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Chapter 9 Materiality and Risk

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.
Answer: The three main factors that affect an auditor’s judgment about materiality are:
• Materiality is a relative rather than an absolute concept. A misstatement of a given size might be material for a small company, whereas the same dollar misstatement could be immaterial for a larger one.
• Bases are needed for evaluating materiality. Since materiality is relative, it is necessary to have bases for establishing whether misstatements are material. Net income before taxes is normally the most commonly used base, but other possible bases include current assets, total assets, current liabilities, and owners’ equity.
• Qualitative factors also affect materiality. Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same, such as misstatements involving frauds.
Terms: Factors that affect auditor’s preliminary judgment
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

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.
Answer: Qualitative factors that affect an auditor’s materiality judgment include:
• Amounts involving fraud. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory of the same amount.
• Misstatements affecting contractual obligations. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum account balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users.
• Profit vs. loss. Misstatements that cause a loss to be reported as a profit or misstatements that affect trends in earnings are likely to be important to users.
Terms: Qualitative factors that affect auditor’s materiality judgment
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

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.
Answer:llocating 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?
Answer: Tolerable misstatement is the term for the auditor’s allocation of the preliminary judgment of materiality to any given account balance. The three difficulties auditors face when allocating the preliminary materiality judgment to account balances are:
1. Auditors expect certain accounts to have more misstatement than others.
2. Both overstatements and understatements must be considered.
3. Audit costs can affect the allocation.
Terms: Allocation of preliminary misstatement to account balances and difficulties that auditors face allocating preliminary materiality judgment to account balances
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

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.
Answer: Step 1. Set preliminary judgment about materiality. This is the combined amount of misstatements in the financial statements that would be considered material. This decision is made in the planning stage of the audit.
Step 2. Allocate preliminary judgment about materiality to segments. In this step, the auditor normally allocates the preliminary judgment about materiality to the balance sheet accounts. The amount of materiality allocated to an account is referred to as that account’s tolerable misstatement. This allocation is performed in the audit planning stage.
Step 3. Estimate total misstatement in segment. In this step, the auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This would be performed after the substantive tests for each account are completed.
Step 4. Estimate the combined misstatement. In this step, the projected errors for each account are added, along with total sampling error, to calculate the combined misstatement. This would be performed after all substantive tests have been completed.
Step 5. Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, then the auditor concludes the financial statements are fairly presented. This would be performed after all substantive tests have been completed, in the final review stage of the audit.
Terms: Five steps in applying materiality in audit
Diff: Challenging
Objective: LO 9-2, LO 9-3, and LO 9-4
AACSB: Reflective thinking skills

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. ________.
Answer:
1. decrease
2. increase
3. decrease
4. decrease
5. decrease
Terms: Relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, and tolerable misstatement with planned evidence
Diff: Moderate
Objective: LO 9-3 and LO 9-4
AACSB: Analytic skills
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?
Answer: The audit risk model is used primarily for planning purposes in deciding how much evidence to accumulate in each cycle. The auditor sets an acceptable level of audit risk, (AAR) assesses inherent risk (IR) and control risk (CR), and then uses the following audit risk model to determine an appropriate level of planned detection risk (PDR):

PDR = AAR
IR × CR
Terms: Audit risk model
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills
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.
Answer: Inherent risk is the auditor’s assessment of the likelihood that there are material misstatements in the audit segment before the consideration of internal controls. Inherent risk is important because it attempts to predict where misstatements are most and least likely to occur. Factors that the auditor considers when assessing inherent risk include but are not limited to:
• The nature of the client’s business
• Results of previous audits
• Initial verse repeat engagements
• Related parties
• Non-routine transactions
• Amount of subjectivity in an audit estimate
• Degree of industry regulation
• Factors related to fraudulent financial reporting
Terms: Audit risk model
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills

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.

Answer:
1. d
2. a
3. h
4. f
5. g
6. b
7. e
8. i
9. c
Terms: Business risk; Control risk; Acceptable audit risk; Materiality; Audit assurance; Preliminary judgment about materiality; Tolerable misstatement;
Diff: Moderate
Objective: LO 9-1, LO 9-2, LO 9-3, and LO 9-6
AACSB: Reflective thinking skills

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.
Answer:usiness 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.
Answer: The planning form of the audit risk model is stated as follows:

PDR = AAR
IR × CR

where: PDR = planned detection risk
AAR = acceptable audit risk
IR = inherent risk
CR = control risk

Planned detection risk is a measure of the risk that audit evidence for an account (segment) will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate.

Acceptable audit risk is 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. It is influenced primarily by the degree to which external users will rely on the statements, the likelihood that a client will have financial difficulties after the audit report is issued, and the auditor’s evaluation of management’s integrity.

Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account due to error or fraud before considering the effectiveness of internal control.

Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account (segment) will be prevented or detected on a timely basis by the client’s internal controls.
Terms: Audit risk model
Diff: Moderate
Objective: LO 9-5, LO 9-6, and LO 9-7
AACSB: Reflective thinking skills

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

Answer:
1. a
2. b
3. a
4. c
5. c
6. a
7. b
8. c
9. a
Terms: Responsible parties
Diff: Moderate
Objective: LO 9-1, LO 9-2, LO 9-3, LO 9-4, LO 9-5, LO 9-6, LO 9-7, and LO 9-8
AACSB: Reflective thinking skills
Learning Objective 9-9

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
________
________

Answer:
1. low, high
2. medium, medium
3. medium, medium
4. high, low
Terms: Planned detection risk and planned evidence in relation to acceptable audit risk, inherent risk, and control risk
Diff: Moderate
Objective: LO 9-9
AACSB: Analytic skills

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.

Answer:
1. a
2. a
3. b
4. b
5. b
6. b
7. b
8. a
Terms: Audit risk
Diff: Moderate
Objective: LO 9-6, LO 9-7, LO 9-8, and LO 9-9
AACSB: Analytic skills

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 objectives
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?
Answer: The three objectives are:
• Reliability of financial reporting. Management has both a legal and professional responsibility to be sure that the information is fairly presented in according with reporting requirements such as GAAP.
• Efficiency and effectiveness of operations. Controls within an organization are meant to encourage efficient and effective use of its resources to optimize the company’s goals.
• Compliance with laws and regulations. Public, non-public, and not-for-profit organizations are required to follow many laws and regulations. Some relate to accounting only indirectly, such as environmental protection and civil rights laws. Others are closely related to accounting, such as income tax regulations and anti-fraud legal provisions.

The auditor’s focus in both the audit of financial statements and the audit of internal controls is on the controls over the reliability of financial reporting plus those controls over operations and compliance with laws and regulations that could materially affect financial reporting.
Terms: Three broad objectives management has for internal control
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills

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.
Answer:
1. Adequate separation of duties
2. Proper authorization of transactions and activities
3. Adequate documents and records
4. Physical control over assets and records
5. Independent checks on performance
Terms: Control activities
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
Topic: Public
23) Certain principles dictate the proper design and use of documents and records. Briefly describe several of these principles.
Answer:
• Documents should be prenumbered consecutively to facilitate control over missing documents and as an aid in locating documents when they are needed at a later date.
• Documents and records should be prepared at the time a transaction takes place, or as soon as possible thereafter, to minimize timing errors.
• Documents and records should be designed for multiple uses, when possible, to minimize the number of different forms. For example, a properly designed and used shipping document can be the basis for releasing goods from storage to the shipping department, informing billing of the quantity of goods to bill to the customer and the appropriate billing date, and updating the perpetual inventory records.
• Documents and records should be constructed in a manner that encourages correct preparation. This can be done by providing internal checks within the form or record. For example, computer screen prompts may force online data entry of critical information before record is electronically routed for authorizations and approvals. Similarly, screen controls can validate the information entered, such as when an invalid general ledger account number is automatically rejected when the account number does not match the chart of accounts master file.
Terms: Principles for design and use of documents and records
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

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.
Answer: There are many factors that may lead to increased risk in an organization. Some examples include:
• failure to meet prior objectives,
• quality of personnel,
• geographic dispersion of company operations,
• significance and complexity of core business processes,
• introduction of new information technologies, and
• entrance of new competitors.
Terms: Factors which may lead to increased risk
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

25) Separation of duties is essential in preventing errors and intentional misstatements on the financial statements. List below the four general guidelines.
Answer:
1. Separation of custody of the assets from accounting
2. Separation of the authorization of transactions from custody of related assets
3. Separation of operational responsibility from record keeping responsibility
4. Separation of IT duties from user departments
Terms: General guidelines for separation of duties
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
26) In developing an understanding of the client’s accounting information system the auditor follows a sequential process. Describe the process below:
Answer:
1. Major classes of transactions of the entity
2. How these transactions are initiated and recorded
3. What accounting records exist and their nature
4. How the system captures other events that are significant to the financial statements
5. The nature and details of the financial reporting process followed
Terms: Sequential process
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

27) The internal control framework developed by COSO includes five so-called “components” of internal control. Discuss each of these five components.
Answer:ive components of internal control are:
• The control environment. The control environment consists of 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 company.
• Risk assessment. This is management’s identification and analysis of risks relevant to the preparation of financial statements in conformance with appropriate accounting standards.
• Information and communication. The purpose of the entity’s system is to initiate, record, process, and report the entity’s transactions and to maintain accountability for the related assets.
• Control activities. These are the policies and procedures that help ensure that necessary actions are taken to address risks to the achievement of the entity’s objectives.
• Monitoring. This is management’s ongoing and periodic assessment of the quality of internal control by management to determine that controls are operating as intended and that they are modified as appropriate for changes in conditions.
Terms: Internal control framework; COSO
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

28) Discuss what is meant by the term “control environment” and identify four control environment subcomponents that the auditor should consider.
Answer: The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about control and its importance to the entity. Subcomponents include integrity and ethical values, commitment to competence, board of directors or audit committee participation, management’s philosophy and operating style, organizational structure, assignment of authority and responsibility and human resource policies and practices.
Terms: Control environment
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
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.
Answer: The general guidelines are:
• Custody of assets should be separated from accounting,
• Authorizing transactions should be separated from custody of related assets,
• Operational responsibility should be separated from record-keeping, and
• IT duties should be separated from user departments.
Terms: Separation of duties
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

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.
Answer:
• 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 in the normal course of performing their assigned functions.
• A significant deficiency exists if one or more control deficiencies exist that is less severe than a material weakness but important enough to merit attention by those responsible for oversight of the company’s financial statements.
• A material weakness exists if a significant deficiency, by itself, or in combination with other significant deficiencies, results in a reasonable possibility that internal control will not prevent or detect material financial statement misstatements on a timely basis.
Terms: Control deficiency; Significant deficiency; Material weakness
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

19) Describe the auditor’s responsibilities related to required communications between the auditor and those charged with governance (remove auditor committee) regarding internal control.
Answer: The auditor must communicate significant deficiencies and material weaknesses in writing to those charged with governance as soon as they become aware of their existence. The communication is usually addressed to the audit committee and to management. Timely communications may provide management an opportunity to address control deficiencies before management’s report on internal control must be issued. In some instances, deficiencies can be corrected sufficiently early such that both management and the auditor can conclude that controls are operating effectively as of the balance sheet date.
Terms: Control activities
Diff: Challenging
Objective: LO 10-5
AACSB: Reflective thinking skills

20) The text suggested a five-step approach to identify deficiencies, significant deficiencies, and material weaknesses. Describe this approach.
Answer:
1. Identify existing controls. Because deficiencies and material weaknesses are the absence of adequate controls, the auditor must first know which controls exist.
2. Identify the absence of key controls. Internal control questionnaires, flowcharts, and walkthroughs are useful tools to identify where controls are lacking and the likelihood of misstatement is therefore increased.
3. Consider the possibility of compensating controls. A compensating control is one elsewhere in the system that offsets the absence of a key control. When a compensating control exists, there is no longer a significant deficiency or material weakness.
4. Decide whether there is a significant deficiency or material weakness. The likelihood of misstatements and their materiality are used to evaluate if there are significant deficiencies or material weaknesses.
5. Determine potential misstatements that could result. This step is intended to identify specific misstatements that are likely to result because of the significant deficiency or material weakness. The importance of a significant deficiency or material weakness is directly related to the likelihood and materiality of potential misstatements.
Terms: Required communications between auditor and those charged with governance
Diff: Challenging
Objective: LO 10-5
AACSB: Reflective thinking skills; Analytic skills

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.
Answer:
• Make inquiries of appropriate client personnel
• Examine documents, records, and reports
• Observe control-related activities
• Reperform client procedures
Terms: Operational effectiveness; internal controls; audit procedures
Diff: Challenging
Objective: LO 10-6
AACSB: Reflective thinking skills

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.
Answer:
1. E
2. G
3. A
4. F
5. I
6. B
7. D
Terms: Control environment; Control activities; Internal control; Monitoring; Separation of duties; General authorization; Risk assessment
Diff: Moderate
Objective: LO 10-1 through LO 10-8
AACSB: Reflective thinking skills

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.
Answer: In the context of financial statement auditing, fraud is defined as an intentional misstatement of the financial statements.

The two main categories of fraud are fraudulent financial reporting and misappropriation of assets. Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users of the financial statement. Misappropriation of assets involve theft of an entity’s assets.
Terms: Fraud and main categories
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

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.
Answer:
• Incentives/pressures  Management or other employees have incentives or pressures to commit fraud.
• Opportunities  Circumstances provide opportunities for management or employees to commit fraud.
• Attitudes/Rationalization  An attitude, character, or set of ethical values exists that allows management or employees to intentionally commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
Terms: Conditions for fraud
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

12) List and briefly describe examples of risk factors for each condition of fraud for fraudulent financial reporting.
Answer: Incentives/Pressures: 1. Financial stability or profitability is threatened by economic, industry, or entity operating conditions. 2. Excessive pressure for management to meet debt repayment or other debt covenant requirements. 3. Management or the board of directors’ personal net worth is materially threatened by the entity’s financial performance.

