excessive recurring losses on retired assets
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills
2) Which of the following expenses is not typically evaluated as part of the audit of the acquisition and payment cycle?
A) Depreciation expense
B) Insurance expense
C) Estimated Liability for Warranties
D) Property tax expense
Answer
Terms: Acquisition and payment cycle
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

3) Which of the following would generally not be a component of the audit of the acquisition and payment cycle?
A) Adequacy of controls over acquisitions of long-lived assets
B) Tracing disposals of long-lived assets to the Fixed Asset Master File
C) Determining the adequacy of the funds available for capital expenditures
D) Reperformance of recorded depreciation expense
Answer
Terms: Acquisition and payment cycle
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

4) Normally it may be unnecessary to examine supporting documentation for each addition to property, plant, and equipment, but it would be customary to verify:
A) all large transactions.
B) all unusual transactions.
C) a representative sample of typical additions.
D) all three of the above.
Answer
Terms: Property, plant, and equipment documentation
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills
5) The auditor must know the client’s capitalization policies to determine whether acquisitions are:
A)
Recorded in accordance with GAAP Treated consistently with those of the preceding year Necessary
Yes Yes Yes

B)
Recorded in accordance with GAAP Treated consistently with those of the preceding year Necessary
Yes No No

C)
Recorded in accordance with GAAP Treated consistently with those of the preceding year Necessary
No No No

D)
Recorded in accordance with GAAP Treated consistently with those of the preceding year Necessary
Yes Yes No

Answer
Terms: Acquisitions; Capitalization policy
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

6) To be capitalized as part of property, plant and equipment, assets must:
A) have expected useful lives of more than one year.
B) not be acquired for resale.
C) be useful in multiple productive capacities within the organization.
D) A and B, but not C.
Answer
Terms: Property, plant, and equipment; Capitalized
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

7) The primary accounting record for manufacturing equipment and other fixed assets is the:
A) depreciation ledger.
B) fixed asset master file.
C) asset inventory.
D) equipment roster.
Answer
Terms: Primary accounting record for equipment
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills
8) Which of the following statements about the audit of fixed assets is the least correct?
A) The primary accounting record for manufacturing equipment and other property, plant and equipment is generally a fixed asset master file.
B) Manufacturing equipment and current assets are normally audited in the same fashion regardless of the activity within a particular account.
C) The emphasis on auditing fixed assets is on verification of current-period acquisitions.
D) Failure to record the acquisition of a fixed asset affects the income statement until the assets are fully depreciated.
Answer
Terms: Audit of fixed assets
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

9) You are the in-charge auditor for a long-term client. Which of the following is not a category of tests commonly associated with the audit of manufacturing equipment?
A) Verification of depreciation expense.
B) Analytical procedures.
C) Verification of current-period disposals.
D) Verification of the beginning balance in accumulated depreciation.
Answer
Terms: Audit of manufacturing equipment; Category of tests
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

10) The audit procedure that requires an auditor to “foot the acquisition schedule” relates to which balance-related audit objective?
A) Classification
B) Detail tie-in
C) Existence
D) Cut-off
Answer
Terms: Audit procedure; Balance-related audit objective; Foot acquisition schedule
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

11) You are auditing Manufacturing Company and testing the audit related objective of completeness for the equipment accounts. Which of the following audit procedures is most likely to achieve your objective?
A) Examine vendor invoices and receiving reports
B) Physically examine assets
C) Examine vendor invoices of closely related accounts such as repairs and maintenance
D) Trace individual acquisitions to the fixed asset master file
Answer
Terms: Testing audit related objective of completeness for equipment accounts
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills
12) Which of the following audit procedures would be the most correct in determining the audit objective of existence for the equipment account in the fixed asset master file?
A) Examine vendor invoices and receiving reports
B) Review transactions near the balance sheet date
C) Recalculate vendor invoices
D) Examine vendor invoices for correct accounting treatment
Answer
Terms: Audit objective of existence for equipment account; Fixed asset master file
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

13) Inadequate controls and misstatements discovered through tests of controls and substantive tests of transactions are an indication of the likelihood of misstatements in:
A) the balance sheet.
B) the income statement.
C) the cash flow statement.
D) both the income statement and the balance sheet.
Answer
Terms: Inadequate controls and misstatements; Tests of controls and substantive tests of transactions
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

14) Failure to capitalize a fixed asset at the correct amount would impact which financial statements until the company disposes of the asset?
A) The balance sheet only
B) The income statement only
C) The cash flow statement only
D) Both the income statement and the balance sheet
Answer
Terms: Failure to capitalize a fixed asset; Financial statements
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

15) Which of the following tests are typically not necessary when auditing a client’s schedule of recorded disposals?
A) Footing the schedule.
B) Tracing schedule totals to the general ledger.
C) Tracing cost and accumulated depreciation of the disposals to the property master file.
D) All of the above are necessary.
Answer
Terms: Tests when auditing schedule of recorded disposals
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

16) Which of the following would indicate a deficiency in internal controls in the acquisition and payment cycle?
A) Repairs and maintenance accounts are reviewed for unusual entries each quarter
B) Acquisitions are made and approved by the department that will use the equipment
C) Acquisitions of equipment greater than $1,000 are to be capitalized
D) Acquisitions of equipment less than $1,000 are to be expensed as incurred
Answer
Terms: Deficiency in internal controls in the acquisition and payment cycle
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

17) A set of records for each piece of equipment that includes descriptive information, date of acquisition, original cost, current year depreciation, and accumulated depreciation is the:
A) acquisitions journal.
B) depreciation schedule.
C) fixed asset master file.
D) file of purchase requisitions.
Answer
Terms: Set of records for each piece of equipment
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

18) In testing acquisitions the auditor needs to understand the appropriate accounting guidance related to acquisition accounting. Which of the following is NOT an accounting consideration for the auditor as regards to acquisition cost?
A) Inclusion of material transportation and installation costs
B) Recording of trade-in costs
C) Allocating costs when building and equipment are purchased at one price
D) Verifying that purchased equipment amounts correspond to the budgeted amount
Answer
Terms: Appropriate accounting guidance related to acquisition accounting
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

19) Methods used to determine if there are legal encumbrances related to fixed assets include all but which of the following?
A) Reading terms of loan and credit agreements
B) Reviewing loan confirmations received from banks
C) Having discussions with the client or sending letters to legal counsel
D) All of the above may be used to identify legal encumbrances
Answer
Terms: Methods to determine legal encumbrances related to fixed assets
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

20) The test of details of balances procedure which requires a “recalculation of investment credit” satisfies the audit objective of:
A) classification.
B) detail tie-in.
C) existence.
D) accuracy.
Answer
Terms: Test of details of balances
Diff: Challenging
Objective: LO 19-2
AACSB: Analytic skills

21) The test of details of balances procedure to “examine vendors’ invoices of closely related accounts such as repairs to uncover items that should be property, plant, and equipment” satisfies the audit objective of:
A) completeness.
B) detail tie-in.
C) cutoff.
D) existence.
Answer
Terms: Test of details of balances; Audit objective
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

22) The auditor’s starting point for verifying disposals of property, plant, and equipment is the:
A) equipment account in the general ledger.
B) file of shipping documents.
C) client’s schedule of recorded disposals.
D) equipment subsidiary ledger.
Answer
Terms: Disposals of property, plant, and equipment
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

23) Improperly classifying a fixed asset by recording the amount in the repairs and maintenance expense account will have an effect on which of the following financial statements until the asset would normally have been depreciated?
A) The balance sheet
B) The income statement
C) The cash flow statement
D) Both the income statement and the balance sheet
Answer
Terms: Failure to capitalize a fixed asset
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

24) Because the failure to record disposals of property, plant, and equipment can significantly affect the financial statements, the search for unrecorded disposals is essential. Which of the following is not a procedure used to verify disposals?
A) Make inquiries of management and production personnel about the possibility of the disposal of assets.
B) Review whether newly acquired assets replace existing assets.
C) Test the valuation of fixed assets recorded in prior periods.
D) Review plant modifications and changes in product line, taxes, or insurance coverage.
Answer
Terms: Unrecorded disposals of property, plant, and equipment
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

25) When the auditor is determining appropriate depreciation calculations for the classifications in the client’s fixed asset master file she is testing the audit objective of:
A) completeness.
B) existence.
C) classification.
D) valuation and allocation.
Answer
Terms: Determining appropriate depreciation calculations; Testing audit objective
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

26) A major consideration in verifying the ending balance in fixed assets is the possibility of existing legal encumbrances. Tests to identify possible legal encumbrances would satisfy the audit objective of:
A) existence.
B) presentation and disclosure.
C) detail tie-in.
D) classification.
Answer
Terms: Tests to identify legal encumbrances
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

27) When auditing depreciation expense, the two major concerns related to the accuracy audit objective are:
A) consistent application of depreciation method and useful lives.
B) consistent application of depreciation method and classification of assets.
C) correctness of calculations and consistent application of depreciation method.
D) cost of the fixed asset and useful lives.
Answer
Terms: Auditing depreciation expense
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills
28) The auditor needs to gain reasonable assurance that the equipment accounts in the fixed asset master file are not understated. Which of the following accounts would most likely be reviewed in making that determination?
A) Depreciation expense
B) Repairs and maintenance expense
C) Gains/losses on sales and retirements
D) Cash
Answer
Terms: Reasonable assurance that equipment accounts in the fixed asset master file are not understated
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

29) Changing circumstances may require a change in the useful life of an asset. When this occurs, it involves a change in:
A) accounting estimate rather than a change in accounting principle.
B) accounting principle rather than a change in accounting estimate.
C) both accounting principle and accounting estimate.
D) neither accounting principle nor accounting estimate.
Answer
Terms: Change in useful life of an asset
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

30) The auditor normally does not need to test the accuracy or classification of fixed assets recorded in prior periods if they are the continuing auditor because:
A) they are rarely material to the audit.
B) they rarely contain misstatements.
C) they are verified in previous audits.
D) they don’t affect the balance sheet.
Answer
Terms: Test accuracy or classification of fixed assets recorded in prior periods
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