Opportunities: 1. Significant accounting estimates involve subjective judgments or uncertainties that are difficult to verify. 2. Ineffective board of director or audit committee oversight over financial reporting. 3. High turnover or ineffective accounting, internal audit, or information technology staff.

Attitudes/Rationalization: 1. Inappropriate or ineffective support of the entity’s ethics and values. 2. Known history of violations of laws and regulations. 3. Management’s disregard for the financial reporting process.
Terms: Risk factors for conditions of fraud
Diff: Challenging
Objective: LO 11-2
AACSB: Reflective thinking skills

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.
Answer: SAS No. 1 states that, in exercising professional skepticism, an auditor “neither assumes that management is dishonest nor assumes unquestioned honesty.” Auditors need to maintain their skepticism and a questioning mind throughout the audit so that they can identify fraud risk and critically evaluate audit evidence.
Terms: Professional skepticism
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

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.
Answer: SAS No. 99 requires the audit team to conduct discussions to share insights from more experienced audit team members and to “brainstorm” ideas that address several ideas. The ideas that should be discussed are:
• How and where the entity’s financial statements might be susceptible to material misstatements due to fraud.
• How management could perpetrate and conceal fraudulent financial reporting.
• How assets of the entity could be misappropriated.
• How the auditor might respond to the susceptibility of material misstatements due to fraud.
Terms: Brainstorming session required by SAS No. 99
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

9) Describe the sources of information gathered to assess fraud risks.
Answer: When the auditor is assessing fraud risks the following information sources should be considered:
• Information obtained from communications among audit team members about their knowledge of the company and its industry; including how and where the company’s financial statements might be susceptible to material misstatements due to fraud.
• Responses to auditor inquiries of management about their views of the risks of fraud and about existing programs and controls to address specific identified fraud risks.
• Specific risk factors in fraudulent financial reporting or misappropriation of assets.
• Analytical procedures results obtained during planning that indicate possible implausible or unexpected analytical relationships.
• Knowledge obtained through other procedures such as client acceptance and retention decisions, interim review of financial statements, and consideration of inherent and control risks.
Terms: Sources of information to assess fraud risks
Diff: Challenging
Objective: LO 11-3
AACSB: Reflective thinking skills

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.
Answer: (may vary)

Employee conduct–Employees should conduct themselves in a professional manner and prohibit unprofessional behavior

Relationships with client and suppliers: Employees should avoid investing in or acquiring a financial interest in any business organization that has a contractual relationship with the organizations

Conflicts of Interest– Employees are expected to perform their duties conscientiously, honestly, and in accordance with the best interests of the organization and to not use their positions or knowledge gained for private or personal advantage
Terms: Elements for Code of Conduct
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills
Topic: Public

8) Senior management is responsible for promoting a culture of honesty and ethics. Describe what that implies for the organization.
Answer: Management cannot act one way and expect others in the company to behave differently. Through its actions and communications, management can show that dishonest or unethical behavior is not tolerated, even if the results benefit the company. Statements by management about the absolute need to meet operating and financial targets create undue pressures that may lead employees to commit fraud to achieve them. In contrast, statements indicating management’s desire to aggressively pursue entity’s goals and targets while at the same time requiring honest and ethical actions to achieve those goals clearly indicates to employees that integrity is a requirement. Whichever course management pursues, its actions establish the “tone at the top.”
Terms: Management responsitility for promoting a culture of honesty and ethics
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills

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?
Answer:
SAS No. 99 requires the following:
• Examine journal entries and other adjustments for evidence of possible misstatements due to fraud.
• Review accounting estimates for bias.
• Evaluate the business rationale for significant unusual transactions.
Terms: Audit procedures required to address the risk of management override of internal controls
Diff: Challenging
Objective: LO 11-5
AACSB: Reflective thinking skills

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?
Answer: The three main types of revenue manipulation are:
• Fictitious revenues–preparation of fictitious documentary evidence for sales and reduction of inventory
• Premature revenue recognition, and–bill and hold; side agreements; unlimited right of return
• Manipulation of adjustments to revenues – adjustments to the sales and returns allowance account; i.e. not recording returns
Terms: Types of revenue manipulation
Diff: Moderate
Objective: LO 11-6
AACSB: Reflective thinking skills
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?
Answer: Review sales journal for unusual activity near year end
Review the contractual terms of sales regarding rights of return
Review historical evidence of distributor shipments
Review sales invoices and shipping documents for two weeks after year end
Terms: Audit procedures concerning revenue recognition issues
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills

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?
Answer: Only payments to approved vendors
Detailed review of legitimacy of approved vendors
Careful review of document authorizing the acquisition
Segregation duties between authorizing payments and authorizing the acquisition
Cancelling supporting documents to prevent their use as support for multiple payments
Terms: Procedures to prevent fraud in the acquisition and payment cycle
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills

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?
Answer: There are three main types of inquiry available for use by auditors. These are information inquiry, assessment inquiry, and interrogative inquiry. Information inquiry is used to obtain information about facts and details that the auditor does not have. Assessment inquiry is used to corroborate or contradict prior information. Interrogative inquiry is often used when the auditor seeks responses from an individual about his or her knowledge of an event or circumstances.
Terms: Inquiry techniques
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

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.
Answer:nhancements 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?
Answer: Three specific risks to IT systems include risks to hardware and data, a reduced audit trail, and the need for IT experience and separation of IT duties.
Terms: Risks in an IT system
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

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.
Answer:eneral controls are those that relate to all aspects of the IT function. They include controls related to administration, software acquisition and maintenance, physical and on-line security, backup and disaster recovery planning, and hardware controls. Application controls relate to the processing of individual transactions. Application controls are specific to certain software applications and typically do not affect all IT functions.
Terms: General controls and application controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

39) Identify the three categories of application controls, and give one example of each.
Answer:pplication 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.
Answer:ccess 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:
Answer: Validation: ensure the use of the correct master file, database, and programs in processing

Sequence: determines the data submitted for processing are in the correct order

Data Reasonableness: determines whether the data exceeds prespecified amounts

Completeness: determines that every field in a record has been completed
Terms: Tests of processing controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

42) What are the two software testing strategies that companies typically use? Which strategy is more expensive?
Answer:ompanies may use pilot testing and parallel testing to test new software. Pilot testing involves operating the new software at a limited number of facilities, while continuing to operate the old software at all other locations. Parallel testing involves operating the new and old software simultaneously. Parallel testing is more expensive than pilot testing.
Terms: Software testing strategies
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

43) Discuss the four areas of responsibility under the IT function that should be segregated in large companies.
Answer: The responsibilities for IT management, systems development, operations, and data control should be separated:
• IT Management. Oversight of the IT function should be segregated from the systems development, operations, and data control functions. Oversight of IT should be the responsibility of the Chief Information Officer or IT manager.
• Systems development. Systems analysts are responsible for the overall design of each application system. Programmers develop, test, and document applications software. Programmers and analysts should not have access to input data or computer operations.
• Operations. Computer operators are responsible for the day-to-day operations of the computer.
• Data control. Data control personnel independently verify the quality of input and the reasonableness of output.
Terms: Areas of responsibility under IT function
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
44) Identify the six categories of general controls and give one example of each.
Answer:eneral controls fall into the following six categories:
• Administration of the IT function. For example, the chief information officer (CIO) should report to senior management and board of directors.
• Segregation of IT duties. For example, there should be separation of duties between the computer programmers, operators, and the data control group.
• Systems development. Users, analysts, and programmers develop and test software.
• Physical and online security. For example, passwords should be required for access to computer systems.
• Backup and contingency planning. Written backup plans should be prepared and tested on a regular basis throughout the year.
• Hardware controls. For example, uninterruptible power supplies should be used to avoid loss of data in the event of a power blackout.
Terms: Categories of general controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

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.
Answer:omputer 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.
Answer:dvantages 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
Answer: Verify extensions and footings: verify accuracy of the clients computations; foot any subsidiary ledger

Print confirmation requests: print data for sample items selected for testing; randomly select accounts receivable customer balances for testing

Compare data on separate files: determine that information contained in two or more files agrees; changes in accounts payable or accounts receivables accounts using purchases/sales journals and cash disbursement/cash receipts registers.
Terms: Generalized Audit Software and testing of internal controls
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

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.

Answer:
1. k
2. e
3. j
4. n
5. i
6. a
7. l
8. h
Terms: Application controls; General controls; Parallel testing; Parallel simulation; Input
Diff: Moderate
Objective: LO 12-3 and LO 12-5
AACSB: Reflective thinking skills
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?
Answer: Requires the auditor to consider the need to obtain an understanding and test the service center’s controls if the provider’s application involves processing significant financial data.
Terms: Outsources IT requirements to Application Service Provider
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

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: D
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: D
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: D
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.
Answer:
• Procedures to obtain an understanding of internal control – documentation, observation, inquiries of the client, and reperformance.
• Tests of controls – documentation, observation, inquiries of the client, and reperformance.
• Substantive tests of transactions – documentation, inquiries of the client, and reperformance.
• Analytical procedures – inquiries of the client and analytical procedures.
• Tests of details of balances – physical examination, confirmation, documentation, inquiries of the client, and reperformance.
Terms: Audit tests and types of evidence
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

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.
Answer: The five types of audit tests used to determine whether financial statements are fairly stated are: procedures to obtain an understanding of internal control, tests of controls, substantive tests of transactions, analytical procedures, and tests of details of balances. Substantive tests of transactions, analytical procedures, and tests of details of balances are substantive tests, whereas procedures to obtain an understanding of internal control and tests of controls are used to reduce assessed control risk.
Terms: Types of audit tests; Substantive tests which reduce assessed control risk
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

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.
Answer: The purpose of substantive tests of transactions is to determine whether all six transaction-related audit objectives have been satisfied for each class of transactions. For example, as part of the auditor’s test of the accuracy objective for sales, the auditor would compare the amount recorded in the sales journal for a sample of sales transactions with the total on the corresponding sales invoices.
The purpose of tests of controls is to determine the effectiveness of both the design and operations of specific internal controls. For example, the auditor might observe for a month whether statements are mailed to all customers.
The purpose of tests of details of balances is to determine the monetary correctness of the accounts to which they relate. The confirmation of accounts receivable is an example.
Terms: Substantive tests of transactions, tests of controls and tests of details of balances
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

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.
Answer:nalytical 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.
Answer:
1. Tests of controls. Documentation, observation, inquiries of the client, reperformance.
2. Substantive tests of transactions. Documentation, inquiries of the client, reperformance.
3. Analytical procedures. Inquiries of the client, analytical procedures.
4. Tests of details of balances. Physical examination, confirmation, documentation, inquiries of the client, reperformance.
Terms: Relationship of audit tests and types of audit evidence
Diff: Challenging
Objective: LO 13-1
AACSB: Reflective thinking skills

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: D
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: D
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: D
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: D
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?
Answer:
1. Apply the transaction-related audit objectives to the class of transactions being tested.
2. Identify key controls that should reduce control risk for each transaction- related audit objective.
3. Develop appropriate tests of controls for all internal controls that are used to reduce the preliminary assessment of control risk below maximum.
4. For potential types of misstatements related to each transaction-related audit objective, design appropriate substantive tests of transactions, considering deficiencies in internal control and expected results of the tests of controls.
Terms: Four-step approach to reduce assessed control risk
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

4) What are the four steps auditors follow when they plan to reduce assessed control risk?
Answer: The steps are as follows:
1. Apply transaction-related audit objectives to the class of transaction being tested.
2. Identify key controls that should reduce control risk for each transaction-related audit objective.
3. Develop appropriate tests of controls for all internal controls used to reduce the preliminary assessment of control risk below maximum.
4. For potential types of misstatements related to each transaction-related audit objectives, design appropriate substantive tests of transactions, considering deficiencies in internal control and expected results of the tests of controls.
Terms: Steps auditors follow when they plan to reduce assessed control risk
Diff: Challenging
Objective: LO 13-5
AACSB: Reflective thinking skills

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.
Answer: Inherent risk and control risk are directly related to the extent of planned tests of details of balances; that is, as inherent risk and/or control risk increase, the extent of planned tests of details of balances also increases. Tolerable misstatement and acceptable audit risk are inversely related to the extent of planned tests of details of balances; that is, as tolerable misstatement and/or acceptable audit risk increase, the extent of planned tests of details of balances decreases.
Terms: Relationship of extent of planned tests of details of balances and tolerable misstatement, inherent risk, control risk, and acceptable audit risk
Diff: Challenging
Objective: LO 13-5
AACSB: Reflective thinking skills

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: D
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: D
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.
Answer:
1. Perform additional tests for presentation and disclosure
2. Accumulate final evidence
3. Evaluate results
4. Issue audit report
5. Communicate with audit committee and management
Terms: Phase 4 of audit
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

14) In accumulating final evidence upon which to base an audit opinion, the auditor should perform four activities. List the activities below.
Answer:
1. Perform final analytical procedures
2. Evaluate the going concern assumption
3. Obtain a client representation letter
4. Read information in the annual report to ensure that it is consistent with the financial statements
Terms: Accumulating final evidence and final activities
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

15) Discuss the major activities and procedures performed by the auditor in the plan and design of the audit approach.
Answer: The major activities performed in the planning and design phase (Phase I) are:
• Accept client and perform initial planning
• Understand the clients business and industry
• Assess client business risk
• Perform preliminary analytical procedures
• Set materiality and assess acceptable audit risk and inherent risk
• Understand internal control and assess control risk
• Gather information to assess fraud risks
• Develop overall audit plan and audit program
Terms: Major activities and procedures performed by auditor in the plan and design of the audit approach
Diff: Challenging
Objective: LO 13-7
AACSB: Reflective thinking skills

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
Answer:
1. Customer order  request for merchandise by a customer. Appears in the Sales class of transactions.
2. Shipping document  document prepared to initiate shipment of goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. Appears in the Sales class of transactions.
3. Remittance advice  document that is mailed to the customer and typically returned to the seller with payment. Appears in the Cash receipts class of transactions.
4. Sales returns and allowance journal  journal used to record all sales returns and allowances. It performs the same function as the sales journal. Appears in the Sales returns and allowance class of transactions.
5. Uncollectible account authorization form  document used internally to indicate authority to write off an account receivable. Appears in the charge off of Uncollectible accounts class of transactions.
Terms: Documents and class of transactions
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

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.
Answer: The five classes of transactions that comprise the sales and collection cycle are:
• Sales (cash and sales on account)
• Cash receipts
• Sales returns and allowances
• Write-off of uncollectible accounts
• Bad debt expense
Terms: Classes of transactions that comprise the sales and collection cycle
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

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?
Answer: The most important aspects of billing are:
• To make sure that all shipments made have been billed (completeness),
• That no shipment has been billed more than once (occurrence), and
• That each shipment is billed for the proper amount (accuracy).
Terms: Aspects of billing and related objectives
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

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.
Answer: The four business functions that result in sales transactions, and related documents and records, are:
• Processing customer orders. Key documents include customer order and sales order.
• Granting credit. Customer order or sales order.
• Shipping goods. Shipping document (bill of lading).
• Billing customers and recording sales. Sales invoice, sales journal, summary sales report, accounts receivable master file, accounts receivable trial balance, and monthly statements.
Terms: Business functions that result in sales transactions; Sales and collection cycle; Documents
Diff: Challenging
Objective: LO 14-2
AACSB: Analytic skills

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.