31) The auditor is examining the accounting entries made to the accumulated depreciation account during the year and notices a significant amount of debits to the account. Which of the following provides the most logical explanation?
A) Large number of asset retirements
B) Salvage values were revised downward
C) Useful lives were revised downward
D) Allocation of fixed overhead were revised
Answer
Terms: Accounting entries (debits) made to accumulated depreciation account
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills
32) In determining the reasonableness of the client’s amount for depreciation expense the auditor is primarily concerned that the client has followed a consistent policy and the calculations are correct. Which of the following audit objectives best addresses the above concerns?
A) Existence
B) Accuracy
C) Valuation
D) Allocation
Answer
Terms: Depreciation expense; Consistency policy and calculations are correct
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

33) Which of the following audit procedures would be least likely to lead the auditor to find an unrecorded fixed asset disposal?
A) Examination of insurance policies
B) Review of repairs and maintenance expense
C) Review of property tax files
D) Scanning of invoices for fixed asset additions
Answer
Terms: Unrecorded fixed asset disposal
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

34) To achieve effective internal accounting control over fixed asset additions, a company should establish procedures that require:
A) authorization and approval of major fixed asset additions.
B) capitalization of the cost of fixed asset additions in excess of a specific dollar amount.
C) classification, as investments, of those fixed asset additions that are not used in the business.
D) performance of recurring fixed asset maintenance work solely by maintenance department employees.
Answer
Terms: Effective internal control over fixed asset additions
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

35) The auditor is testing for unrecorded retirements/disposals of equipment. Which of the following audit procedures would the auditor most likely use?
A) Select items from the fixed asset master file and then physically locate them.
B) Examine the repairs and maintenance amount for large debits.
C) Compare current years depreciation expense with the previous year’s depreciation expense.
D) Trace acquisition documents to the fixed asset master file.
Answer
Terms: Testing for unrecorded retirements/disposals of equipment
Diff: Challenging
Objective: LO 19-2
AACSB: Analytic skills

36) The failure to capitalize a permanent asset, or the recording of an asset acquisition at the improper amount, affects the balance sheet:
A) forever.
B) for the current period.
C) for the depreciable life of the asset.
D) until the firm disposes of the asset.
Answer
Terms: Failure to capitalize a permanent asset; Recording of an asset acquisition at improper amount
Diff: Challenging
Objective: LO 19-2
AACSB: Analytic skills

37) One of the primary objectives in examining the repairs and maintenance accounts is to obtain evidence that:
A) expenditures of equipment have not been charged to expense.
B) the actual amount recorded is the same as the budgeted amount.
C) expenditures for equipment have been recorded in the proper period.
D) revenue expenditures made on behalf of equipment have been recorded in the proper period.
Answer
Terms: Primary objective in examining repairs and maintenance accounts
Diff: Challenging
Objective: LO 19-2
AACSB: Reflective thinking skills

38) If the client fails to record disposals of property, plant, and equipment, both the original cost of the asset account and the net book value will be incorrect. What will the effect be of this misstatement on the original cost and the book value?
A) Both will be overstated indefinitely.
B) The original cost will be overstated indefinitely, and the net book value will be overstated until the asset is fully depreciated.
C) The original cost will be overstated indefinitely, and the net book value will be understated indefinitely.
D) The original cost will be overstated indefinitely, and the net book value will be understated until the asset is fully depreciated.
Answer
Terms: Client fails to record disposals of property, plant, and equipment
Diff: Challenging
Objective: LO 19-2
AACSB: Analytic skills

39) Which of the following explanations might satisfy an auditor who discovers significant debits to an accumulated depreciation account?
A) Extraordinary repairs have lengthened the life of an asset.
B) Prior years’ depreciation charges were erroneously understated.
C) A reserve for possible loss on retirement has been recorded.
D) An asset has been recorded at its fair value.
Answer
Terms: Significant debits to accumulated depreciation account
Diff: Challenging
Objective: LO 19-2
AACSB: Analytic skills
40) The primary accounting record for property, plant, and equipment accounts is the fixed asset master file. What is included for each fixed asset in the master file?
Answerescription of the asset
Date of Acquisition
Acquisition (original) cost
Current year depreciation
Accumulated depreciation for the asset
Terms: Included for each fixed asset in the master file
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

41) The auditor receives the client’s schedule of recorded disposals and then performs detail tie-in tests of the recorded disposals schedule. What procedures does the auditor perform on the client’s schedule of recorded disposals?

42) In auditing depreciation expense one the auditors concerns is on determining that the client’s calculations are correct. In determining that the auditor must weigh which four considerations?

43) In testing acquisitions, the auditor must understand the relevant accounting standards to insure the client adheres to accepted accounting practices for property, plant, and equipment. Describe below the auditor concerns in this area.

44) Property, plant, and equipment is normally audited in a different manner than current asset accounts. State three reasons why this is so, and discuss the differences in how property, plant, and equipment is audited compared to current assets.

45) State four of the seven specific balance-related audit objectives for property, plant, and equipment additions and, for each objective, describe one common test of details of balances.

46) When auditing disposals of property, plant, and equipment, the search for unrecorded disposals is essential. State the four audit procedures frequently used for verifying disposals.

48) Completeness and existence are the auditor’s primary objectives in auditing manufacturing equipment.
A) True
B) False
Answer
Terms: Completeness and existence; Primary objectives in auditing equipment
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

49) Accrued payroll taxes are normally considered to be associated with the acquisition and payment cycle.
A) True
B) False
Answer
Terms: Accrued payroll taxes
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

50) The primary characteristic that distinguishes property, plant, and equipment from inventory, prepaid expenses, and investments is the intention to use property, plant, and equipment as a part of the operations of the client’s business over their expected life.
A) True
B) False
Answer
Terms: Primary characteristic of property, plant, and equipment
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

51) The emphasis in auditing manufacturing equipment is on the verification of current-period disposals and acquisitions.
A) True
B) False
Answer
Terms: Auditing equipment; Current-period disposals and acquisitions
Diff: Easy
Objective: LO 19-2
AACSB: Reflective thinking skills

52) The starting point for the verification of current-year acquisitions of property, plant, and equipment is normally a client-prepared schedule of all acquisitions recorded in the general ledger during the year.
A) True
B) False
Answer
Terms: Verification of acquisitions; Client-prepared schedule of acquisitions
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills
53) The least helpful common audit test to verify current period acquisitions of property, plant, and equipment is examining vendors’ invoices and receiving reports.
A) True
B) False
Answer
Terms: Audit tests to verify current period acquisitions
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

54) Depreciation expense is normally verified as a part of tests of details of balances rather than as part of tests of controls or substantive tests of transactions.
A) True
B) False
Answer
Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests of transactions
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

55) The most important audit objective for depreciation expense is detail tie-in.
A) True
B) False
Answer
Terms: Audit objective for depreciation expense
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

56) In auditing the current year acquisitions of property, plant, and equipment, all balance-related audit objectives except realizable value and disclosure are used as a framework for subsequent audit testing.
A) True
B) False
Answer
Terms: Auditing current year acquisitions; Balance-related audit objectives
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

57) The auditor’s review of current year acquisition’s cutoff is normally done as part of accounts payable cutoff tests.
A) True
B) False
Answer
Terms: Review of acquisition’s cutoff; Accounts payable cutoff tests
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

58) The auditor’s tests for proper cutoff of current year acquisitions of property, plant, and equipment are usually done as part of accounts payable cutoff tests.
A) True
B) False
Answer
Terms: Cutoff of acquisitions; Accounts payable cutoff tests
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

59) The company’s choices for fixed asset on the assets useful life and residual value impact the amount of depreciation recorded.
A) True
B) False
Answer
Terms: Asset’s useful lige and residual value; Impact depreciation recorded
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

60) The audit procedure “foot the schedule of fixed assets acquisitions and trace the total to the general ledger” relates most closely to the completeness objective for fixed assets acquisitions.
A) True
B) False
Answer
Terms: Audit procedure for completeness objective
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

61) Confirmations are commonly used to verify additions of property, plant, and equipment.
A) True
B) False
Answer
Terms: Confirmations to verify additions
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

62) One very useful method of auditing depreciation is to use an analytical procedure to test for reasonableness.
A) True
B) False
Answer
Terms: Auditing depreciation; Analytical procedures to test for reasonableness
Diff: Moderate
Objective: LO 19-2
AACSB: Reflective thinking skills

63) The approach to auditing patents and copyrights is similar to that used for property, plant, and equipment accounts.
A) True
B) False
Answer
Terms: Auditing patents and copyrights
Diff: Challenging
Objective: LO 19-2
AACSB: Reflective thinking skills

64) Recording an acquisition of a fixed asset at an improper amount affects the balance sheet until the company disposes of the asset, but the income statement is not affected.
A) True
B) False
Answer
Terms: Recording acquisition at improper amount
Diff: Challenging
Objective: LO 19-2
AACSB: Reflective thinking skills

65) Ordinarily, if you are auditing a continuing client, it is unnecessary to test the accuracy objective or the classification objective for fixed assets acquired in prior years.
A) True
B) False
Answer
Terms: Accuracy objective; Classification objective; Fixed assets in prior years
Diff: Challenging
Objective: LO 19-2
AACSB: Reflective thinking skills

66) When auditing acquisitions of property, plant, and equipment, the auditor’s review of lease and rental agreements most closely relate to the cutoff objective.
A) True
B) False
Answer
Terms: Auditing acquisitions; Lease and rental agreements; Cutoff objective
Diff: Challenging
Objective: LO 19-2
AACSB: Reflective thinking skills

Learning Objective 19-3

1) Which of the following accounts would normally not be a part of the acquisition and payment cycle of Prepaid Insurance?
A) Cash
B) Insurance Payable
C) Insurance Expense
D) Prepaid Insurance
Answer
Terms: Acquisition and payment cycle; Prepaid insurance
Diff: Easy
Objective: LO 19-3
AACSB: Reflective thinking skills
2) Which type of audit procedure would normally be sufficient for purposes of auditing prepaid expenses and deferred charges?
A) Tests of controls.
B) Tests of transactions.
C) Tests of details of balances.
D) Analytical procedures.
Answer
Terms: Audit procedure for auditing prepaid expenses and deferred charges
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

3) When the auditor recomputes the unexpired portion of prepaid insurance, she is satisfying which audit objective?
A) Completeness
B) Existence
C) Accuracy and detail tie-in
D) Rights
Answer
Terms: Audit objective; Recompute unexpired portion of prepaid insurance
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

4) A record of insurance policies in force and the due date of each policy is contained in the:
A) voucher register.
B) insurance register.
C) insurance expense account.
D) prepaid insurance account.
Answer
Terms: Record of insurance policies
Diff: Easy
Objective: LO 19-3
AACSB: Reflective thinking skills

5) Insurance expense for the period is a function of which of the following?
A) The beginning prepaid balance, current premium payments and the ending prepaid balance.
B) The beginning prepaid balance and the current period premium payments.
C) The current period premium payments.
D) The current period premium payments and the ending prepaid balance.
Answer
Terms: Insurance expense if a function of
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills
6) In connection with a review of the prepaid insurance account, which of the following audit procedures would you be least likely to use?
A) Recompute the portion of the premium that expired during the year.
B) Prepare excerpts of insurance policies for audit working papers.
C) Confirm premium rates with an independent insurance broker.
D) Examine support for premium payments.
Answer
Terms: Prepaid insurance; Audit procedures
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

7) Controls over the acquisition and recording of insurance are a part of which of the following transaction cycles?
A) Inventory and warehousing cycle
B) Capitalization cycle
C) Treasury cycle
D) Acquisition and payment cycle
Answer
Terms: Acquisition and recording of insurance; Transaction cycles
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

8) Which balance-related audit objective is not relevant to an audit of prepaid expenses?
A) Rights
B) Accuracy
C) Detail tie-in
D) Realizable value
Answer
Terms: Balance-related audit objective for audit of prepaid expenses
Diff: Challenging
Objective: LO 19-3
AACSB: Reflective thinking skills

9) Describe two ways the verification of existence and tests for omissions of the client’s insurance policies in force can be performed.

10) What are several analytical procedures used in the audit of prepaid insurance and insurance expense?

11) Describe the audit procedures used to verify the accuracy and detail tie-in objectives for prepaid insurance.

12) Discuss the key internal controls for prepaid insurance that affect the auditor’s extent of testing of the prepaid insurance account.

13) The realizable value audit objective is not applicable when auditing prepaid insurance or insurance expense.
A) True
B) False
Answer
Terms: Auditing prepaid insurance and insurance expense; Realizable value
Diff: Easy
Objective: LO 19-3
AACSB: Reflective thinking skills

14) The audit of insurance expense is normally limited to analytical procedures and a brief test of whether charges to insurance expense arose from credits to prepaid insurance.
A) True
B) False
Answer
Terms: Audit of insurance expense; Analytical procedures
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

15) Tests of the cutoff objective for prepaid insurance is normally not performed by auditors.
A) True
B) False
Answer
Terms: Tests of cutoff objective for prepaid insurance
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills

16) When auditing insurance expense, auditors normally rely on analytical procedures and limited testing of the debits to ensure that they arose from credits to prepaid insurance.
A) True
B) False
Answer
Terms: Auditing insurance expense; Analytical procedures
Diff: Moderate
Objective: LO 19-3
AACSB: Reflective thinking skills
Learning Objective 19-4

1) Which of the following is a customary audit procedure for the verification of the legal ownership of real property?
A) Examination of correspondence with the corporate counsel concerning acquisition matters.
B) Examination of ownership documents registered and on file at a public hall of records.
C) Examination of corporate minutes and resolutions concerning the approval to acquire property, plant, and equipment.
D) Examination of deeds and title guaranty policies on hand.

2) Which of the following would offer the best evidence of owning real estate as of the balance sheet date?
A) Property insurance policies
B) Paid real estate tax bills
C) Acquisition documents
D) Cash disbursements register
Answer
Terms: Evidence of owning real estate
Diff: Moderate
Objective: LO 19-4
AACSB: Reflective thinking skills

3) When auditors verify accrued property taxes two audit objectives are especially significant. These are:
A) completeness and accuracy.
B) completeness and net realizable value.
C) detail tie-in and completeness.
D) accuracy and classification.
Answer
Terms: Accrued property taxes; Audit objectives
Diff: Challenging
Objective: LO 19-4
AACSB: Reflective thinking skills

4) The balance in the property tax expense account is most similar to:
A) depreciation expense.
B) insurance expense.
C) compensation expense.
D) utilities expense.
Answer
Terms: Property tax expense
Diff: Challenging
Objective: LO 19-4
AACSB: Reflective thinking skills
5) The audit procedures used to verify accrued liabilities differ from those employed for the verification of accounts payable because:
A) accrued liability balances are less material than accounts payable balances.
B) accrued liabilities at year end will become accounts payable during the following year.
C) evidence supporting accrued liabilities is non-existent, whereas evidence supporting accounts payable is readily available.
D) accrued liabilities usually pertain to services of a continuing nature, whereas accounts payable are the result of completed transactions.
Answer
Terms: Audit procedures to verify accrued liabilities
Diff: Challenging
Objective: LO 19-4
AACSB: Analytic skills

6) Explain the allocation audit objective and explain why it is important to have accurate allocation within the financial statements, in relationship to Property, Plant, and Equipment

7) In the audit of accrued property taxes, the two most important balance-related audit objectives are completeness and accuracy.
A) True
B) False
Answer
Terms: Audit of accrued property taxes; Balance-related audit objectives of completeness and accuracy
Diff: Challenging
Objective: LO 19-4
AACSB: Reflective thinking skills

Learning Objective 19-5

1) Which of the following audit tests both have the effect of simultaneously verifying balance sheet and income statement accounts?
A) Analytical procedures and substantive tests of transactions
B) Tests of controls and substantive tests of transactions
C) Tests of details of balances and substantive tests of transactions
D) Tests of controls and analytical procedures
Answer
Terms: Audit tests that have effect simultaneously verifying balance sheet and income statement accounts
Diff: Challenging
Objective: LO 19-5
AACSB: Analytic skills
2) The most effective and efficient audit approach in the examination of the income statement would be which of the following?
A) Examination of income statement accounts concurrently with the related balance sheet accounts.
B) Compare company’s components of net income to other businesses in the same industry.
C) Compare company’s components of net income to the previous two years.
D) Examine changes in all balance sheet accounts.
Answer
Terms: Effective and efficient audit approach in examination of the income statement
Diff: Challenging
Objective: LO 19-5
AACSB: Reflective thinking skills

3) The erroneous inclusion of transactions that should properly be recorded as assets into accounts such as repairs expense, lease expense, or supplies is a common client error. The auditor is most lkely to evaluate the likelihood of these types of misclassifications in conjunction with:
A) obtaining an understanding of internal control.
B) the tests of controls.
C) the tests of transactions.
D) the tests of details of balances.
Answer
Terms: Erroneous inclusion of transactions that should be properly recorded as assets in expense accounts
Diff: Challenging
Objective: LO 19-5
AACSB: Analytic skills

4) Income statement accounts resulting from allocations are typically verified as a part of:
A) tests of controls.
B) substantive tests of transactions.
C) analytical procedures.
D) planning.
Answer
Terms: Income statement accounts resulting from allocations
Diff: Challenging
Objective: LO 19-5
AACSB: Reflective thinking skills

5) Explain the audit objective allocation and why it is important to have accurate allocation within the financial statements, particularly for property, plant, and equipment
Answerllocation is the process of assigning a portion of the cost of an asset to a product or a period. For example, calculating and then recording depreciation expense is an allocation process. It is important to determine when an expenditure is an asset or a current period expense so that the financial statements are fairly stated. If the client fails to follow accounting standards or fails to calculate the allocation correctly, then financial statements can be materially misstated.
Terms: Allocation within financial statements
Diff: Moderate
Objective: LO 19-5
AACSB: Reflective thinking skills
6) In performing expense account analysis the focus is on substantive tests of transactions. How do these tests of transactions differ from tests to assess control risk.

7) While analytical procedures are commonly used when auditing balance sheet accounts, they are normally not very useful when auditing income statement accounts.
A) True
B) False
Answer
Terms: Analytical procedures used in auditing balance sheet accounts and income statement accounts
Diff: Moderate
Objective: LO 19-5
AACSB: Reflective thinking skills

8) Tests of controls provide an indication of the likelihood of misstatements in both the income statement and the balance sheet, simultaneously.
A) True
B) False
Answer
Terms: Tests of controls; Misstatements in income statement and balance sheet
Diff: Moderate
Objective: LO 19-5
AACSB: Reflective thinking skills

9) Typically, analytical procedures are the primary means of verifying income statement accounts resulting from allocations.
A) True
B) False
Answer
Terms: Analytical procedures; Verifying income statement accounts resulting from allocations
Diff: Challenging
Objective: LO 19-5
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 20 Audit of the Payroll and Personnel Cycle

Learning Objective 20-1

1) Which of the following statements about the payroll and personnel cycle is correct?
A)
There are three classes of transactions within
the payroll cycle —
salaried employees,
hourly employees, and commissioned
employees. Transactions are
more significant
than related
balance sheet
accounts. Internal controls
over payroll are
effective for almost
all companies, even
small ones.
No No Yes

B)
There are three classes of transactions within
the payroll cycle —
salaried employees,
hourly employees, and commissioned
employees. Transactions are
more significant
than related
balance sheet
accounts. Internal controls
over payroll are
effective for almost
all companies, even
small ones.
Yes No Yes

C)
There are three classes of transactions within
the payroll cycle —
salaried employees,
hourly employees, and commissioned
employees. Transactions are
more significant
than related
balance sheet
accounts. Internal controls
over payroll are
effective for almost
all companies, even
small ones.
No Yes Yes

D)
There are three classes of transactions within
the payroll cycle —
salaried employees,
hourly employees, and commissioned
employees. Transactions are
more significant
than related
balance sheet
accounts. Internal controls
over payroll are
effective for almost
all companies, even
small ones.
No Yes No

Answer
Terms: Payroll and personnel cycle
Diff: Easy
Objective: LO 20-1
AACSB: Reflective thinking skills
2) Discuss three important differences between the payroll and personnel cycle and other cycles in a typical audit.