Answer:
1. i
2. j
3. c
4. b
5. h
6. k
7. d
Terms: Documents and records
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

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).
Answer:
1. Unintentional–sales included in the journals for which no shipment was made and sales that were recorded more than once.
2. Intentional (fraud)–shipments made to nonexistent customers and were recorded as sales.
Terms: Substantive audit procedures for tests of transactions for sales; Misstatements; Fraud
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills

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
Answer: The potential audit tests include the following:
• Sales included in the journals for which there was no shipment. Vouch selected entries in the sales journal to related copies of shipping and other supporting documents.
• Sale recorded more than once. Review a numerically sorted list of recorded sales transactions for duplicate numbers. The auditor can also test for proper cancellation of shipping documents.
• Shipments made to nonexistent customers and recorded as sales. Trace customer information on sales invoices to the customer master file.
Terms: Audit test used to detect misstatement
Diff: Challenging
Objective: LO 14-3
AACSB: Reflective thinking skills
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?
Answer: The first difference is materiality. In many instances, sales returns and allowances are so immaterial that auditors ignore them. The second difference is the emphasis on the occurrence objective. For sales returns and allowances, auditors usually emphasize testing recorded transactions to uncovering any theft of cash from the collection of accounts receivable that was covered up by fictitious sales returns and allowances.
Terms: Transaction-related audit objectives for credit memos and sales
Diff: Challenging
Objective: LO 14-4
AACSB: Reflective thinking skills

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.
Answer:redit 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.
Answer: (1) shipments made to nonexistent customers and recorded as sales, (2) sales recorded more than once, and (3) sales included in the journals for which no shipment was made.
Terms: Occurrence objective (assertion); Transaction testing for sales; Potential misstatements
Diff: Moderate
Objective: LO 14-5
AACSB: Reflective thinking skills

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.
Answer: Lapping, which is a common type of embezzlement, is the postponement of entries for the collection of receivables to conceal an existing cash shortage. The embezzlement is perpetrated by a person who handles cash receipts and then enters them into the computer system. He or she defers recording the cash receipts from one customer and covers the shortages with subsequent receipts from another. These in turn are covered from the receipts of a third customer a few days later. The employee must continue to cover the shortage through repeated lapping, replace the stolen money, or find another way to conceal the shortage. The embezzlement can be easily prevented by segregation of duties and a mandatory vacation policy for employees who hand cash and enter cash receipts into the system. It can be detected by comparing the name, amount, and dates shown on remittance advices with cash receipts, journal entries and related duplicate deposit slips. Because this procedure is relatively time-consuming, it is ordinarily performed only when specific concerns with embezzlement exist because of a deficiency in internal control.
Terms: Lapping; Internal control deficiency
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills
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.
Answer:ontrol Tests: 1. Observe prelisting of cash receipts. 2. Observe endorsement of incoming checks. 3. Examine file of batch totals to initials of data control clerk. 4. Observe whether monthly statements are sent.

Transaction Tests: 1. Trace amounts of prelisted cash receipts to the cash receipts journal, testing for names, amounts, dates. 2. Compare the prelisting with the duplicate deposit slip.
Terms: Sales and collection business process; Tests of controls and test of transactions for completeness objective/assertion
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills

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.
Answer: The three basic steps in designing tests of controls and substantive tests of transactions are:
• Determine key internal controls for each audit objective.
• Design tests of controls for each control used to support a reduced control risk.
• Design substantive tests of transactions to test for monetary misstatements for each objective.
Terms: Audit procedures performed for business cycle or class of transactions
Diff: Challenging
Objective: LO 14-5
AACSB: Reflective thinking skills

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.
Answer:uditors 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”.
Answer: Sampling risk occurs when the sample is not representative of the population; that is, the characteristics of interest in the sample are not the same as those in the population.
Nonsampling risk occurs when audit tests do not uncover existing exceptions in the sample.
Terms: Sampling and nonsampling risks
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills

14) Discuss what is meant by “nonsampling risk.”
Answer: Nonsampling risk occurs when audit tests do not uncover existing exceptions in the sample.
Terms: Nonsampling risk
Diff: Easy
Objective: LO 15-1
AACSB: Reflective thinking skills
15) Discuss two causes of nonsampling risk. Also discuss ways the auditor can control nonsampling risk.
Answer: The two causes of nonsampling risk are (1) the auditor’s failure to recognize exceptions and (2) inappropriate or ineffective audit procedures. The auditor can control nonsampling risk through careful design of audit procedures and through proper instruction, supervision, and review.
Terms: Nonsampling risk
Diff: Moderate
Objective: LO 15-1
AACSB: Reflective thinking skills

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.
Answer: Nonstatistical sampling differs from statistical sampling in that non-probabilistic sampling can be used for the former but not the latter. In addition, sampling risk can be quantified when using statistical sampling but not when using nonstatistical sampling.
Terms: Differences between statistical and nonstatistical sampling applying sample selection methods and quantification of sampling risk
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

14) You are designing the audit plan for Mathews & Company. You are a strong proponent for statistical sampling over nonstatistical sampling. Make your case.
Answer:
• More efficient samples
• Quantifies sampling risk
• Improved correlation between the sample and the population
Terms: Statistical sampling vs. nonstatistical sampling
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills
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.
Answer:ommonly-used criteria used in directed sample selection are:
• Items most likely to contain misstatements; for example, unusual or complex transactions, overdue receivables.
• Items containing selected population characteristics, such as transactions selected from each month during the year or from each location.
• Large dollar coverage in which the auditor focuses on selecting the relatively large items in the population for testing.
Terms: Directed sample selection approaches
Diff: Moderate
Objective: LO 15-2
AACSB: Reflective thinking skills

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?
Answer: The key advantage is its ease of use. Generally, systematic samples are easily drawn from the population and supporting documentation is easily developed. The key disadvantage is the potential for bias. Once the first item in the sample is selected, all other items are chosen automatically. Auditors should be careful to consider any potential pattern in the data prior to selecting their sample to ensure that their selection considers the possible bias.
Terms: Systematic sample selection
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills
11) Describe each of the four types of sample selection methods commonly associated with statistical audit sampling.
Answer: Four types of sample selection methods commonly associated with statistical audit sampling are:
• Simple random sample selection. Every possible combination of elements in the population has an equal chance of constituting the sample.
• Systematic sample selection. A probabilistic method of sampling in which the auditor calculates an interval (the population size divided by the number of sample items desired) and selects the items for the sample based on the size of the interval and a randomly selected number between zero and the interval size.
• Probability proportional to size sample selection. The probability of selecting any individual population item is proportional to its recorded amount.
• Stratified sample selection. A probabilistic method of sampling in which the population is divided into subpopulations, and sub-samples are taken from each of the subpopulations.
Terms: Types of sample selection methods associated with statistical audit sampling
Diff: Moderate
Objective: LO 15-3
AACSB: Reflective thinking skills

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?
Answer: There are three types of exceptions that auditors are generally concerned with when evaluating populations of accounting data. They are:
1. Deviations from client’s established controls.
2. Monetary misstatements in populations of transaction data.
3. Monetary misstatements in populations of account balance details.
Terms: Types of exceptions and concern when evaluating populations of accounting data
Diff: Moderate
Objective: LO 15-4
AACSB: Reflective thinking skills

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?
Answer:
1. Tolerable exception rate (TER)
2. Acceptable risk of assessing control risk too low (ARACR)
3. Estimated population exception rate (EPER)
Terms: Factors to determine appropriate sample size
Diff: Easy
Objective: LO 15-5
AACSB: Reflective thinking skills

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.
Answer: The tolerable exception rate and acceptable risk of assessing control risk too low are inversely related to sample size; that is, as TER or ARACR increase, sample size will decrease. The estimated population exception rate and the population size are directly related to sample size; that is, as EPER increases, sample size will also increase, and as population size increases, sample size may slightly increase.
Terms: Effects on sample size when increasing tolerable exception, estimated population exception rate, acceptable risk of assessing control risk too low, and population size
Diff: Moderate
Objective: LO 15-5
AACSB: Reflective thinking skills
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.

Answer:
1. i
2. c
3. h
4. b
5. a
6. f
7. k
8. g
Terms: Haphazard selection; Attributes sampling; Block sample selection; Probabilistic sample selection; Random sample; Representative sample; Statistical sampling; Sampling distribution
Diff: Moderate
Objective: LO 15-1, LO 15-2, LO 15-3, and LO 15-6
AACSB: Reflective thinking skills

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.
Answer: The steps that comprise the “evaluate the results” section in attributes sampling are:
1. Generalize from the sample to the population. Tables can be used to determine the upper precision limit (computed upper exception rate) based on the acceptable risk of assessing control risk too low and the sample exception rate.
2. Analyze exceptions. In this step, the auditor should analyze individual exceptions to determine the breakdown in the internal controls that caused them.
3. Decide the acceptability of the population. In the final step, the auditor compares the computed upper exception rate with the tolerable exception rate. If the computed upper exception rate is less than or equal to the tolerable exception rate, then the population is considered acceptable.
Terms: Steps that comprise evaluate the results section of 14 steps to attributes sampling
Diff: Challenging
Objective: LO 15-6
AACSB: Reflective thinking skills

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.
Answer: The steps that comprise the “plan the sample” section in attributes sampling are:
1. State the objectives of the audit test. Typically, in attributes sampling, the overall objective is to test the application of controls and determine whether transactions contain monetary misstatements.
2. Decide if audit sampling applies. Audit procedures involving documentation normally can be performed using sampling, whereas procedures involving observation, inquiry of the client, and analytical procedures are not suited to audit sampling.
3. Define attributes and exception conditions. In this step, the auditor carefully defines the attributes of interest and the conditions that constitute exceptions or errors.
4. Define the population. The population is the body of data about which the auditor wished to generalize, from which the sample must be drawn.
5. Define the sampling unit. In attributes sampling, the sampling unit is normally a document, identified by document numbers, or a transaction recorded in a journal.
6. Specify tolerable exception rate. This is the exception rate that the auditor will permit in the population and still be willing to rely on internal controls.
7. Specify acceptable risk of assessing control risk too low. This 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 tolerable exception rate.
8. Estimate the population exception rate. This is the exception rate the auditor expects to find in the population before testing begins.
9. Determine the initial sample size. The initial sample size is determined from tables, based on values for the tolerable exception rate, acceptable risk of assessing control risk too low, and the estimated exception rate.
Terms: Steps in Plan the sample in attributes sampling
Diff: Challenging
Objective: LO 15-6
AACSB: Reflective thinking skills

Learning Objective 15-7

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

Learning Objective 16-1

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
Answer:
a. compare gross margin percentage with previous year by product line; compare sales by month, (by product line), over time
b. compare bad debt expense as a percentage of sales from previous years
c. compare sales returns and allowances as a percentage of gross sales with previous years
Terms: Analytical procedures; Sales and collection cycle; Possible misstatement
Diff: Moderate
Objective: LO 16-2
AACSB: Analytic skills

Learning Objective 16-3

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.
Answer:onfirmation 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.
Answer: 1. Decide on the appropriate criteria for cutoff
2. Evaluate whether the client has established adequate procedures to ensure a reasonable cutoff
3. Test whether the cutoff was correct
Terms: Cutoff for Accounts Receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Analytic skills

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.
Answer: When testing the detail tie-in objective for accounts receivable, the total column and the columns depicting the aging on the aged trial balance are footed, and the total is compared to the general ledger. In addition, a sample of individual balances on the aged trial balance should be traced to supporting documents to verify the customer’s name, balance, and proper aging. These tests are ordinarily done before any other tests to assure the auditor that the population being tested agrees with the general ledger and accounts receivable master file.
Terms: Audit objectives for accounts receivable
Diff: Moderate
Objective: LO 16-3
AACSB: Reflective thinking skills