3) Most companies, with the exception of small ones, have effective controls over the payroll cycle.
A) True
B) False
Answer
Terms: Effective controls over payroll cycle
Diff: Easy
Objective: LO 20-1
AACSB: Reflective thinking skills

4) While most cycles include at least two classes of transactions, the payroll and personnel cycle includes only one class of transactions.
A) True
B) False
Answer
Terms: Payroll and personnel cycle includes one class of transactions
Diff: Easy
Objective: LO 20-1
AACSB: Reflective thinking skills

5) Because of the cycle’s pervasive nature, audit tests of the payroll cycle are usually extensive.
A) True
B) False
Answer
Terms: Audit tests of payroll cycle
Diff: Moderate
Objective: LO 20-1
AACSB: Reflective thinking skills

Learning Objective 20-2

1) Which of the following departments is most likely responsible for pay rate changes and changes in deductible amounts for employees?
A) General Accounting
B) Human Resources
C) Treasury
D) Controller
Answer
Terms: Department responsible for pay rate changed
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

2) The payroll and personnel cycle ends with which of the following events?
A) interviewing job candidates
B) hiring a new employee
C) existing employees submitting requests for payment for work performed
D) issuance of paychecks
Answer
Terms: Payroll and personnel cycle
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

3) Which of the following includes all payroll transactions processed by the accounting system for a given period of time?
A) payroll journal
B) payroll transaction file
C) time report
D) payroll summary
Answer
Terms: Includes all payroll transactions processed by the accounting system
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

4) An imprest payroll account that has a significant balance may indicate the presence of:
A) employees have not yet deposited or cashed payroll checks.
B) fraudulent transfer of funds by the company.
C) lack of controls over payroll distribution.
D) the company is overpaying its employees.
Answer
Terms: Imprest payroll account has significant balance
Diff: Easy
Objective: LO 20-2
AACSB: Analytic skills

5) Records that include data about employees such as employment date, performance ratings and pay rates are the:
A) human resource records.
B) employee screening forms.
C) summary payroll reports.
D) employee folders.
Answer
Terms: Records that include data about employees
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

6) The computer file used for recording payroll transactions for each employee and maintaining total wages paid for the year to date is the:
A) payroll transaction file.
B) payroll master file.
C) payroll bank account reconciliation.
D) payroll tax returns.
Answer
Terms: Computer file used for recording payroll transactions
Diff: Moderate
Objective: LO 20-2
AACSB: Reflective thinking skills

7) The file for recording each payroll transaction for each employee and maintaining total employee wages paid for the year to date is the:
A) payroll master file.
B) summary payroll report.
C) payroll journal.
D) job time ticket.
Answer
Terms: File for recording each payroll transaction
Diff: Moderate
Objective: LO 20-2
AACSB: Reflective thinking skills

8) The total of the individual employee earnings in the payroll master file should equal the total:
A) balance of gross payroll in general ledger accounts.
B) of the checks drawn to employees for payroll.
C) gross payroll plus the total contributed by the employer for payroll taxes.
D) gross pay for the current week’s payroll.
Answer
Terms: Total of individual employee earnings in payroll master file equals
Diff: Moderate
Objective: LO 20-2
AACSB: Reflective thinking skills

9) Which department should be authorized to add and delete employees from the payroll or change pay rates and deductions?
A) the supervising department
B) the accounting department
C) the human resources department
D) the treasurer’s department
Answer
Terms: Department authorized to add and delete employees from payroll
Diff: Moderate
Objective: LO 20-2
AACSB: Reflective thinking skills

10) The auditor, in auditing payroll, wants to determine that the individuals included in her sample were employees of the company for the period under review. What is the auditor’s best source of evidence?
A) Examination of Human Resource Records
B) Examination of the Payroll Master File
C) Examination of the Payroll Transaction File
D) Examination of the Payroll Tax Records
Answer
Terms: Auditor source of evidence to test individuals are employees of company
Diff: Moderate
Objective: LO 20-2
AACSB: Reflective thinking skills

11) What events initiate and terminate the payroll and personnel cycle?

12) Discuss each of the following primary documents and records used in the personnel and employment function in the payroll and personnel cycle: personnel records, deduction authorization form, and the rate authorization form.

13) Discuss each of the following documents and records used in the timekeeping and payroll preparation function in the payroll and personnel cycle: time card, job time ticket, summary payroll report, payroll journal and payroll master file.

14) Discuss each of the following primary documents and records used in the (1) payment of payroll function, and (2) preparation of payroll tax returns and payment of taxes function in the payroll and personnel cycle: payroll check, W-2 form, and payroll tax returns.

15) Match seven of the terms for documents and records (a-k) used in the payroll and personnel cycle with the descriptions provided below (1-7):

a. Human resource records
b. Deduction authorization form
c. Rate authorization form
d. Time card
e. Job time ticket
f. Summary payroll report
g. Payroll check
h. W-2 form
i. Payroll tax returns
j. Payroll journal
k. Payroll master file

________ 1. A file used for recording payroll transactions for each employee and maintaining total employee wages paid for the year to date.

________ 2. A document indicating the time the hourly employee started and stopped working.

________ 3. A document written in exchange for services received from an employee.

________ 4. Forms submitted to local, state, and federal units of government for the payment of withheld taxes and the employer’s tax.

________ 5. A form authorizing payroll deductions, including the number of exemptions for withholding of income taxes, U.S. savings bonds, and union dues.

________ 6. A form used to authorize the amount of pay.

________ 7. Records including date of employment, personnel investigations, rates of pay, etc.

16) Hiring personnel initiates the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Initiates payroll and personnel cycle
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

17) Firing personnel terminates the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Terminates payroll and personnel cycle
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

18) Paying employees for their services ends the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Terminates payroll and personnel cycle
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills
19) The deduction authorization form authorizes the rate of pay and the deductions for taxes, dues, etc.
A) True
B) False
Answer
Terms: Deduction authorization form
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

20) The job time ticket indicates the starting and stopping times of work during the pay period.
A) True
B) False
Answer
Terms: Job time ticket
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

21) The use of an imprest payroll account prevents losses from payment of unauthorized payroll to no more than the balance in the imprest account.
A) True
B) False
Answer
Terms: Imprest payroll account
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

22) Imprest accounts usually carry a significant balance.
A) True
B) False
Answer
Terms: Imprest accounts
Diff: Easy
Objective: LO 20-2
AACSB: Reflective thinking skills

Learning Objective 20-3

1) Which of the following statements is false?
A) The payroll cycle consists of one class of transactions.
B) Balance sheet accounts related to payroll are generally more significant than related transactions.
C) Internal controls over payroll are effective for most companies.
D) Small companies usually have effective controls over payroll.
Answer
Terms: False regarding payroll cycle
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills
2) Which of the following would have the least amount of importance regarding controls over the processing of payroll?
A) The person authorized to sign paychecks should not be otherwise involved in the preparation of the payroll.
B) A check-signing machine should not be used to replace a manual signature.
C) Distribution of pay checks should be performed by someone who is not involved in the other payroll functions.
D) Unclaimed paychecks should be immediately returned for redeposit.
Answer
Terms: Least important regarding controls over processing payroll
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

3) Which of the following types of audit procedures is ordinarily emphasized the least when auditing payroll?
A) Tests of controls
B) Tests of transactions
C) Analytical procedures
D) Tests of details of balances
Answer
Terms: Audit procedure emphasized least in auditing payroll
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

4) An auditor is vouching a sample of hourly employees from the payroll master file to approved time clock or time sheet data in order to provide evidence that:
A) employees work the number of hours for which they are paid.
B) payments are made at the contractual rate.
C) product cost information is accurate.
D) segregation of duties is present between the payroll function and the payment function for cash disbursements.
Answer
Terms: Vouch from payroll master file to approved time sheets
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

5) The payroll and personnel cycle begins with which of the following events?
A) interviewing job candidates
B) hiring a new employee
C) existing employees submitting requests for payment for work performed
D) issuance of paychecks
Answer
Terms: Payroll and personnel cycle
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills
6) Which of the following best describes the systems of internal control for payroll for large companies ?
A) loosely structured but well controlled
B) loosely structured and loosely controlled
C) highly structured and well controlled
D) highly structured but loosely controlled
Answer
Terms: Systems of internal control for payroll for large companies
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

7) Which of the following internal control objectives is likely to be the most important in the audit of the payroll cycle?
A) Payroll transactions are properly disclosed and presented in the notes to the financial statements.
B) Payroll transactions are processed by an outside service provider.
C) Recorded transactions represent valid payments.
D) Recorded transactions are recorded in the proper accounting period.
Answer
Terms: Internal control objectives most important in audit of payroll cycle
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

8) In audits of companies in which payroll is a significant portion of inventory, the improper account classification of payroll can:
A)
Increase inventory asset valuations. Decrease inventory asset valuations.
Yes Yes

B)
Increase inventory asset valuations. Decrease inventory asset valuations.
No No

C)
Increase inventory asset valuations. Decrease inventory asset valuations.
Yes No

D)
Increase inventory asset valuations. Decrease inventory asset valuations.
No Yes

Answer
Terms: Audits of payroll in which payroll is a significant portion of inventory
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills
9) To minimize the opportunity for fraud, unclaimed salary checks should be:
A) deposited in a special bank account.
B) kept in the payroll department.
C) left with the employee’s supervisor.
D) held for the employee in the personnel department.
Answer
Terms: Minimize opportunity for fraud, unclaimed salary checks
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

10) Which of the following audit procedures would be most useful in testing the cut-off audit objective for payroll-related liabilities?
A) Review documentation for proper classification between long and short term liabilities.
B) Compare the clients accrual of payroll liabilities with the payroll tax return.
C) Examine payment tax returns to determine that the expense was recorded in the correct period.
D) Examine subsequent cash disbursements to determine when the liabilities for payroll were paid.
Answer
Terms: Audit procedures useful in testing the cutoff objective for payroll-related liabilities
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

11) When examining payroll transactions, an auditor is primarily concerned with the possibility of:
A) incorrect summaries of employee time records.
B) overpayments and unauthorized payments.
C) under withholding of amounts required to be withheld.
D) posting of gross payroll amounts to incorrect salary expense accounts.
Answer
Terms: Examining payroll transactions, auditor primarily concerned with
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

12) For which of the following functions is the use of prenumbered documents least important?
A) Use of prenumbered time cards in the payroll function.
B) Use of prenumbered sales invoices in the sales function.
C) Use of prenumbered receiving reports in the acquisitions function.
D) Use of prenumbered deposit slips in the cash receipts function.
Answer
Terms: Prenumbered documents
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
13) Which of the following audit procedures would be the most effective in testing for nonexistent employees?
A) Trace transactions recorded in the payroll journal to the HR department to determine employment status.
B) Examine cancelled checks for proper endorsement.
C) Recalculate net pay .
D) Reconcile the disbursements in the payroll journal with the disbursements on the payroll bank statements.
Answer
Terms: Audit procedures most effective in testing for nonexistent employees
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

14) No individual with access to time cards, payroll records, or checks should also be permitted access to:
A) the computer.
B) job time tickets.
C) personnel records.
D) the canceled check file.
Answer
Terms: Individual with access to time cards, payroll records, or checks should not have access to
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

15) Many companies use outside payroll services to process payroll. Which of the following regarding the auditors responsibilities is most correct regarding their reliance on the internal controls of these outside payroll services?
A) must
B) cannot
C) rarely
D) can often
Answer
Terms: Use of outside payroll services and responsibility regarding reliance on internal control
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

16) You are responsible for the audit of payroll. You have assessed control risk as low for the payroll transactions. Substantive tests of payroll would most likely be limited to analytical procedures and:
A) tracing employee time records to the payroll transaction file.
B) recomputing an entire payroll period and compare to the client’s records.
C) tracing amounts in the payroll transaction file to the payroll master file.
D) recalculating payroll accruals.
Answer
Terms: Assessed control risk as low for the payroll transactions; Substantive tests of payroll likely be limited to analytical procedures and
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
17) The careful and timely preparation of all payroll tax returns is necessary to avoid penalties and criminal charges. The most important control in the timely preparation of these returns is:
A) computerized preparation of tax returns.
B) a well-defined set of policies that indicate when each form must be filed.
C) independent verification of computer output by a competent individual.
D) a Gaant chart.
Answer
Terms: Control for careful and timely preparation of payroll tax returns
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

18) Which of the following types of audit tests is usually emphasized due to a lack of independent third-party evidence related to payroll transactions?
A) Analytical procedures
B) Tests of details of balances
C) Tests of controls
D) Each of the above is emphasized.
Answer
Terms: Audit test emphasized due to lack of independent third-party evidence related to payroll transactions
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

19) The most important means of verifying account balances in the payroll and personnel cycle are:
A) tests of controls and substantive tests of transactions.
B) analytical procedures and tests of controls.
C) analytical procedures and substantive tests of transactions.
D) tests of controls and tests of details of balances.
Answer
Terms: Most important means of verifying account balances in payroll and personnel cycle
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

20) Audit tests of payroll are usually not extensive because:
A)
employees will
likely complain
if underpaid.
payroll
transactions are
uniform and
uncomplicated. payroll transactions are subject to audit by federal
and state governments.

Yes Yes Yes

B)
employees will
likely complain
if underpaid.
payroll
transactions are
uniform and
uncomplicated. payroll transactions are subject to audit by federal
and state governments.

No Yes No

C)
employees will
likely complain
if underpaid.
payroll
transactions are
uniform and
uncomplicated. payroll transactions are subject to audit by federal
and state governments.

No No Yes

D)
employees will
likely complain
if underpaid.
payroll
transactions are
uniform and
uncomplicated. payroll transactions are subject to audit by federal
and state governments.

Yes No No

Answer
Terms: Audit tests of payroll are usually not extensive because
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

21) If an auditor wishes to test the completeness transaction-related audit objective in the payroll and personnel cycle, which of the following would be a reasonable test of control?
A) Account for a sequence of payroll checks.
B) Examine procedures manual and observe the recording of transactions.
C) Examine payroll records for indication of pay rate approval.
D) Reconcile the payroll bank account.
Answer
Terms: Auditor test completeness transaction-related audit objective in payroll and personnel cycle, a test of control
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

22) Which of the following is a substantive test of transactions?
A) Review personnel policies.
B) Account for a sequence of payroll checks.
C) Reconcile the disbursements in the payroll journal with the disbursements on the payroll bank statement.
D) Examine printouts of transactions rejected by the computer as having invalid employee IDs.
Answer
Terms: Substantive test of transactions
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

23) As a part of the auditor’s responsibility for ________, the auditor should review the preparation of at least one of each type of payroll tax form the client is responsible for filing.
A) doing tests of controls
B) doing tests of balances
C) doing tests of transactions
D) understanding the client’s internal controls
Answer
Terms: Auditor’s responsibility and review of preparation of at least one type of payroll tax form
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

24) Which of the following is not an assertion related to the classes of transactions underlying the payroll cycle?
A) Classification
B) Accuracy
C) Existence
D) Occurrence
Answer
Terms: Not an assertion related to the classes of transactions underlying the payroll cycle
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

25) When labor is a material factor in inventory valuation, the auditor should place special emphasis on testing the internal controls concerning:
A) fictitious employees.
B) authorization of wage rates.
C) proper valuation and allocation of balances.
D) completeness of recorded transactions.
Answer
Terms: Labor is material factor in inventory valuation
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

26) Which of the following is not a procedure that can be performed on canceled checks in an effort to detect defalcations?
A) Compare the endorsements on checks with authorized signatures.
B) Scan endorsements for unusual or recurring second endorsements.
C) Examine voided checks to be sure they haven’t been used.
D) Examine the payroll records in subsequent periods to determine that terminated employees are no longer being paid.
Answer
Terms: Not a procedure performed on canceled checks in effort to detect defalcations
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

27) What potential problems may arise when an auditor considers the relationship between payroll and inventory valuation?
A)
Improper
account
classification. Improper
allocation to jobs
or processes. Non-manufacturing payroll expenses charged to inventory.
Yes Yes Yes

B)
Improper
account
classification. Improper
allocation to jobs
or processes. Non-manufacturing payroll expenses charged to inventory.
No Yes No

C)
Improper
account
classification. Improper
allocation to jobs
or processes. Non-manufacturing payroll expenses charged to inventory.
No No Yes

D)
Improper
account
classification. Improper
allocation to jobs
or processes. Non-manufacturing payroll expenses charged to inventory.
Yes Yes No

Answer
Terms: Potential problems considering relationship between payroll and inventory valuation
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

28) Which of the following errors gives the auditor the least concern in auditing payroll transactions?
A) An error that indicates possible fraud.
B) Computational errors in formulas when a computerized system is used.
C) Classification errors in charging labor to inventory and job cost accounts.
D) Each of the above gives the auditor significant concern.
Answer
Terms: Error that gives least concern in auditing payroll transactions
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
29) Auditors may extend their tests of payroll in which of the following circumstances?
A)
Payroll materially affects the valuation of inventory.
The auditor is concerned there may be nonexistent employees on the payroll.
Yes Yes

B)
Payroll materially affects the valuation of inventory.
The auditor is concerned there may be nonexistent employees on the payroll.
No No

C)
Payroll materially affects the valuation of inventory.
The auditor is concerned there may be nonexistent employees on the payroll.
Yes No

D)
Payroll materially affects the valuation of inventory.
The auditor is concerned there may be nonexistent employees on the payroll.
No Yes

Answer
Terms: Auditors may extend tests of payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

30) To check the accuracy of hours worked, an auditor would ordinarily compare clock cards with:
A) personnel records.
B) job time tickets.
C) labor variance reports.
D) time recorded in the payroll register.
Answer
Terms: Check accuracy of hours worked
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

31) A surprise payroll payoff in which employees must pick-up and sign for their pay check is one means of:
A) identifying employees who do not have proper work credentials.
B) establishing a tightly controlled, fraud-free work environment.
C) testing for nonexistent employees.
D) identifying employees who have not submitted proper W-2 forms.
Answer
Terms: Surprise payroll payoff means to check
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
32) Which of the following is the best way for an auditor to determine that every name on a company’s payroll for the Rodgers factory is that of a bona fide employee presently on the job?
A) Examine personnel records for accuracy and completeness.
B) Examine employees’ names listed on payroll tax returns for agreement with payroll accounting records.
C) Make a surprise observation of the company’s regular distribution of paychecks.
D) Visit the working areas and confirm with employees their badge or identification numbers.
Answer
Terms: Audit procedure to verify bona fide employee name on payroll check
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

33) Which of the following best describes inherent risk for balance-related audit objectives as they relate to payroll?
A) not considered
B) low
C) moderate
D) high
Answer
Terms: Inherent risk for balance-related audit objectives related to payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

34) It would be appropriate for the payroll department to be responsible for which of the following functions?
A) Approval of employee time records.
B) Maintain records of employment, firings, and raises.
C) Temporary retention of unclaimed employee paychecks.
D) Preparation of governmental reports as to employees’ earnings and withholding taxes.
Answer
Terms: Payroll department responsible for functions
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