36) Assuming the client’s internal controls are adequate, describe how the auditor can verify proper cutoff of sales transactions.
Answer:ssuming 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?
Answer: The three exceptions are:
1. Accounts receivable are immaterial.
2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable.
3. The combined level of inherent risk and control risk is low and other substantive evidence can be accumulated to provide sufficient evidence.
Terms: Exceptions to auditing standards requiring confirmations
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills

16) Describe the differences between positive and negative confirmations. Which type is generally viewed as more reliable?
Answer: positive confirmation requests the recipient to respond regardless of whether the balance as stated on the confirmation is correct or incorrect. In contrast, a negative confirmation requests the recipient to respond only if the balance as stated on the confirmation is incorrect. Positive confirmations are more reliable because the auditor can perform follow-up procedures if a response is not received from the customer.
Terms: Positive and negative confirmations
Diff: Easy
Objective: LO 16-4
AACSB: Reflective thinking skills

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.
Answer: For any positive confirmation not returned, the auditor can examine the following to verify the existence of individual sales transactions making up the ending balance in accounts receivable:
• Subsequent cash receipts–evidence of the receipt of cash after the confirmation date includes examining remittance advices and entries in the cash receipts records.
• Duplicate sales invoices.
• Shipping documents.
• Correspondence with the client.
Terms: Alternative procedures; Existence objective for accounts receivable; Confirmation requests
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
18) Discuss the advantages and disadvantages of using negative accounts receivable confirmations rather than positive confirmations.
Answer: The primary advantage of negative confirmations is that they are less expensive than positive confirmations because there are no second requests and no follow-up of no responses. The primary disadvantage of negative confirmations is that they are less reliable than positive confirmations because a nonresponse must be regarded as a correct response, even though the debtor may have ignored the confirmation request.
Terms: Negative accounts receivable confirmations; Positive confirmations
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

19) Briefly describe the circumstances in which it is acceptable to use negative confirmation requests.
Answer: It is acceptable to use negative confirmation requests only when all of the following circumstances are present:
• The auditor has assessed the risk of material misstatements as low and has obtained sufficient appropriate evidence regarding the design and operating effectiveness of controls relevant to the assertion being tested by the confirmation procedures.
• The population of items subject to negative confirmation procedures is made up of a large number of small, homogeneous account balances, transactions, or other items.
• The auditor expects a low exception rate.
• The auditor reasonably believes that recipients of negative confirmation requests will give the request adequate consideration.
Terms: Negative confirmation requests
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills

20) Describe each of the following types of confirmations:
• Positive confirmation
• Blank confirmation
• Invoice confirmation
• Negative confirmation
Answer:
• Positive confirmations are communications addressed to a debtor requesting the recipient to confirm whether the balance as stated on the confirmation is correct or incorrect.
• Blank confirmation is a type of positive confirmation that does not state the amount, but requests the recipient to fill in the balance or furnish other information.
• Invoice confirmation is a type of positive confirmation in which an individual invoice is confirmed rather than a customer’s entire accounts receivable balance.
• Negative confirmations are addressed to debtor, but request responses only if the information is incorrect.
Terms: Positive confirmation; Blank confirmation; Invoice confirmation; Negative confirmation
Diff: Moderate
Objective: LO 16-4
AACSB: Reflective thinking skills
21) What are the major factors affecting sample size for confirming accounts receivable?
Answer: The factors include:
• tolerable misstatement,
• inherent risk (e.g., relative size of total accounts receivable, number of accounts, prior-year results, and expected misstatements),
• control risk,
• achieved detection risk form other substantive tests (extent and results of substantive tests of transactions, analytical procedures, and other tests of details), and
• type of confirmation (negatives normally require a larger sample size).
Terms: Sample size for confirming accounts receivable
Diff: Challenging
Objective: LO 16-4
AACSB: Reflective thinking skills

22) When an auditor uses negative confirmations, several factors must be considered. What are those factors?
Answer: When negative confirmations are used, the auditor puts considerable emphasis on:
• the effectiveness of internal controls
• substantive tests of transactions
• analytical procedures as evidence of the fairness of accounts receivable, and
• assumes that the large majority of recipients will provide a conscientious reading and response to the confirmation request
Terms: Negative confirmations
Diff: Challenging
Objective: LO 16-4
AACSB: Reflective thinking skills

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.

Answer:
1. c
2. h
3. e
4. f
5. g
6. j
7. b
Terms: Alternative procedures; Positive and negative confirmations; Aged trial balance; Cutoff misstatements; Evidence planning worksheet; Timing difference; Accounts receivable confirmation
Diff: Moderate
Objective: LO 16-3, LO 16-4, and LO 16-5
AACSB: Reflective thinking skills

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.
Answer: Tests of controls focus on testing the effectiveness of internal controls. In substantive tests of transactions, the auditor is concerned about both the effectiveness of internal controls and the monetary correctness of transactions in the accounting system. In tests of details of balances, the concern is determining whether the dollar amount of an account balance is materially misstated.
Terms: Difference among tests of controls, substantive tests of transactions, and tests of details of balances
Diff: Moderate
Objective: LO 17-1
AACSB: Reflective thinking skills

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.
Answer: The steps included in the “evaluate the results” section are:
1. Generalize from the sample to the population. This involves (1) projecting misstatements found in the sample to the population and (2) allowing for sampling risk.
2. Analyze the misstatements. The auditor should evaluate the nature and cause of each misstatement found in the sample.
3. Decide the acceptability of the population. If the projected misstatement (point estimate), combined with the allowance for sampling risk, is less than tolerable misstatement, the auditor will accept the population as fairly stated.
Terms: Steps included in the Evaluate the Results section for nonstatistical sampling
Diff: Moderate
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: The differences are as follows:

Tests of Details
1. Define a misstatement
2. Specify tolerable misstatement
3. Specify acceptable risk of incorrect acceptance
4. Estimate misstatements in the population
5. Analyze misstatements Tests of Controls
1. Define attributes and exception conditions
2. Specify tolerable exception rate
3. Specify acceptable risk of incorrect acceptance
4. Estimate population exception rate
5. Analyze exceptions

Terms: Steps in sampling for tests of details and tests of controls
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: Factors that influence sample size for nonstatistical tests are:
• Control risk. Control risk is directly related to sample size; as control risk increases, sample size also increases.
• Risk for other substantive tests related to the same assertion. Directly related to sample size; as these risks increase, sample size also increases.
• Acceptable audit risk. Inversely related to sample size; as AAR increases, sample size decreases.
• Tolerable misstatement. Inversely related; as tolerable misstatement increases, sample size decreases.
• Inherent risk. Directly related; as inherent risk increases, sample size also increases.
• Expected size and frequency of misstatements. Directly related; as the size and frequency of expected misstatements increase, sample size also increases.
• Number of items in the population. Directly related, but has only a minor effect on sample size.
Terms: Factors that influence sample size for nonstatistical tests of details of balances
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: The steps comprising the “plan the sample” section are:
1. State the objective of the audit test. For tests of details of balances, the objective is to determine whether the account balance being audited is fairly stated.
2. Decide if audit sampling applies. In certain situations, the auditor may choose to test all large items and no small items. In those situations, the auditor has not sampled.
3. Define misstatement conditions. Misstatement conditions are any conditions that represent a monetary misstatement in a sample item.
4. Define the population. The recorded book value of the account being audited is the population.
5. Define the sampling unit. For nonstatistical sampling in tests of details of balances, the sampling unit is almost always the item making up the account balance.
6. Specify tolerable misstatement. This is the amount of materiality allocated to the account under audit.
7. Specify the acceptable risk of incorrect acceptance. This is 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.
8. Estimate misstatements in the population.
9. Determine the initial sample size. In nonstatistical sampling, this is determined judgmentally considering the previous eight factors.
Terms: Audit sampling for tests of details of balances
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: Other factors the auditor must consider are:
• The extent to which items in the population have been audited 100%.
• Whether misstatements tend to be offsetting or in only one direction.
• The amounts of individual misstatements.
• Sample size.
Terms: Factors to consider whether population misstatement exceeds tolerable misstatement
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: 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 are:
• Take no action until tests of other audit areas are completed. If offsetting misstatements are found in other parts of the audit, the auditor may conclude that the population is acceptable.
• Perform expanded audit tests in specific areas.
• Increase the sample size. As sample size increases, sampling error is reduced if the rate of misstatements in the expanded sample, their dollar amount, and their direction are similar to those in the original sample. This may result in the population being acceptable.
• Adjust the account balance. In some circumstances, if the client corrects the misstatements discovered by the auditor, the book value of the account may become acceptable.
• Request the client to correct the e population.
• Refuse to give an unqualified opinion. If none of the prior courses of action results in an acceptable population, the auditor will have to issue either a qualified or an adverse opinion.
Terms: Possible courses of action auditor can take when conclusion that population is misstated by more than tolerable amount
Diff: Challenging
Objective: LO 17-2
AACSB: Reflective thinking skills

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.
Answer: The auditor will accept the conclusion that the population (book value) is not misstated by a material amount if both the lower misstatement bound and the upper misstatement bound fall between the understatement and overstatement tolerable misstatement amounts.
Terms: Monetary-unit sampling
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

24) Explain why monetary-unit sampling, or probability proportional to size sampling, is not useful for detecting understatements.
Answer: Monetary-unit sampling is a technique that assigns physical units to an item in the population based on the dollar value of the item. Larger dollar items are more likely to be chosen for the sample than smaller items. So, if a client has understated an item there is less likelihood that the item will be selected. Consequently, auditors do not commonly use monetary-unit sampling when they are concerned with potential understatements.
Terms: Monetary-unit sampling; Probability proportional to size sampling; Detecting understatements
Diff: Easy
Objective: LO 17-3
AACSB: Reflective thinking skills

25) Discuss the advantages and disadvantages of monetary-unit sampling over other sampling methods.
Answer:dvantages 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?
Answer: There are two basic alternatives to testing negative balances when using MUS. First, the auditor may choose to ignore negative balances for MUS selection and test those amounts by some other means. Second, the auditor could treat the negative balances as positive and add them to the number of monetary units being tested.
Terms: Monetary-unit sampling to evaluate population with negative balances
Diff: Moderate
Objective: LO 17-3
AACSB: Reflective thinking skills

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.
Answer: The remaining six steps are:
• Calculate misstatement per dollar unit in each sample item (misstatement/recorded value).
• Layer misstatements per dollar unit from highest to lowest.
• Determine upper precision limit from attributes sampling table, and calculate the percent misstatement bound for each misstatement (layer).
• Calculate initial upper and lower misstatement bounds for each layer and total.
• Calculate point estimate for overstatements and understatements.
• Calculate adjusted upper and lower misstatement bounds.
Terms: Steps to calculate adjusted misstatement bounds in monetary-unit sampling
Diff: Challenging
Objective: LO 17-3
AACSB: Reflective thinking skills

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.
Answer: The auditor will decide to accept the population as fairly stated when the two-sided confidence interval for the misstatements is completely within the plus and minus tolerable misstatements. Otherwise, the auditor will conclude that the book value is misstated by a material amount.
Terms: Decision rule used with difference estimation sampling
Diff: Moderate
Objective: LO 17-4
AACSB: Reflective thinking skills

14) Explain acceptable risk of incorrect acceptance and acceptable risk of incorrect rejection within the context of variables sampling.
Answer:fter an audit test is performed and statistical results are calculated, the auditor must conclude either that the population is not materially misstated or that it is materially misstated. ARIA is the statistical risk that the auditor has accepted a population that is actually materially misstated. This is a serious concern to auditors because there are potential legal implications in concluding that an account balance is fairly stated when it is misstated by a material amount.

ARIR is the statistical risk that the auditor has concluded that a population is materially misstated when it is not. The only time that ARIR affects the auditor’s actions is when an auditor concludes that a population is not fairly stated. ARIR is important only when there is a high cost to increasing the sample size or performing other tests.
Terms: Variables sampling; Acceptable risk of incorrect acceptance; Acceptable risk of incorrect rejection
Diff: Challenging
Objective: LO 17-2 and LO 17-4
AACSB: Reflective thinking skills
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.