35) Which of the following best describes effective internal control over payroll?
A) The preparation of the payroll must be under the control of the personnel department.
B) The confidentiality of employee payroll data should be carefully protected to prevent fraud.
C) The duties of hiring, payroll computation, and payment to employees should be segregated.
D) The payment of cash to employees should be replaced with payment by checks.
Answer
Terms: Effective internal control over payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
36) The periodic payment from the general cash account to the payroll account for net payroll should be tested for at least one payroll period. The primary audit procedure is a(n):
A) analytical review procedure that net pay is reasonable.
B) test of controls that an imprest account is being used for payroll.
C) substantive test that the correct amount was transferred for this test period.
D) test of transactions that the check is prepared for the proper amount and transmitted to an imprest bank account before payroll checks are handed out.
Answer
Terms: Audit procedure to test periodic payment from general cash account to payroll account
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

37) In auditing payroll, which of the following procedures will normally require the least amount of auditor time under normal circumstances?
A) Tests of controls
B) Substantive tests of transactions
C) Analytical procedures
D) Tests of details of balances
Answer
Terms: Procedure which requires least amount of time when auditing payroll
Diff: Challenging
Objective: LO 20-3
AACSB: Reflective thinking skills

38) A weak internal control system allows a department supervisor to “clock in” for a fictitious employee and then approve the employee’s time card at the end of the pay period. This fraud would be detected if other controls were in place, such as having an independent party:
A) distribute paychecks.
B) recompute hours worked from time cards.
C) foot the payroll journal and trace postings to the general ledger and the payroll master file.
D) compare the date of the recorded check in the payroll journal with the date on the canceled checks and time cards.
Answer
Terms: Weak internal control system; Fraud of fictitious employee
Diff: Challenging
Objective: LO 20-3
AACSB: Reflective thinking skills

39) Effective internal accounting control over unclaimed payroll checks that are kept by the company would include accounting department procedures that require:
A) effective cancellation and stop payment orders for checks representing unclaimed wages.
B) preparation of a list of unclaimed wages on a periodic basis.
C) accounting for all unclaimed wages in a current liability account.
D) periodic accounting for the actual checks representing unclaimed wages.
Answer
Terms: Effective internal accounting control over unclaimed payroll checks
Diff: Challenging
Objective: LO 20-3
AACSB: Reflective thinking skills
40) An auditor traces a sample of electronic time cards before and after the bi-weekly payroll report and then traces to the payroll master file to determine that payroll transactions are reported in the correct period is gathering evidence for which audit objective?
A) Completeness
B) Existence
C) Cut-off
D) Accuracy
Answer
Terms: Tracing to determine payroll transactions are reported in correct period is testing which audit objective
Diff: Challenging
Objective: LO 20-3
AACSB: Analytic skills

41) Which of the following statements is correct?
A) The overhead charged to inventory at the balance sheet date can be understated if the salaries of administrative personnel are inadvertently or intentionally charged to indirect manufacturing overhead.
B) When jobs are billed on a cost-plus basis, revenue and total expenses are both affected by charging labor to incorrect jobs.
C) Payroll is a significant portion of inventory for retail and service industry companies.
D) The valuation of inventory is affected if the direct labor cost of individual employees is improperly charged to the wrong job or process.
Answer
Terms: Effect of payroll costs on inventory
Diff: Challenging
Objective: LO 20-3
AACSB: Reflective thinking skills

42) Which of the following is an effective internal accounting control used to prove that production department employees are properly validating payroll time cards at a time-recording station?
A) Internal auditors should make observations of distribution of paychecks on a surprise basis.
B) Time cards should be carefully inspected by those persons who distribute pay envelopes to the employees.
C) One person should be responsible for maintaining records of employee time for which salary payment is not to be made.
D) Daily reports showing time charged to jobs should be approved by the supervisor and compared to the total hours worked on the employee time cards.
Answer
Terms: Effective internal accounting control for production department
Diff: Challenging
Objective: LO 20-3
AACSB: Reflective thinking skills
43) Generally, is the inherent risk level for the audit of the payroll and personnel set at low, moderate, or high? Explain.

44) What types of audit procedures are typically emphasized during the audit of the payroll cycle?
Answeruditors typically emphasize tests of controls, tests of transactions and annalytical procedures.
Terms: Types of audit procedures in audit of payroll cycle
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

45) Discuss the procedures involved in, and the purpose of, a surprise payroll payoff.
Answer surprise payroll payoff is a procedure in which each employee must pick up and sign for his or her check in the presence of a supervisor and the auditor. Any checks that are not claimed are subject to an extensive investigation to determine whether an unclaimed check is fraudulent. The purpose is to test for nonexistent employees; that is, the issuance of payroll checks to individuals who do not work for the company.
Terms: Procedures and purpose of surprise payroll payoff
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

46) There are several key internal controls over the payment of payroll function that should be present. For example, the payroll should be distributed by someone who is not involved in the other payroll functions. Discuss other key internal controls over the payment of payroll function.
Answerontrols over payroll checks should include limiting the authorization for signing the checks to a responsible employee who does not have access to timekeeping or the preparation of the payroll, and the immediate return of unclaimed checks for redeposit. If a check-signing machine is used to replace a manual signature, the machine must be carefully controlled. An imprest payroll account can be used to prevent the payment of unauthorized payroll transactions.
Terms: Internal controls over payment of payroll function
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
47) Discuss the two circumstances under which auditors would extend their procedures considerably in the audit of payroll.
Answeruditors often extend their procedures considerably in the audit of payroll under the following circumstances: (1) when payroll significantly affects the valuation of inventory and (2) when the auditor is concerned about the possibility of material fraudulent payroll transactions.
Terms: Circumstances for auditors to extend procedures in audit of payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

48) What is one audit procedure that may be used to test for proper handling of terminated employees?
Answer procedure that tests for proper handling of terminated employees is to select several files from the personnel records for employees who were terminated in the current year to determine whether each received termination pay consistent with company policy. Continuing payments to terminated employees can be tested by examining payroll records in the subsequent period to verify that the employee is no longer being paid. Naturally, this procedure is not effective if the personnel department is not informed of terminations.
Terms: Audit procedure to test for proper handling of terminated employees
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

49) There are several internal controls in the personnel and employment function that are important from an audit perspective. For example, there should be an adequate investigation of the competence and trustworthiness of new employees. Discuss other internal controls in the personnel and employment function that are important from an audit perspective.

50) There are several key internal controls over the timekeeping and payroll preparation function that should be present. For example, adequate control over the time on employees’ time cards includes the use of a time clock or other method of making certain that employees are paid for the number of hours they worked. Discuss other key internal controls over the timekeeping and payroll preparation function.

51) What key separation of duties should the auditor expect to find within the payroll and personnel cycle?

52) Payroll checks should be distributed by someone independent of the payroll and timekeeping functions.
A) True
B) False
Answer
Terms: Payroll checks distributed by someone independent
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

53) Auditors seldom expect to find misstatements when testing payroll transactions.
A) True
B) False
Answer
Terms: Misstatements when testing payroll transactions
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills
54) The nature, extent, and timing of substantive tests of payroll transactions vary depending, in part, on assessed control risk.
A) True
B) False
Answer
Terms: Substantive tests of payroll transactions; Assessed control risk
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

55) “Physical control over assets” is not a type of control that is applicable to the payroll cycle.
A) True
B) False
Answer
Terms: Physical control over assets control applicable to payroll cycle
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

56) When auditing the payroll and personnel cycle, tests of controls are routinely performed.
A) True
B) False
Answer
Terms: Audit of payroll and personnel cycle and test of controls
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

57) When labor is a material part of inventory, auditors should emphasize substantive tests of transactions.
A) True
B) False
Answer
Terms: Labor material part of inventory
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

58) A signed payroll check that has not been cashed is considered an asset to the company that issued the check.
A) True
B) False
Answer
Terms: Signed payroll check that is not cashed
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills
59) For proper internal control, the person(s) responsible for signing the payroll checks should not have access to timekeeping or be otherwise involved in the preparation of payroll.
A) True
B) False
Answer
Terms: Proper internal control
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

60) There is very little opportunity for confirmation from third parties of balance sheet accounts related to the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Little opportunity for confirmation
Diff: Easy
Objective: LO 20-3
AACSB: Reflective thinking skills

61) When a client uses an outside payroll service for processing payroll, professional auditing standards permit the auditor to rely on the internal controls of the service organization if the service organization’s auditor has issued a favorable report on the internal controls of the service organization.
A) True
B) False
Answer
Terms: Use of outside payroll service for processing payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

62) When a client uses an outside payroll service for processing payroll, professional auditing standards require the auditor to rely on the internal controls of the service organization if the service organization’s auditor has issued a favorable report on internal controls.
A) True
B) False
Answer
Terms: Use of outside payroll service for processing payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

63) For good internal control, the payroll function should be independent of the human resources department.
A) True
B) False
Answer
Terms: Good internal control; Payroll function independent of human resources department
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
64) If an audit client is a public company, the understanding of internal control must be sufficient to identify opportunities to increase audit effectiveness.
A) True
B) False
Answer
Terms: Understanding of internal control in public company
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
Topic: Public

65) Tests of controls and tests of details of balances are the auditor’s most important means of verifying account balances in the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Tests of controls and tests of details of balances
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

66) The primary purpose of a surprise payroll payoff is to detect employees who have reported more time than was actually worked (fraudulent hours).
A) True
B) False
Answer
Terms: Purpose of surprise payroll payoff
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
67) Because of confidentiality requirements and potential losses of payroll funds, outside service center systems are rarely used by companies for payroll-related functions.
A) True
B) False
Answer
Terms: Outside service centers for payroll-related functions
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

68) Internal control over payroll is normally highly structured and well controlled.
A) True
B) False
Answer
Terms: Internal control over payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
69) Supervisory personnel in the functional department is responsible for evaluating employees who should be responsible for authorizing the addition and deletion of employees from the payroll.
A) True
B) False
Answer
Terms: Supervisory personnel responsibilities
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

70) Despite the large dollar amounts involved in the payroll and personnel cycle, auditors typically spend less time auditing this cycle than others.
A) True
B) False
Answer
Terms: Time spent auditing payroll and personnel cycle
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

71) It is generally more difficult for the auditor to detect payment of fraudulent hours than payment of fictitious employees.
A) True
B) False
Answer
Terms: Detect payment of fraudulent hours and payment of fictitious employees
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

72) One common substantive test of payroll transactions for the existence objective is to compare canceled payroll checks with personnel records.
A) True
B) False
Answer
Terms: Substantive test of payroll transactions for existence objective
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills

73) The audit procedure “Recompute hours worked from time cards” is normally performed when testing the completeness objective for payroll.
A) True
B) False
Answer
Terms: Testing completeness objective for payroll
Diff: Moderate
Objective: LO 20-3
AACSB: Reflective thinking skills
Learning Objective 20-4

1) Inherent risk for payroll-related liabilities is normally higher than for accounts receivable.
A) True
B) False
Answer
Terms: Inherent risk for payroll-related liabilities
Diff: Easy
Objective: LO 20-4
AACSB: Reflective thinking skills

Learning Objective 20-5

1) Which of the following is a major balance-related audit objective in testing payroll liabilities?
A) Payroll tax expense is properly recorded.
B) Transactions in the payroll and personnel cycle are recorded in the proper period.
C) Accrual of salaries is the same as the amounts paid on the payroll tax returns.
D) Time records are recorded by supervisors.
Answer
Terms: Balance-related audit objective in testing payroll liabilities
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills

2) The primary concern in testing payroll-related liabilities is to make sure that:
A) accruals are properly valued.
B) transactions are recorded in the proper period.
C) there are no understated or omitted accruals.
D) the accruals are not overstated.
Answer
Terms: Primary concern in testing payroll-related liabilities
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills

3) Verification of the legitimacy of year-end unpaid bonuses to officers and employees can be accomplished by comparing the recorded accrual to the amount:
A) in the expense account.
B) used in the prior period.
C) authorized in the minutes of the board.
D) paid in the subsequent period.
Answer
Terms: Verification of legitimacy of unpaid bonuses
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills
4) The usual audit test for a public company’s officer compensation is to obtain the authorized salary of each officer from the minutes of the board of directors and compare it with:
A)
the SEC’s 10-K report. the company’s federal income tax return.
Yes Yes

B)
the SEC’s 10-K report. the company’s federal income tax return.
No No

C)
the SEC’s 10-K report. the company’s federal income tax return.
Yes No

D)
the SEC’s 10-K report. the company’s federal income tax return.
No Yes

Answer
Terms: Audit test for public company officer compensation
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills
Topic: Public

5) What are the two major balance-related audit objectives in testing payroll liabilities?
A) Accuracy and detail tie-in
B) Completeness and valuation
C) Completeness and rights and obligations
D) Accuracy and cutoff
Answer
Terms: Major balance-related audit objective in testing payroll liabilities
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills

6) Once the auditor determines that the company’s policy for accruing wages is consistent with prior years, the appropriate audit procedure to test for accuracy and cutoff is:
A) recalculating the client’s accrual.
B) performing extensive tests of controls.
C) performing extensive tests of details.
D) none of the above.
Answer
Terms: Audit procedure to test for accuracy and cutoff for accruing wages
Diff: Challenging
Objective: LO 20-5
AACSB: Reflective thinking skills
7) The most important consideration in evaluating the fairness of the amounts accrued for vacation pay, sick pay, and other benefits is the:
A) consistent accrual of these liabilities relative to those of preceding periods.
B) actual expense incurred for the prior period.
C) amount expended to date in the current period.
D) profitability of the client which will enable these liabilities to be met.
Answer
Terms: Consideration in evaluating amounts for vacation pay, sick pay and other benefits
Diff: Challenging
Objective: LO 20-5
AACSB: Reflective thinking skills

8) Once the auditor has determined the company’s policy for accruing wages and knows it is consistent with that of previous years, the appropriate audit procedure to test for cutoff and accuracy is to:
A) recalculate the client’s accruals.
B) compare the ledger balance with the journal and the tax form.
C) confirm the amount with employees.
D) compare the recorded accrued wages with the amount approved in the minutes of the Board.
Answer
Terms: Audit procedure to test for cutoff and accuracy for accruing wages
Diff: Challenging
Objective: LO 20-5
AACSB: Reflective thinking skills

9) Mathews and Company has $112,000 in an accrued payroll account. The company’s weekly payroll is $186,700 and the accrual represents 3 days out o 5 working days. If the auditor has determined that controls are effective over payroll, what additional work should the auditor perform for this account?

10) How do auditors commonly verify sales commission expense?

11) The two major balance-related audit objectives in testing payroll liabilities are accuracy and cutoff.
A) True
B) False
Answer
Terms: Balance-related audit objectives in testing payroll liabilities; Accuracy and cutoff
Diff: Moderate
Objective: LO 20-5
AACSB: Reflective thinking skills

12) In most audits, payroll tax expense is not tested because the audit risk does not justify the time required to perform the tests.
A) True
B) False
Answer
Terms: Audit of payroll tax expense
Diff: Challenging
Objective: LO 20-5
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 21 Audit of the Inventory and Warehousing Cycle

Learning Objective 21-1

1) Receipt of ordered materials by the receiving department will generate the completion of a form called the:
A) bill of lading.
B) receiving report.
C) materials requisition.
D) inventory acquisition summary.
Answer
Terms: Receipt of ordered materials generate completion of form
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

2) Which of the following would you normally characterize as a difficult and complex account to audit?
A) property, plant and equipment
B) cash
C) inventory
D) prepaid insurance
Answer
Terms: Complex and difficult account to audit
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

3) Inventory is a complex area to audit for all but which of the following reasons?
A) Inventory is often in different locations.
B) There are several acceptable valuation methods and some entities use different methods for different types of inventory.
C) Inventory is often the largest account in working capital.
D) Inventory valuation includes few estimates.
Answer
Terms: Reasons inventory is complex to audit
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

4) In most manufacturing companies, the inventory and warehousing cycle begins with the:
A) receipt of a customer’s order.
B) completion of production of a customer’s order.
C) initiation of production of a customer’s order.
D) acquisition of raw materials for production of an order.
Answer
Terms: Inventory and warehousing cycle begins with
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills
5) ________ accumulate costs by individual jobs as material is issued into production and labor costs are incurred.
A) Just-in-time production systems
B) Job order cost systems
C) Process cost systems
D) Manufacturing systems
Answer
Terms: Accumulate costs by individual jobs
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

6) In performing audit tests of the client’s cost accounting system, the auditor is primarily concerned with which of the following?
A) System is functioning properly in providing costing and pricing information for management.
B) Costs have been properly assigned to finished goods, work-in-process, and cost of goods sold.
C) Inventory counts agree with the client’s accounting records.
D) The client’s cost accounting system is designed on the basis on acceptable cost accounting systems.
Answer
Terms: Audit tests of cost accounting system
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

7) Master files, worksheets, and reports that accumulate material, labor, and overhead as the costs are incurred are:
A) accounting systems.
B) storeroom documents.
C) cost accounting records.
D) finished goods inventory records.
Answer
Terms: Master files, worksheets, and reports that accumulate material, labor and overhead as costs
Diff: Moderate
Objective: LO 21-1
AACSB: Reflective thinking skills

8) The main difference between job order and process costing systems is that:
A) one accumulates costs by materials issued and the other by labor incurred.
B) one accumulates costs by individual jobs and the other by particular processes.
C) one emphasizes costs accumulated in completed products and the other emphasizes costs associated with work-in-process.
D) one emphasizes costs adding value to the product and the other emphasizes costs incurred because of waste, scrap, and obsolescence.
Answer
Terms: Main difference between job order and process costing systems
Diff: Moderate
Objective: LO 21-1
AACSB: Reflective thinking skills
9) The auditor’s main concerns in verifying transfers of inventory do not include whether:
A) recorded transfers exist.
B) transfers represent appropriate uses of company resources.
C) all actual transfers are recorded.
D) the details of the transfer are accurately recorded.
Answer
Terms: Main concern in verifying transfers of inventory
Diff: Moderate
Objective: LO 21-1
AACSB: Reflective thinking skills

10) What are two factors affecting the complexity of the audit of inventory?

11) State the six functions that make up the inventory and warehousing cycle and, for each function, identify the related documents and/or records that would be used by a manufacturing company.