Answer:
1. j
2. l
3. b
4. e
5. c
6. a
Terms: Acceptable risk of incorrect acceptance; Acceptable risk of incorrect rejection
Diff: Moderate
Objective: LO 17-2, LO 17-3, LO and 17-4
AACSB: Reflective thinking skills

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.
Answer: The four steps to generalize from the sample to the population using difference estimation sampling are:
1. Compute the point estimate of the total misstatement.
2. Compute the population standard deviation of the misstatements from the sample.
3. Compute the precision interval for the estimate of the total population misstatements at the desired confidence level.
4. Compute the confidence limits at the CL desired.
Terms: Four steps to generalize sample to population using difference estimation sampling
Diff: Moderate
Objective: LO 17-5
AACSB: Reflective thinking skills

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.
Answer: The three differences in the steps in planning the sample for nonstatistical sampling and difference estimation are:
• When using difference estimation, in addition to acceptable risk of incorrect acceptance, the auditor specifies acceptable risk of incorrect rejection.
• When using difference estimation, the auditor makes an advance estimate of the population standard deviation.
• When using difference estimation, the sample size is calculated using a formula.
Terms: Differences in nonstatistical sampling and difference estimation
Diff: Challenging
Objective: LO 17-2 and LO 17-5
AACSB: Reflective thinking skills
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 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: D
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: D
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?
Answer:
• Inventory is often the largest account in the working capital.
• Inventory is often in different locations.
• Diverse items in inventory are often difficult to value.
• Inventory valuation is difficult due to the estimates involved.
• There are several acceptable methods of valuing inventory and some entities use different methods for different types of inventory.
Terms: Factors affecting complexity of audit of inventory
Diff: Easy
Objective: LO 21-1
AACSB: Reflective thinking skills

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.
Answer: The six functions are:
• Process purchase orders. Related documents are the purchase requisition and the purchase order.
• Receive raw materials. Related documents are the receiving report and the vendor’s invoice.
• Store raw materials. Related record is the raw materials perpetual inventory master file.
• Process the goods. Related documents and records are the raw materials requisition and the cost accounting records.
• Store finished goods. Related records are the finished goods perpetual inventory master file and the cost accounting records.
• Ship finished goods. Related documents and records are the shipping document, the finished goods perpetual inventory master file, and the cost accounting records.
Terms: Functions that make up the inventory and warehousing cycle and related documents/records
Diff: Challenging
Objective: LO 21-1
AACSB: Reflective thinking skills

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: D
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: D
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.
Answer:cquisition 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?
Answer: 1. recorded transfers exist
2. all transfers are recorded
3. the quantity, description, and date of all recorded transfer are accurate
Terms: Methodology for designing tests of details of balances for inventory
Diff: Moderate
Objective: LO 21-2
AACSB: Reflective thinking skills

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.
Answer: The five parts are:
• Acquire and record raw materials, labor, and overhead. This is tested during the audits of the acquisition and payment cycle, and the payroll and personnel cycle.
• Internally transfer assets and costs. This is tested in the inventory and warehousing cycle.
• Ship goods, and record revenue and costs. This is tested during the audit of the sales and collection cycle.
• Physically observe inventory. This is tested in the inventory and warehousing cycle.
• Price and compile inventory. This is tested in the inventory and warehousing cycle.
Terms: Parts of inventory and warehousing cycle and cycle in which tested by auditor
Diff: Challenging
Objective: LO 21-2
AACSB: Reflective thinking skills

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: D
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: D
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: D
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: D
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: D
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.
Answer: The auditor is most concerned with:
• Physical controls over inventory.
• Documents and records for transferring inventory. The auditor’s primary concerns in verifying the transfer of inventory from one location to another are that the recorded transfers exist, the transfers that have actually taken place are recorded, and the quantity, description, and date of all recorded transfers are accurate.
• Perpetual inventory master files. The adequacy of perpetual inventory master files has a major effect on the timing and extent of the auditor’s physical examination of inventory.
• Unit cost records.
Terms: Four aspects of audit of cost accounting
Diff: Moderate
Objective: LO 21-3
AACSB: Reflective thinking skills

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.
Answer: Size and weight of inventory products

Methods of storage

Storage capacity
Terms: Non-financial measures to determine reasonableness of inventory
Diff: Easy
Objective: LO 21-4
AACSB: Reflective thinking skills

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

Answer: Inventory turnover for 2010 is 12, and for 2011 is 10, industry average is 16 Basic accounting information that should be known applied to the inventory chapter

Inventory is increasing with lower inventory turns, and much below industry average. Principal audit concern would be that inventory is over-valued on the balance sheet.
Terms: Analytical procedures
Diff: Moderate
Objective: LO 21-4
AACSB: Analytic skills

3) A comparison of the current year’s inventory turnover ratio with previous years’ may indicate the presence of obsolete inventory.
A) True
B) False
Answer:
Terms: Comparison of inventory turnover ratios
Diff: Easy
Objective: LO 21-4
AACSB: Reflective thinking skills

Learning Objective 21-5

1) You are auditing the inventory account and are concerned about the possibility of an inventory overstatement. What is the best audit procedure to detect damaged inventory?
A) observe the condition of inventory during the client’s physical count
B) compare the condition of inventory from the previous year’s count to the current year
C) compare inventory turnover from the previous year’s inventory to the current year’s inventory
D) reconcile the inventory counts to the cost accounting records
Answer:
Terms: Best audit procedure to detect damaged inventory
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

2) The audit procedure “observe the client taking a physical inventory count and test the count” is sufficient to determine all of the following except:
A) whether recorded inventory actually exists.
B) whether recorded inventory was properly valued by the client.
C) whether recorded inventory was properly counted by the client.
D) whether client inventory instruction had properly been followed.
Answer:
Terms: Audit procedure observe client taking physical inventory count
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

3) There must be a periodic physical count by the client of the inventory items on hand:
A) only if the client uses the LIFO method.
B) only if the client uses a lower-of-cost-or-market method.
C) regardless of the client’s inventory valuation method.
D) only if the client uses either the LIFO or FIFO method.
Answer:
Terms: Periodic physical count on inventory on hand
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

4) If the auditor concludes that physical controls over inventory are so inadequate that the inventory will be difficult to count, the auditor should ordinarily:
A) withdraw from the engagement.
B) issue a qualified audit report.
C) conduct expanded observation tests of physical inventory.
D) hire a specialist to assist the auditor.
Answer:
Terms: Auditor concludes physical controls over inventory are so inadequate
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

5) From which of the following evidence-gathering audit procedures would an auditor obtain most assurance concerning the existence of inventories?
A) observation of physical inventory counts
B) written inventory representations from management
C) confirmation of inventories in a public warehouse
D) auditor’s recomputation of inventory extensions
Answer:
Terms: Evidence-gathering audit procedures for auditor to obtain most assurance concerning existence of inventories
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

6) Which of the following is the best audit procedure for the discovery of damaged merchandise in a client’s ending inventory?
A) Compare the physical quantities of slow-moving items with corresponding quantities of the prior year.
B) Observe merchandise and raw materials during the client’s physical inventory count.
C) Review the management’s inventory representation letter for accuracy.
D) Test overall fairness of inventory values by comparing the company’s turnover ratio with the industry average.
Answer:
Terms: Best audit procedure for discovery of damaged merchandise
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

7) It is frequently possible to test the physical inventory prior to the balance sheet date when:
A) there are accurate perpetual inventory master files.
B) year-end sales are small.
C) the internal control system is no better at year-end than at an earlier point in time.
D) the client counts inventory at interim dates.
Answer:
Terms: Test of physical inventory prior to balance sheet date
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

8) Tests of the perpetual inventory master files for the purpose of reducing the tests of physical inventory or changing their timing are done through the use of:
A) inquiry.

B) observation.
C) confirmation.
D) documentation.
Answer: D
Terms: Tests of perpetual inventory master files to reduce tests of physical inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

9) Which one of the following analytical procedures would be most useful in alerting the auditor to the possibility of obsolete inventory?
A) Compare gross margin percentage with previous years’.
B) Compare unit costs of inventory with previous years’.
C) Compare inventory turnover ratio with previous years’.
D) Compare current year manufacturing costs with previous years’.
Answer:
Terms: Analytical procedure useful in alerting for obsolete inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills
10) Which of the following statements is correct regarding the auditor’s responsibility with respect to the year-end inventory procedures of an audit client?
A)
The auditor is responsible for reconciling the physical count with the perpetual inventory matter files. The auditor is responsible for taking and compiling the inventory.
The auditor is responsible for observing the physical counting of inventory.

Yes No No

B)
The auditor is responsible for reconciling the physical count with the perpetual inventory matter files. The auditor is responsible for taking and compiling the inventory.
The auditor is responsible for observing the physical counting of inventory.

No No Yes

C)
The auditor is responsible for reconciling the physical count with the perpetual inventory matter files. The auditor is responsible for taking and compiling the inventory.
The auditor is responsible for observing the physical counting of inventory.

Yes No Yes

D)
The auditor is responsible for reconciling the physical count with the perpetual inventory matter files. The auditor is responsible for taking and compiling the inventory.
The auditor is responsible for observing the physical counting of inventory.

No Yes No

Answer:
Terms: Auditor’s responsibility for year-end inventory procedures
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

11) McKesson & Robbins Company is a well-known audit case involving auditor responsibility. What occurred at the McKesson & Robbins Company to change the way in which auditors audit inventory?
A) The company recorded nonexistent inventory.
B) The auditor did not perform any audit tests of the inventory.
C) The auditor and company colluded to overstate inventory balances.
D) The company counted inventory three months prior to year-end.
Answer:
Terms: McKesson & Robbins Company audit case; Auditor responsibility in auditing inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

12) When a physical count of inventory is performed at an interim date, the auditor observes it at that time and tests the perpetual records for transactions:
A) throughout the year.
B) which are a representative sample of the period under audit.
C) from the date of the count to year-end.
D) from the date of the count to the end of the audit field work.
Answer:
Terms: Count of inventory performed at interim date
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

13) When there are no perpetual inventory files and inventory is material:
A) an audit cannot be performed, so the auditor must issue a disclaimer.
B) a physical inventory should be taken by the client near year-end.
C) the auditor will have to perform the inventory count and determine valuation.
D) the auditor need not observe inventory counts but must do test counts.
Answer:
Terms: No perpetual inventory files and inventory is material
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

14) The most important part of the observation of inventory is to determine whether:
A) all counts are accurate.
B) the inventory-takers are qualified.
C) obsolete inventory has been identified.
D) the physical count is being taken in accordance with the client’s instructions.
Answer: D
Terms: Most important part of observation of inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

15) A useful starting point for becoming familiar with the client’s inventory is for the auditor to:
A) read the AICPA’s Industry Audit Guide.
B) review accounting theory covering special problems, such as gas and oil accounting, or lease-purchase agreements.
C) read the client’s Accounting Manual.
D) tour the client’s facility.
Answer: D
Terms: Starting point for becoming familiar with client’s inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

16) A common inventory observation procedure is to select a random sample of tag numbers and identify the tag with that number attached to the actual inventory item. The audit objective being achieved by this procedure is:
A) inventory as recorded on tags actually exists (existence).
B) existing inventory is counted and tagged (completeness).
C) inventory is counted accurately (accuracy).
D) inventory is classified correctly (classification).
Answer:
Terms: Audit objective of procedure to select random sample
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

17) If a client intends to count inventory at an interim date, the auditor should expect there to be all of the following except:
A) controls over the preparation and maintenance of perpetual inventory records.
B) competent personnel assigned to count the inventory.
C) third-party inventory counting specialists.
D) an adequately designed plan to count the inventory.
Answer:
Terms: Inventory count at interim date
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

18) A common inventory observation procedure is to be alert for items that are damaged, rust- or dust-covered, or located in inappropriate places. The balance-related audit objective being achieved by this procedure is:
A) classification.
B) cutoff.
C) realizable value.
D) rights.
Answer:
Terms: Balance-related audit objective for alert for items that are damaged
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

19) The test of details of balance procedure which requires the auditor to account for unused inventory tag numbers to make sure none have been deleted is associated with the audit objective of:
A) accuracy.
B) existence.
C) detail tie-in.
D) completeness.
Answer: D
Terms: Audit objective related to test of details of balances procedure to account for unused inventory tag numbers
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills
20) Most of the audit testing of the storage of finished goods as well as the shipment of merchandise takes place during the testing of the:
A) sales and collection cycle.
B) payroll and personnel cycle.
C) acquisitions and payments cycle.
D) inventory and warehousing cycle.
Answer:
Terms: Audit testing of storage of finished goods and shipment of merchandise
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

21) Which of the following situations would most likely require special audit planning?
A) Inventory consists of precious stones.
B) Some items of factory and office equipment do not bear identification numbers.
C) Depreciation methods used on the client’s tax return differ from those used on the books.
D) Assets costing less than $500 are expensed even though their expected life exceeds one year.
Answer:
Terms: Situation that require special audit planning
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

22) For several years, a client’s physical inventory count has been lower than what was shown on the books at the time of the count so that downward adjustments to the inventory account were required. Contributing to the inventory problem could be weaknesses in internal control that led to the failure to adjust the accounting records for some:
A) purchases returned to vendors.
B) sales returns received.
C) sales discounts allowed.
D) cash purchases.
Answer:
Terms: Client’s physical inventory count lower than what was shown on bools
Diff: Moderate
Objective: LO 21-5
AACSB: Analytic skills

23) The physical counting of inventory may be performed at which of the following times?
A)
Interim dates On a cycle basis during the year
Yes Yes

B)
Interim dates On a cycle basis during the year
No No

C)
Interim dates On a cycle basis during the year
Yes No

D)
Interim dates On a cycle basis during the year
No Yes

Answer:
Terms: Physical counting of inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

24) When an auditor observes that personnel who are responsible for physically counting inventory are not following the inventory instructions, the auditor should:
A) contact a client’s supervisor in an attempt to correct the problem.
B) modify the client’s physical inventory instructions.
C) not discuss the problem with client’s supervisor in order to maintain independence.
D) assign audit staff to the inventory count.
Answer:
Terms: Observation of personnel taking inventory not following instructions
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

25) The auditor’s objective during an observation of a client’s physical inventory count is to:
A) discover whether a client has counted a particular inventory item or group of items.
B) obtain direct knowledge that the inventory exists and has been properly counted.
C) provide an appraisal of the quality of the merchandise on hand on the day of the physical count.
D) allow the auditor to supervise the conduct of the count so as to obtain assurance that inventory quantities are reasonably accurate.
Answer:
Terms: Auditor’s objective during observation of physical inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

26) The audit of year-end physical inventories should include steps to verify that the client’s purchases and sales cutoffs were adequate. The audit steps should be designed to detect whether merchandise included in the physical count at year-end was not recorded as a:
A) sale in the current period.
B) sale in the subsequent period.
C) purchase in the current period.
D) purchase return in the subsequent period.
Answer:
Terms: Audit of year-end physical inventories
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