12) In process cost systems, costs are accumulated by individual jobs.
A) True
B) False
Answer
Terms: Process cost system
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills
13) In job cost systems, costs are accumulated by individual jobs.
A) True
B) False
Answer
Terms: Job cost systems
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

14) While separate perpetual inventory records are normally kept for raw materials and finished goods, most companies do not use perpetual for work-in-process.
A) True
B) False
Answer
Terms: Perpetual inventory records for inventories
Diff: Challenging
Objective: LO 21-1
AACSB: Reflective thinking skills

Learning Objective 21-2

1) The audit tests to verify that the client is using an inventory method which is generally accepted and to verify that physical counts were correctly summarized are performed during the audit of the:
A) acquisition and payments cycle.
B) payroll and personnel cycle.
C) inventory and warehousing cycle.
D) sales and collection cycle.
Answer
Terms: Audit tests to verify client is using inventory method which is generally accepted
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills

2) Handling the receipt of ordered goods is a part of the ________ cycle.
A) purchasing
B) acquisition and payment
C) inventory
D) inventory and warehousing
Answer
Terms: Handling receipt of ordered goods
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills
3) Which of the following is not a function within the inventory and warehousing cycle?
A) process the goods
B) store raw materials
C) ship finished goods
D) process invoices for shipped goods
Answer
Terms: Functions within inventory and warehousing cycle
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills

4) The inventory and warehousing cycle can be thought of as having two separate but closely related systems, one involving the actual physical flow of goods, and the other the:
A) related documentation.
B) storage of the goods.
C) internal control over those goods.
D) prevention of waste, obsolescence, and theft.
Answer
Terms: Inventory and warehousing cycle; Separate but closely related systems
Diff: Moderate
Objective: LO 21-2
AACSB: Reflective thinking skills

5) Auditors test the quantity of materials charged to work-in-process by tracing these quantities to:
A) cost ledgers.
B) perpetual inventory records.
C) receiving reports.
D) material requisitions.
Answer
Terms: Test quantity of materials charged to work-in-process by tracing to
Diff: Moderate
Objective: LO 21-2
AACSB: Reflective thinking skills

6) The audit of the inventory and warehousing cycle will be affected by the results from other business processes. Identify the “other” business cycles and how they impact the audit of inventory.
Answercquisition and Payment: Acquire and record raw materials, labor, overhead
Sale and collection: Ship goods and record revenue and the appropriate costs
Terms: Audit of inventory and warehousing cycle affected by other business cycles
Diff: Moderate
Objective: LO 21-2
AACSB: Reflective thinking skills
7) What are the auditor’s primary concerns in verifying the transfer of inventory from one location to another?

8) The audit of the inventory and warehousing cycle consists of five parts. State the five parts and, for each part, identify the cycle in which that part is tested by the auditor.

9) Perpetual inventory records should be maintained by persons having access to inventory.
A) True
B) False
Answer
Terms: Maintaining of perpetual inventory records
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills

10) An approved purchase requisition form authorizes shipment of goods to customers.
A) True
B) False
Answer
Terms: Approved purchase requisition authorizes shipment of goods
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills

11) The receipt of raw materials is a part of the acquisition and payment cycle.
A) True
B) False
Answer
Terms: Acquisition and payment cycle; Receipt of raw materials
Diff: Easy
Objective: LO 21-2
AACSB: Reflective thinking skills
12) Internal controls over the processing of purchase orders function, the receipt of raw materials function, and the storage of raw materials function in the inventory and warehousing cycle are normally tested by the auditor as a part of performing tests of controls and substantive tests of transactions in the acquisition and payment cycle and the payroll and personnel cycle.
A) True
B) False
Answer
Terms: Internal controls over functions in the inventory and warehousing cycle tested
Diff: Moderate
Objective: LO 21-2
AACSB: Reflective thinking skills

Learning Objective 21-3

1) Auditor tests of the physical controls over raw materials, work in process, and finished goods are generally limited to:
A) observation and confirmation.
B) observation and inquiry.
C) inquiry and reconciliation.
D) observation and reconciliation.
Answer
Terms: Auditor tests of physical controls over inventory limited
Diff: Easy
Objective: LO 21-3
AACSB: Reflective thinking skills

2) Almost all companies need physical controls over their assets to prevent loss. Which of the following is not an example of such a control?
A) perpetual inventory master files
B) segregated, limited-access storage areas
C) custody of assets assigned to specific responsible individuals
D) approved prenumbered documents for authorizing movement of inventory
Answer
Terms: Physical controls over assets to prevent loss
Diff: Easy
Objective: LO 21-3
AACSB: Reflective thinking skills

3) Which department within a manufacturing company is often responsible for the review of production and scrap reports?
A) Purchasing
B) Accounts Payable
C) Accounting
D) Production
Answer
Terms: Department responsible for review of production and scrap reports
Diff: Easy
Objective: LO 21-3
AACSB: Reflective thinking skills
4) Johnson Co.’s physical count of inventories was lower than the inventory quantities shown in its perpetual records. This situation could be the result of the failure to record:
A) sales.
B) sales returns.
C) purchases.
D) purchase discounts.
Answer
Terms: Count of inventories lower than inventory quantities in perpetual records
Diff: Easy
Objective: LO 21-3
AACSB: Analytic skills

5) Which of the following controls would be appropriate regarding the release of materials from a stockroom?
A) Production employees request materials be delivered to their work areas as they need them.
B) Stockroom employees deliver materials to work areas throughout the day to maintain acceptable levels of safety stock — no written records are maintained.
C) Production employees submit approved requisition forms to the stockroom for materials needed.
D) Production employer in need of materials should personally pick up needed materials from the stockroom.
Answer
Terms: Control appropriate regarding release of materials from stockroom
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

6) To assure proper segregation of duties, who should maintain the perpetual inventory master files?
A) production personnel
B) inventory storeroom personnel
C) inventory receiving personnel
D) accounting department personnel
Answer
Terms: Segregation of duties; Maintain perpetual inventory master files
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

7) In any company involved in manufacturing, an adequate cost accounting internal control system is necessary to indicate the relative profitability of the various products for management planning and control and to:
A) determine variances from standards.
B) determine variances from budgets.
C) value inventories for financial statement purposes.
D) value inventories for audit verification.
Answer
Terms: Adequate cost accounting internal control system
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills
8) A well-designed computerized system of perpetual inventory master files includes information about the:
A) units of inventory purchased, sold, and on hand.
B) unit costs of inventory purchased, sold, and on hand.
C) units of raw materials, work-in-process, and finished goods.
D) units and unit costs of inventory purchased, sold, and on hand.
Answer
Terms: Well-designed computerized system of perpetual inventory master files
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

9) Which of the following is a significant audit concern related to the transfer of inventory from one location to another?
A) recorded transfers occurred
B) transfers were properly transported
C) transfers were properly planned
D) transfers represent efficient movement of assets
Answer
Terms: Significant audit concern related to transfer of inventory
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

10) The auditor’s tests of the adequacy of the physical controls over raw materials, work-in-process, and finished goods are usually restricted to:
A) observation and inquiry.
B) documentation and observation.
C) documentation and confirmation.
D) documentation and inquiry.
Answer
Terms: Audit test of adequacy of physical controls over inventory
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

11) A major difficulty in the verification of inventory cost records for the purpose of inventory valuation is in determining the reasonableness of:
A) direct labor’s hourly rate.
B) raw materials per unit cost.
C) cost allocations.
D) number of direct labor hours applied.
Answer
Terms: Difficulty in verification of inventory cost records for valuation
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

12) Auditor tests of physical controls over raw materials, work-in-process, and finished goods are performed by:
A)
Examination Observation Inquiry
Yes No Yes

B)
Examination Observation Inquiry
No Yes No

C)
Examination Observation Inquiry
Yes Yes No

D)
Examination Observation Inquiry
No Yes Yes

Answer
Terms: Auditor tests of physical controls over inventory
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

13) If the perpetual inventory master files show lower quantities of inventory than the physical count, an explanation of the difference might be unrecorded:
A) sales.
B) sales discounts.
C) purchases.
D) purchase discounts.
Answer
Terms: Perpetual inventory master file shows lower quantities of inventory than physical count
Diff: Moderate
Objective: LO 21-3
AACSB: Analytic skills

14) Cost accounting controls are those related to the physical inventory and the consequent costs from the point at which:
A) materials are ordered for purchase until the finished product is sold.
B) the customer’s order is received until the finished product is shipped.
C) raw materials are requisitioned until the finished product is sent to storage.
D) raw materials are requisitioned until the finished product is completely manufactured.
Answer
Terms: Cost accounting controls related to physical inventory and costs
Diff: Challenging
Objective: LO 21-3
AACSB: Reflective thinking skills

15) Hardy Company mass-produces eight different products. The controller who is interested in strengthening internal controls over the accounting for materials used in production would be most likely to implement a(n):
A) perpetual inventory system.
B) job order cost accounting system.
C) economic order quantity system.
D) separation of duties among production personnel.
Answer
Terms: Strengthen internal controls over accounting for materials used in production
Diff: Challenging
Objective: LO 21-3
AACSB: Reflective thinking skills

16) Which of the following is an internal control weakness for a company whose inventory of supplies consists of a large number of individual items?
A) The cycle basis is used for physical counts.
B) Supplies of relatively little value are expensed when purchased.
C) Perpetual inventory records are maintained only for items of significant value.
D) The storekeeper is responsible for maintenance of perpetual inventory records.
Answer
Terms: Internal control weakness when inventory consists of large number of items
Diff: Challenging
Objective: LO 21-3
AACSB: Reflective thinking skills

17) Discuss the four aspects of the audit of cost accounting with which the auditor is most concerned.

18) If the perpetual inventory master files show lower quantities of inventory than the physical count, one explanation of the difference might be unrecorded sales.
A) True
B) False
Answer
Terms: Perpetual inventory master files show lower quantities of inventory
Diff: Easy
Objective: LO 21-3
AACSB: Reflective thinking skills
19) When verifying the transfer of inventory from one location to another, the audit objectives with which the auditor is primarily concerned are occurrence of recorded transfers, completeness of recorded transfers, and accuracy of recorded transfers.
A) True
B) False
Answer
Terms: Transfer of inventory; Occurrence, completeness, and accuracy
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

20) Production personnel should ordinarily be responsible for maintaining perpetual inventory records.
A) True
B) False
Answer
Terms: Responsible for maintaining perpetual inventory records
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

21) The extent and timing of an auditor’s physical examination of inventory is significantly influenced by the adequacy of the client’s perpetual inventory records.
A) True
B) False
Answer
Terms: Extent and timing of auditor’s physical examination of inventory
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

Learning Objective 21-4

1) In addition to performing analytical procedures that examine the relationship of inventory account balances with related financial statement accounts auditor’s will often use non-financial measures in determining the reasonableness of inventory balances. List below at least two non-financial measures that may be useful to auditors.

2) Given the following information about your audit client, perform analytical procedures and comment on your findings.

2010 2011 Industry Average
Inventory $20,000 $32,000 $25,000
Cost of Sales $240,000 $320,000 $400,000

3) A comparison of the current year’s inventory turnover ratio with previous years’ may indicate the presence of obsolete inventory.