27) Which one of the following procedures would not be appropriate for an auditor in discharging his responsibilities concerning the client’s physical inventories?
A) confirmation of goods in the hands of public warehouses
B) supervising the taking of the annual physical inventory
C) carrying out physical inventory procedures at an interim date
D) obtaining written representation from the client as to the existence, quality, and dollar amount of the inventory
Answer:
Terms: Procedures not appropriate for auditor in discharging responsibilities concerning physical inventories
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

28) The auditor generally decides whether the inventory count can be taken before year-end primarily on the basis of:
A) audit efficiency.
B) accuracy of the perpetual inventory master files.
C) client convenience.
D) audit staff availability.
Answer:
Terms: Basis that auditor decides whether inventory count can be taken before year-end
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

29) Which of the following control procedures would most likely be used to maintain accurate perpetual inventory records?
A) independent storeroom count of goods received
B) periodic independent comparison of records with goods on hand
C) periodic independent reconciliation of control and subsidiary records
D) independent matching of purchase orders, receiving reports, and vendors’ invoices
Answer:
Terms: Control procedures likely used to maintain accurate perpetual inventory records
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills
30) In valuing inventory, the auditor must consider all but which of the following factors?
A) The valuation method must be in accordance with GAAP.
B) The valuation method must be applied on a consistent basis.
C) The inventory must be valued at the lower of cost or market.
D) All inventory must be valued using the same valuation method under GAAP.
Answer: D
Terms: Factors considered in valuing inventory
Diff: Challenging
Objective: LO 21-5
AACSB: Reflective thinking skills

31) When an outside specialist has assumed full responsibility for taking the client’s physical inventory, reliance on the specialist’s report is acceptable if:
A) the auditor’s report contains a reference to the assumption of full responsibility.
B) the auditor is satisfied through application of appropriate procedures as to the reputation and competence of the specialist.
C) the auditor conducted the same audit tests and procedures as would have been applicable if the client’s employees took the physical inventory.
D) circumstances made it impracticable or impossible for the auditor either to do the work personally or observe the work done by the inventory firm.
Answer:
Terms: Outside specialists take client’s inventory; Reliance on specialist’s report
Diff: Challenging
Objective: LO 21-5
AACSB: Reflective thinking skills

32) To best ascertain that a company has properly included merchandise that it owns in its ending inventory, the auditor should review and test the:
A) terms of the open purchase orders.
B) purchase cutoff procedures.
C) contractual commitments made by the purchasing department.
D) purchase invoices received on or around year-end.
Answer:
Terms: Auditor should review and test for proper inclusion of merchandise in ending inventory
Diff: Challenging
Objective: LO 21-5
AACSB: Reflective thinking skills

33) When auditing a public warehouse, which of the following is the most important audit procedure with respect to disclosing unrecorded liabilities?
A) observation of inventory
B) review of outstanding receipts
C) inspection of receiving and issuing procedures
D) confirmation of negotiable receipts with holders
Answer:
Terms: Important audit procedure when auditing public warehouse
Diff: Challenging
Objective: LO 21-5
AACSB: Reflective thinking skills
34) When may auditors observe the physical inventory count?
A)
At an interim date At year-end
Yes Yes

B)
At an interim date At year-end
No No

C)
At an interim date At year-end
Yes No

D)
At an interim date At year-end
No Yes

Answer:
Terms: Auditors observe physical inventory count
Diff: Moderate
Objective: LO 21-3 and LO 21-5
AACSB: Reflective thinking skills

35) Discuss the auditor’s responsibilities for inventory maintained in public warehouses or with other outside custodians.
Answer: Ordinarily the auditor will confirm inventory held by outside custodians. However, the auditor may perform additional procedures if the amounts involved are significant. These additional procedures may include: an investigation of the custodian’s performance, requesting an independent accountant’s report on the custodian’s control procedures over the custody of goods, and observing the physical count of goods held by the custodian.
Terms: Auditor responsibilities for inventory maintained in public warehouses
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

36) Discuss the key control procedures relating to the client’s physical count of inventory.
Answer: The key control procedures relating to the client’s physical count of inventory include proper instructions for the physical count, supervision by responsible personnel, independent internal verification of the counts, independent reconciliations of the physical counts with perpetual inventory master files, and adequate control over count sheets or tags.
Terms: Control procedures related to physical count of inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

37) Explain why the audit of work-in-process and finished goods inventory is generally more complex than the audit of purchased inventory.
Answer: The need to verify the cost of raw materials, direct labor, and manufacturing overhead in pricing work-in-process and finished goods has the effect of making the audit of work-in-process and finished goods inventory more complex than the audit of purchased inventory.
Terms: Audit of work-in-process and finished goods inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

38) Auditing standards require that auditors satisfy themselves about the effectiveness of the client’s method’s of counting inventory and the reliance they can place on the client’s representations about the quantities and physical condition of the inventories. To meet this requirement auditors must perform 4 activities. List below.
Answer:
• Be present at the time the client counts the inventory
• Observe the client’s accounting procedures
• Make inquiries of client personnel about their counting procedures
• Make their own independent tests of the physical count
Terms: Effectiveness of client’s method of counting inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

39) Auditing standards recommend that auditors observe physical inventory counts by the client.
A) True
B) False
Answer:
Terms: Audit standards; Auditors observe physical inventory
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

40) In the audit of inventory, the auditor and client are jointly responsible for making and recording the count of physical inventory; while the auditor is responsible for drawing conclusions about the adequacy of the physical inventory.
A) True
B) False
Answer:
Terms: Responsibility for making and recording count of physical inventory count
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

41) When finished goods are completed, they are usually stored in the packing area.
A) True
B) False
Answer:
Terms: Finished goods completed
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills
42) To test for proper sales cutoff, an auditor would obtain the number of the last bill of lading issued during the period under audit and verify that the item shipped had been excluded from the inventory listing.
A) True
B) False
Answer:
Terms: Test for proper sales cutoff
Diff: Easy
Objective: LO 21-5
AACSB: Reflective thinking skills

43) When the client’s perpetual inventory master files are inadequate, the auditor will probably choose to test the physical inventory prior to the balance sheet date.
A) True
B) False
Answer:
Terms: Client’s perpetual inventory master files are inadequate
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

44) When part of the client’s inventory is in a public warehouse or in the possession of other outside custodians, the auditor does not need to observe a physical count of the inventory if a written confirmation is obtained directly from the inventory custodians.
A) True
B) False
Answer:
Terms: Client’s inventory in pubic warehouse
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills

45) When performing audit tests of pricing and compilation for inventory, the client’s perpetual inventory master file may be used in place of vendors’ invoices if controls over the perpetual inventory master file are adequate.
A) True
B) False
Answer:
Terms: Audit tests of pricing and compilation for inventory
Diff: Moderate
Objective: LO 21-5
AACSB: Reflective thinking skills
46) Inherent risk is typically assessed at a moderate level for inventory due to the nature of the asset.
A) True
B) False
Answer:
Terms: Inherent risk for inventory
Diff: Challenging
Objective: LO 21-5
AACSB: Reflective thinking skills
Learning Objective 21-6

1) If an auditor were concerned with obtaining evidence about the appropriateness of the value of inventory, which of the following tests would be most appropriate?
A) compilation tests
B) price tests
C) confirmation of inventory held by outside parties
D) physical examination of the inventory
Answer:
Terms: Tests of evidence about appropriateness of value of inventory
Diff: Easy
Objective: LO 21-6
AACSB: Reflective thinking skills

2) The first step in verifying the valuation of purchased inventory is in determining the valuation method used by the client. The 2nd step is:
A) determining that all inventory that is purchased is expensed through cost of goods sold.
B) determining which costs should be included in the valuation of an item of inventory.
C) determining that all inventory on hand reconciles to the perpetual inventory records.
D) determining that cut-off procedures have been adhered to prior to counting inventory.
Answer:
Terms: Second step in verifying the valuation of purchased inventory
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

3) You are gathering evidence for the audit objective that existing inventory items are included in the inventory listing schedule. The audit procedure that would provide you with the best evidence to confirm this objective is:
A) trace from inventory tags to the inventory listing schedule and make sure the inventory tag is included.
B) trace the inventory totals to the general ledger.
C) perform tests of lower-of-cost-or-market.
D) account for unused tags shown in the auditor’s documentation to make sure no tags have been added.
Answer:
Terms: Audit procedure that provides evidence to confirm audit objective of existence of inventory
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

4) The test of details of balance procedure which requires the auditor to perform tests of lower-of-cost-or-market, selling price, and obsolescence is an attempt to satisfy the objective of:
A) existence.
B) completeness.
C) accuracy.
D) realizable value.
Answer: D
Terms: Objective for tests of details of balance procedure to perform lower-of-cost-or-market, selling price, and obsolescence
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

5) After accounting for a sequence of inventory tags, an auditor traces a sample of tags to the physical inventory listing to obtain evidence that all items:
A) included in the listing have been counted.
B) represented by inventory tags actually exist.
C) represented by inventory tags are included in the listing.
D) included in the listing are represented by inventory tags.
Answer:
Terms: Auditor traces sample of tags to physical inventory listing to obtain evidence
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

6) Pricing manufactured inventory is difficult. Auditors must evaluate the method of allocating manufacturing overhead for all but which of the following?
A) reasonableness
B) computational correctness
C) compliance with accounting standards
D) consistency
Answer: D
Terms: Auditors must evaluate method of allocating manufacturing overhead
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

7) Controls which provide a means of ensuring that the physical counts are properly summarized, priced at the same amount as the unit records, correctly extended and totaled, and included in the general ledger at the proper amount are known as:
A) standard cost controls.
B) pricing internal controls.
C) compilation internal controls.
D) count quantity internal controls.
Answer:
Terms: Controls which provide means of ensuring physical counts are properly summarized
Diff: Challenging
Objective: LO 21-6
AACSB: Reflective thinking skills
8) Assume that the client’s valuation of an inventory item is $10 per unit for 1,000 units, using first-in, first-out (FIFO). If the most recent acquisition of inventory was for 600 units at $10 per unit and the immediately preceding acquisition was for 700 units at $9 per unit, the inventory item is in error and it is:
A) understated $400.
B) understated $300.
C) overstated $400.
D) overstated $700.
Answer:
Terms: Inventory errors  First-in, first-out (FIFO)
Diff: Challenging
Objective: LO 21-6
AACSB: Analytic skills

9) The auditing procedures generally used for the physical observation of inventory and the pricing and compilation of inventory are:
A) analytical procedures and tests of transactions.
B) analytical procedures and tests of details of balances.
C) analytical procedures and control tests.
D) tests of transactions and tests of details of balances.
Answer:
Terms: Inventory errors  Last-in, first-out (LIFO)
Diff: Challenging
Objective: LO 21-6
AACSB: Analytic skills

10) In pricing inventory, it is necessary to consider whether replacement cost is lower than historical cost. When applying lower of cost or market tests, what basis should auditors use for each of the following categories of inventory:
• Raw materials
• Work-in-process
• Purchased finished goods
Answer:
• Raw materials — the most recent cost as found on vendor invoices from the period subsequent to year-end
• Work-in-process — all manufacturing costs from production records from the period subsequent to year-end
• Purchased finished goods — the most recent cost as found on vendor invoices from the period subsequent to year-end and the sales value of these goods
Terms: Applying lower of cost or market tests to categories of inventory
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

11) Internal controls over the ship finished goods function in the inventory and warehousing cycle are not normally tested by the auditor as a part of performing tests of controls and substantive tests of transactions in the sales and collection cycle.
A) True
B) False
Answer:
Terms: Internal controls over ship finished goods function
Diff: Easy
Objective: LO 21-6
AACSB: Reflective thinking skills

12) The audit procedure “Perform tests of lower-of-cost-or-market, selling price, and obsolescence” provides assurance mainly for the realizable value objective for inventory pricing and compilation.
A) True
B) False
Answer:
Terms: Assurance for realizable value objective for inventory pricing and compilation
Diff: Easy
Objective: LO 21-6
AACSB: Reflective thinking skills

13) When performing price tests for purchased inventory, the auditor would not be concerned with the most recent vendors’ invoices if the client uses the FIFO valuation method.
A) True
B) False
Answer:
Terms: Performing price tests for purchased inventory; FIFO valuation method
Diff: Easy
Objective: LO 21-6
AACSB: Reflective thinking skills

14) It is acceptable under generally accepted accounting principles for a company to use different valuation methods for different parts of its inventory.
A) True
B) False
Answer:
Terms: Acceptable for company to use different valuation methods for different parts of inventory
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

15) The major considerations in evaluating the reasonableness of cost allocations are compliance with GAAP and consistency with prior years.
A) True
B) False
Answer:
Terms: Considerations in evaluating reasonableness of cost allocations
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills
16) The audit procedure “Foot the inventory listing schedules for raw materials, work-in-process, and finished goods” provides assurance mainly for the accuracy objective for inventory pricing and compilation.
A) True
B) False
Answer:
Terms: Accuracy objective for inventory pricing and compilation
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

17) The audit procedure “Account for unused tag numbers shown in the auditor’s working papers to make sure no tags have been added” provides assurance mainly for the existence objective for inventory pricing and compilation.
A) True
B) False
Answer:
Terms: Existence objective for inventory pricing and compilation
Diff: Moderate
Objective: LO 21-6
AACSB: Reflective thinking skills

Learning Objective 21-7

1) When labor is a significant part of inventory, verifying the proper accounting of these costs should be tested in the:
A) inventory and warehousing cycle.
B) payroll and personnel cycle.
C) acquisitions and payments cycle.
D) cash cycle.
Answer:
Terms: Labor a significant part of inventory
Diff: Easy
Objective: LO 21-7
AACSB: Reflective thinking skills

2) The design of tests of details of balances for inventory is affected by audit results from multiple cycles. Identify the cycles, other than the inventory and warehousing cycle that affect the audit of inventory.
Answer: Tests of details of balances for inventory are affected by the results of tests of controls and substantive tests of transactions in the sales and collection cycle, acquisition and payment cycle, and payroll and personnel cycle, as well as the inventory and warehousing cycle.
Terms: Cycles that affect inventory
Diff: Moderate
Objective: LO 21-7
AACSB: Reflective thinking skills

Auditing and Assurance Services, 14e (Arens)
Chapter 24 Completing the Audit

Learning Objective 24-1

1) Auditors often integrate procedures for presentation and disclosure objectives with:
A)
Tests for planning objectives Tests for balance-related objectives
Yes Yes

B)
Tests for planning objectives Tests for balance-related objectives
No No

C)
Tests for planning objectives Tests for balance-related objectives
Yes No

D)
Tests for planning objectives Tests for balance-related objectives
No Yes

Answer:
Terms: Procedures for presentation and disclosure objectives
Diff: Easy
Objective: LO 24-1
AACSB: Reflective thinking skills

2) The auditor’s primary concerns relative to presentation and disclosure-related objectives is:
A) accuracy.
B) existence.
C) completeness.
D) occurrence.
Answer:
Terms: Presentation and disclosure-related objectives
Diff: Easy
Objective: LO 24-1
AACSB: Reflective thinking skills

Learning Objective 24-2

1) If a potential loss on a contingent liability is remote, the liability usually is:
A) disclosed in footnotes, but not accrued.
B) neither accrued nor disclosed in footnotes.
C) accrued and indicated in the body of the financial statements.
D) disclosed in the auditor’s report but not disclosed on the financial statements.
Answer:
Terms: Contingent liability; remote
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills
2) A commitment is best described as:
A) an agreement to commit the firm to a set of fixed conditions in the future.
B) an agreement to commit the firm to a set of fixed conditions in the future that depends on company profitability.
C) an agreement to commit the firm to a set of fixed conditions in the future that depends on current market conditions.
D) a potential future obligation to an outside party for an as yet to be determined amount.
Answer:
Terms: Commitments
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

3) At the completion of the audit, management is asked to make a written statement that it is not aware of any undisclosed contingent liabilities. This statement would appear in the:
A) management letter.
B) letter of inquiry.
C) letters testamentary.
D) management letter of representation.
Answer:
Terms: Completion of audit; written statement by management
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

4) Which of the following groups has the responsibility for identifying and deciding the appropriate accounting treatment for recording or disclosing contingent liabilities?
A) auditors
B) legal counsel
C) management
D) management and the auditors
Answer: C
Terms: Recording or disclosing contingent liabilities
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

5) You are auditing Rodgers and Company. You are aware of a potential loss due to non-compliance with environmental regulations. Management has assessed that there is a 40% chance that a $10M payment could result from the non-compliance. The appropriate financial statement treatment is to:
A) accrue a $4 million liability.
B) disclose a liability and provide a range of outcomes.
C) since there is less than a 50% chance of occurrence, ignore.
D) since there is greater that a remote chance of occurrence, accrue the $10 million.
Answer:
Terms: Potential loss for noncompliance
Diff: Moderate
Objective: LO 24-2
AACSB: Analytic skills
6) Which of the following is not a contingent liability with which an auditor is particularly concerned?
A)
Notes receivable discounted Product warranties
Yes Yes

B)
Notes receivable discounted Product warranties
No No

C)
Notes receivable discounted Product warranties
Yes No

D)
Notes receivable discounted Product warranties
No Yes

Answer:
Terms: Contingent liability; auditor particularly concerned
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

7) Audit procedures related to contingent liabilities are initially focused on:
A) accuracy.
B) completeness.
C) existence.
D) occurrence.
Answer:
Terms: Audit procedures related to contingent liabilities
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

8) With which of the following client personnel would it generally not be appropriate to inquire about commitments or contingent liabilities?
A) Controller
B) President
C) Accounts receivable clerk
D) Vice president of sales
Answer: C
Terms: Inquire for commitments or contingent liabilities
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills
9) Inquiries of management regarding the possibility of unrecorded contingencies will be useful in uncovering:
A)
Management’s intentional failure to disclose existing contingencies. When management does not comprehend accounting disclosure requirements.
Yes Yes

B)
Management’s intentional failure to disclose existing contingencies. When management does not comprehend accounting disclosure requirements.
No No

C)
Management’s intentional failure to disclose existing contingencies. When management does not comprehend accounting disclosure requirements.
Yes No

D)
Management’s intentional failure to disclose existing contingencies. When management does not comprehend accounting disclosure requirements.
No Yes

Answer:
Terms: Inquiries of management; Unrecorded contingencies
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

10) Commitments include all but which of the following?
A) agreements to purchase raw materials
B) pension plans
C) agreements to lease facilities at set prices
D) Each of the above is a commitment.
Answer:
Terms: Commitments
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills
11) If an auditor concludes there are contingent liabilities, then he or she must evaluate the:
A)
Materiality of the potential liability. Nature of the disclosure to be included in
the financial statements.
Yes Yes

B)
Materiality of the potential liability. Nature of the disclosure to be included in
the financial statements.
No No

C)
Materiality of the potential liability. Nature of the disclosure to be included in
the financial statements.
Yes No

D)
Materiality of the potential liability. Nature of the disclosure to be included in
the financial statements.
No Yes

Answer:
Terms: Contingent liabilities
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

12) Which of the following is the most efficient audit procedure for the detection of unrecorded liabilities at the balance sheet date?
A) obtain an attorney’s letter from the client’s attorney
B) confirm large accounts payable balances at the balance sheet date
C) examine purchase orders issued for several days prior to the close of the year
D) compare cash disbursements in the subsequent period with the accounts payable trial balance at year-end
Answer:
Terms: Audit procedure for detection of unrecorded liabilities
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

13) If the auditor concludes that there are contingent liabilities, he or she must evaluate the significance of the potential liability and the nature of the disclosure needed in the financial statements. Which of the following statements is not true?
A) The potential liability is sufficiently well known in some instances to be included in the financial statements as an actual liability.
B) Disclosure may be unnecessary if the contingency is highly remote or immaterial.
C) Frequently, the CPA firm obtains a separate evaluation of the potential liability from its own legal counsel rather than relying on management or management’s attorneys.
D) Answers B and C are correct, but answer A is not.
Answer:
Terms: Contingent liabilities; significance of potential liability; nature of disclosure
Diff: Challenging
Objective: LO 24-2
AACSB: Reflective thinking skills
14) The process of “final evidence accumulation” is always done late in the engagement. Which one of the following would be done the earliest in the engagement?
A) final analytical procedures
B) search for contingent liabilities
C) evaluate the going concern assumption
D) acquire the client’s letter of representation
Answer:
Terms: Final evidence accumulation
Diff: Challenging
Objective: LO 24-2
AACSB: Reflective thinking skills

15) A company guarantees the debt of an affiliate. Which of the following best describes the audit procedure that would make the auditor aware of the guarantee?
A) Review minutes and resolutions of the board of directors.
B) Review prior year’s audit files with respect to such guarantees.
C) Review the possibility of such guarantees with the chief accountant.
D) Review the legal letter returned by the company’s outside legal counsel.
Answer:
Terms: Audit procedure for guarantee
Diff: Challenging
Objective: LO 24-2
AACSB: Reflective thinking skills

16) Elise-Greer, LLP is an affiliate of the audit client and is audited by another firm of auditors. Which of the following is most likely to be used by the auditor to obtain assurance that all guarantees of the affiliate’s indebtedness have been detected?
A) Send the standard bank confirmation request to all of the client’s lender banks.
B) Review client minutes and obtain a representation letter.
C) Examine supporting documents for all entries in intercompany accounts.
D) Obtain written confirmation of indebtedness from the auditor of the affiliate.
Answer:
Terms: Assurance that all guarantees of affiliate’s indebtedness have been detected
Diff: Challenging
Objective: LO 24-2
AACSB: Reflective thinking skills

17) Distinguish between contingent liabilities and commitments.
Answer: Contingent liabilities are potential future obligations to an outside party for an unknown amount resulting from activities that have already taken place. Commitments are agreements to commit the company to a set of fixed conditions in the future regardless of what happens to profits or the economy as a whole.
Terms: Contingent liabilities; commitments
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

18) Define the term contingent liability and discuss the criteria accountants and auditors use to classify these accounting events.
Answer: Contingent liability: a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Three conditions are required for a contingent liability to exist: (1) there is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition; (2) there is uncertainty about the amount for the future payment or impairment; and (3) the outcome will be resolved by some future event or events. Accounting standards describe three levels of likelihood of occurrence and the appropriate financial statement treatment for each likelihood as follows:.

a. Probable–future event likely to occur and amount can be reasonably estimated then the financial statement accounts are adjusted. If amount cannot be reasonably estimated, then a footnote disclosure is necessary.

b. Reasonably possible–chance of occurring is more than remote, but less than probable. Footnote disclosure is necessary.

c. Remote–chance of occurrence is slight, no disclosure is necessary.
Terms: Contingent liabilities
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

19) With what types of contingencies might an auditor be concerned?
Answer: The auditor is generally concerned with contingencies arising from pending litigation for patent infringement, income tax disputes, product warranties, notes receivable discounted, guarantees of obligations of others, and unused balances of outstanding letters of credit.
Terms: Types of contingencies
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

20) What are the three required conditions for a contingent liability to exist?
Answer:
1. There is potential for future payment to an outside party or the impairment of an asset that resulted from an existing condition.
2. There is uncertainty about the amount of the future payment or impairment.
3. The outcome will be resolved by some future event or events.
Terms: Conditions for contingent liability to exist
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

21) An environmental clean-up lawsuit is pending against your client. What information about the lawsuit would you as the auditor need in order to determine the “correct” accounting?
Answer: Three conditions are required for a contingent liability to exist: (1) there is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition; (2) there is uncertainty about the amount for the future payment or impairment; and (3) the outcome will be resolved by some future event or events. Accounting standards describe three levels of likelihood of occurrence and the appropriate financial statement treatment for each likelihood as follows:
a. Probable–future event likely to occur and amount can be reasonably estimated then the financial statement accounts are adjusted. If amount cannot be reasonably estimated, then a footnote disclosure is necessary.

b. Reasonably possible–chance of occurring is more than remote, but less than probable. Footnote disclosure is necessary.

c. Remote–chance of occurrence is slight No disclosure is necessary.
Terms: Correct accounting for lawsuit
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

22) State the two primary types of subsequent events that require consideration by management and evaluation by the auditor, and give two examples of each type.
Answer:
• Type 1: Events that have a direct effect on the financial statements and require adjustment of the current year’s financial statement amounts. Examples include declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to deteriorating financial condition; settlement of litigation at an amount different from the amount recorded on the books, disposal of equipment not being used in operations at a price below the current book value; sale of investments at a price below recorded cost.
• Type 2: Events that have no direct effect on the financial statements but for which disclosure is required. Examples include a decline in the market value of securities held for temporary investment or resale; issuance of bonds or equity securities; a decline in the market value of inventory as a consequence of government action barring further sale of a product; the uninsured loss of inventories as a result of fire; a merger or an acquisition.
Terms: Types of subsequent events
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

23) Discuss three audit procedures commonly used to search for contingent liabilities.
Answer:
• Inquire of management (orally and in writing) about the possibility of unrecorded contingencies.
• Review current and previous years’ internal revenue agent reports for income tax settlements.
• Review the minutes of directors’ and stockholders’ meetings for indications of lawsuits or other contingencies.
• Analyze legal expense for the period under audit, and review invoices and statements from legal counsel for indications of contingent liabilities.
• Obtain a letter from each major attorney performing legal services for the client as to the status of pending litigation or other contingent liabilities.
• Review audit documentation for any information that may indicate a potential contingency.
• Examine letters of credit in force as of the balance sheet date and obtain a confirmation of the used and unused balances.
Terms: Audit procedures for search of contingent liabilities
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

24) A lawsuit has been filed against your client. If, in the opinion of legal counsel, the likelihood your client will lose the lawsuit is remote, no financial statement accrual or disclosure of the potential loss would generally be required.
A) True
B) False
Answer:
Terms: Lawsuit is remote; financial statement accrual or disclosure
Diff: Easy
Objective: LO 24-2
AACSB: Reflective thinking skills

25) Current professional auditing standards make it clear that management, not the auditor, is responsible for identifying and deciding the appropriate accounting treatment for contingent liabilities.
A) True
B) False
Answer:
Terms: Auditing standards; contingent liabilities
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

26) When testing for contingent liabilities, the primary objective at the initial stage of the tests is to determine the existence of contingencies.
A) True
B) False
Answer:
Terms: Existence of contingent liabilities
Diff: Moderate
Objective: LO 24-2
AACSB: Reflective thinking skills

Learning Objective 24-3

1) Auditors will generally send a standard inquiry letter to:
A) only those attorneys who have devoted substantial time to client matters during the year.
B) every attorney that the client has been involved with in the current or preceding year, plus any attorney the client engages on occasion.
C) those attorneys whom the client relies on for advice related to substantial legal matters.
D) only the attorney who represents the client in proceeding where the client is defendant.
Answer:
Terms: Standard inquiry letter
Diff: Easy
Objective: LO 24-3
AACSB: Reflective thinking skills

2) Who may identify matters to be included in a letter of inquiry sent to a client’s legal counsel?
A)
Auditors Company management
Yes Yes

B)
Auditors Company management
No No

C)
Auditors Company management
Yes No

D)
Auditors Company management
No Yes

Answer:
Terms: Letter of inquiry
Diff: Easy
Objective: LO 24-3
AACSB: Reflective thinking skills

3) Auditors, as part of completing the audit, will request the client to send a letter of inquiry to those attorneys the company has been consulting with during the year under audit regarding legal matters of concern to the company. The primary reason the auditor requests this information is to:
A) determine the range of probable loss for asserted claims.
B) corroborate of information supplied by management concerning litigation, claims, and assessments.
C) outside opinion of probability of losses in determining accruals for contingencies.
D) outside opinion of probability of losses in determining the proper footnote disclosure.
Answer:
Terms: Completing the audit; Letter of inquiry
Diff: Moderate
Objective: LO 24-3
AACSB: Reflective thinking skills
4) The standard letter of inquiry to the client’s legal counsel should be prepared on:
A) plain paper (no letterhead) and be unsigned.
B) lawyer’s stationery and signed by the lawyer.
C) auditor’s stationery and signed by an audit partner.
D) client’s stationery and signed by a company official.
Answer:
Terms: Letter of inquiry
Diff: Easy
Objective: LO 24-3
AACSB: Reflective thinking skills

5) When a client will not permit inquiry of outside legal counsel, the audit report will ordinarily contain a(n):
A) disclaimer of opinion.
B) qualified opinion.
C) standard unqualified opinion.
D) unqualified opinion with a separate explanatory paragraph.
Answer:
Terms: Inquiry of outside legal counsel; Audit report
Diff: Moderate
Objective: LO 24-3
AACSB: Reflective thinking skills

6) A CPA has received an attorney’s letter in which no significant disagreements with the client’s assessments of contingent liabilities were noted. The resignation of the client’s lawyer shortly after receipt of the letter should alert the auditor that:
A) an adverse opinion will be necessary.
B) undisclosed unasserted claims may have arisen.
C) the auditor must begin a completely new examination of contingent liabilities.
D) the attorney was unable to form a conclusion with respect to the significance of litigation, claims, and assessments.
Answer:
Terms: Attorney letter; significant disagreements with client’s assessment of contingent liabilities
Diff: Challenging
Objective: LO 24-3
AACSB: Analytic skills

7) Management furnishes the independent auditor with information concerning litigation, claims, and assessments. Which of the following is the auditor’s primary means of initiating action to corroborate such information?
A) Request that client lawyers undertake a reconsideration of matters of litigation, claims, and assessments with which they were consulted during the period under examination.
B) Request that client management send a letter of inquiry to those lawyers with whom management consulted concerning litigation, claims, and assessments.
C) Request that client lawyers provide a legal opinion concerning the policies and procedures adopted by management to identify, evaluate, and account for litigation, claims, and assessments.
D) Request that client management engage outside attorneys to suggest wording for the text of a footnote explaining the nature and probable outcome of existing litigation, claims, and assessments.
Answer:
Terms: Corroborate information concerning litigation, claims, and assessments
Diff: Challenging
Objective: LO 24-3
AACSB: Reflective thinking skills

8) An attorney is responding to an independent auditor as a result of the client’s letter of inquiry. The attorney may appropriately limit the response to:
A) asserted claims and litigation.
B) asserted, overtly threatened, or pending claims and litigation.
C) items which have an extremely high probability of being resolved to the client’s detriment.
D) matters to which the attorney has given substantive attention in the form of legal consultation or representation.
Answer:
Terms: Response to client’s letter of inquiry
Diff: Challenging
Objective: LO 24-3
AACSB: Reflective thinking skills

9) Contingent liability disclosure in the footnotes of the financial statements would normally be made when:
A) the outcome of the accounting event is deemed probable, but a reasonable estimation as to the amount cannot be made by the client or auditor.
B) a reasonable estimation of the loss can be made, but the outcome is not probable.
C) the outcome of the accounting event is deemed probable, and a reasonable estimation as to the amount can be made.
D) the outcome of the accounting event as well as a reasonable estimation of the loss cannot be made.
Answer:
Terms: Contingent liability disclosure
Diff: Challenging
Objective: LO 24-3
AACSB: Reflective thinking skills

10) List at least 3 types of information normally contained in a legal letter to the client’s attorneys.
Answer:
• List and evaluation of pending or threatened litigation to which the attorney has devoted significant attention
• A list of unasserted claims and assessments considered by management to probable and reasonably possible of an unfavorable outcome
• A description and evaluation of the outcome of each pending or threatened litigation
• Comments on unasserted claims where their views are different than managements
Terms: Legal letter to client’s attorneys
Diff: Moderate
Objective: LO 24-3
AACSB: Reflective thinking skills
Topic: Public

11) State three lists or requests that should be included in a standard “inquiry of attorney” letter.
Answer:
• A list, prepared by management, of (1) pending threatened litigation and (2) asserted or unasserted claims or assessments with which the attorney has had significant involvement. An alternative is for the letter to request the attorney to prepare the list.
• A request that the attorney furnish information or comment about the progress of each item listed, the legal action the client intends to take, the likelihood of an unfavorable outcome, and an estimate of the amount or range of the potential loss.
• A request for the identification of any unlisted pending or threatened legal actions or a statement that the client’s list is complete.
• A statement by the client informing the attorney of his or her responsibility to inform management whenever in the attorney’s judgment there is a legal matter requiring disclosure in the financial statements. The letter of inquiry should also request the attorney to respond directly to the auditor that he or she understands this responsibility.
• A request that the attorney identifies and describes the nature of any reasons for any limitations in the response.
Terms: Inquiry of attorney letter
Diff: Challenging
Objective: LO 24-3
AACSB: Reflective thinking skills

12) When preparing a standard inquiry of client’s attorney letter, the client’s letterhead should be used, and the letter should be signed by the client company’s officials.
A) True
B) False
Answer:
Terms: Standard inquiry of client’s attorney letter
Diff: Moderate
Objective: LO 24-3
AACSB: Reflective thinking skills

13) In a standard inquiry of client’s attorney letter, the attorney is requested to communicate about contingencies up to the balance sheet date.
A) True
B) False
Answer:
Terms: Standard inquiry of client’s attorney letter
Diff: Moderate
Objective: LO 24-3
AACSB: Reflective thinking skills

14) If an attorney refuses to provide the auditor with information about material existing lawsuits or unasserted claims, current professional standards require that the auditor consider the refusal as a scope limitation.
A) True
B) False
Answer:
Terms: Attorney refuses to provide auditor with information about material existing lawsuits
Diff: Easy
Objective: LO 24-3
AACSB: Reflective thinking skills

Learning Objective 24-4

1) The auditor has a responsibility to review transactions and activities occurring after the year-end to determine whether anything occurred that might affect the statements being audited. The procedures required to verify these transactions are commonly referred to as the review for:
A) contingent liabilities.
B) subsequent year’s transactions.
C) late unusual occurrences.
D) subsequent events.
Answer:
Terms: Review transactions and activities occurring after year-end
Diff: Easy
Objective: LO 24-4
AACSB: Reflective thinking skills

2) Which type of subsequent event requires consideration by management and evaluation by the auditor?
A)
Subsequent events that have a direct effect on the financial statements and require adjustment. Subsequent events that have no direct effect on the financial statements but for which disclosure is considered.
Yes Yes

B)
Subsequent events that have a direct effect on the financial statements and require adjustment. Subsequent events that have no direct effect on the financial statements but for which disclosure is considered.
No No

C)
Subsequent events that have a direct effect on the financial statements and require adjustment. Subsequent events that have no direct effect on the financial statements but for which disclosure is considered.
Yes No

D)
Subsequent events that have a direct effect on the financial statements and require adjustment. Subsequent events that have no direct effect on the financial statements but for which disclosure is considered.
No Yes

Answer:
Terms: Subsequent events requiring consideration by management
Diff: Easy
Objective: LO 24-4
AACSB: Reflective thinking skills

3) Whenever subsequent events are used to evaluate the amounts included in the statements, care must be taken to distinguish between conditions that existed at the balance sheet date and those that come into being after the end of the year. The subsequent information should not be incorporated directly into the statements if the conditions causing the change in valuation:
A) took place before year-end.
B) did not take place until after year-end.
C) occurred both before and after year-end.
D) are reimbursable through insurance policies.
Answer:
Terms: Subsequent events; balance sheet date and after the end of the year
Diff: Easy
Objective: LO 24-4
AACSB: Reflective thinking skills

4) An auditor has the responsibility to actively search for subsequent events that occur subsequent to the:
A) balance sheet date.
B) date of the auditor’s report.
C) balance sheet date, but prior to the audit report.
D) date of the management representation letter.
Answer: C
Terms: Subsequent events
Diff: Easy
Objective: LO 24-4
AACSB: Reflective thinking skills

5) Which of the following subsequent events is most likely to result in an adjustment to a company’s financial statements?
A) merger or acquisition activities
B) bankruptcy (due to deteriorating financial condition) of a customer with an outstanding accounts receivable balance
C) issuance of common stock
D) an uninsured loss of inventories due to a fire
Answer:
Terms: Subsequent events; Adjustment to financial statements
Diff: Easy
Objective: LO 24-4
AACSB: Analytic skills

6) A significant customer of the firm suffers a large economic loss after year end, but prior to completion of field work. The audit client believes this event will have material effect on the financial statements. The auditor should:
A) adjust the financial statements for the year under audit.
B) add a paragraph to the audit report.
C) advise the client to disclose the event in the notes to the financial statements.
D) advise the client to delay issuing the financial statements until the economic loss can be determined.
Answer: C
Terms: Event will have a material effect on the financial statements
Diff: Easy
Objective: LO 24-4
AACSB: Analytic skills

7) The auditor has completed her assessment of subsequent events. The proper accounting for subsequent events that have a direct effect on the financial statements is to:
A) adjust the financial statements for the year under audit.
B) disclose in the notes to financial statement the amount of the adjustment.
C) duly note in the audit workpapers that next year’s financial statements need to be adjusted.
D) make no adjustment of the financial statements for the year under audit.
Answer:
Terms: Subsequent events; direct effect on the financial statements
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

8) The audit procedures for the subsequent events review can be divided into two categories: (1) procedures integrated as a part of the verification of year-end account balances, and (2) those performed specifically for the purpose of discovering subsequent events. Which of the following procedures is in category 1?
A) Inquiries of client regarding contingent liabilities.
B) Obtain a letter of representation written by client.
C) Subsequent period sales and purchases transactions are examined to determine whether the cutoff is accurate.
D) Review journals and ledgers of year 2 to determine the existence of any transaction related to year 1.
Answer: C
Terms: Audit procedures for subsequent events review
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

9) The audit procedures for the subsequent events review can be divided into two categories: (1) procedures normally integrated as a part of the verification of year-end account balances, and (2) those performed specifically for the purpose of discovering subsequent events. Which of the following procedures is in category 2?
A) Correspond with attorneys.
B) Test the collectability of accounts receivable by reviewing subsequent period cash receipts.
C) Subsequent period sales and purchases transactions are examined to determine whether the cutoff is accurate.
D) Compare the subsequent-period purchase price of inventory with the recorded cost as a test of lower-of-cost-or-market valuation.
Answer:
Terms: Audit procedures for subsequent events review
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

10) Which of the following would be a subsequent discovery of facts which would not require a response by the auditor?
A) discovery of the inclusion of material nonexistent sales
B) discovery of the failure to write off material obsolete inventory
C) discovery of the omission of a material footnote
D) decrease in the value of investments
Answer:
Terms: Subsequent discovery of facts
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

11) In connection with the annual audit, which of the following is not a “subsequent events” procedure?
A) Review available interim financial statements.
B) Read available minutes of meetings of stockholders, directors, and committees and, for meetings where minutes are not available, inquire about matters dealt with at such meetings.
C) Make inquiries with respect to the financial statements covered by the auditor’s previously issued report if new information has become available during the current examination that might affect that report.
D) Discuss with officers the current status of items in the financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data.
Answer:
Terms: Subsequent events procedure
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

12) An auditor performs interim work at various times throughout the year. The auditor’s subsequent events work should be extended to the date of:
A) the auditor’s report.
B) a post-dated footnote.
C) the next scheduled interim visit.
D) the final billing for audit services rendered.
Answer:
Terms: Interim work; Subsequent events
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

13) Which event that occurred after the end of the fiscal year under audit but prior to issuance of the auditor’s report would not require disclosure in the financial statements?
A) sale of a bond or capital stock issue
B) loss of plant or inventories as a result of fire or flood
C) a significant decline in the market price of the corporation’s stock
D) settlement of litigation when the event giving rise to the claim took place after the balance sheet date
Answer: C
Terms: Event that occurred after the end of the fiscal year
Diff: Moderate
Objective: LO 24-4
AACSB: Analytic skills

14) Which of the following material events occurring subsequent to the balance sheet date would require an adjustment to the financial statements before they could be issued?
A) loss of a plant as a result of a flood
B) sale of long-term debt or capital stock
C) settlement of litigation in excess of the recorded liability
D) major purchase of a business that is expected to double the sales volume
Answer: C
Terms: Events occurring subsequent to the balance sheet date; Adjustment
Diff: Moderate
Objective: LO 24-4
AACSB: Analytic skills
15) If the auditor determines that a subsequent event that affects the current period financial statements occurred after fieldwork was completed but before the audit report was issued, what date(s) may the auditor use on the report?
A)
The date of the
original last day of
fieldwork only. The date of the
subsequent
event only. The date on which the last day of fieldwork occurred along with the date of the subsequent event.
Yes Yes No

B)
The date of the
original last day of
fieldwork only. The date of the
subsequent
event only. The date on which the last day of fieldwork occurred along with the date of the subsequent event.
Yes No Yes

C)
The date of the
original last day of
fieldwork only. The date of the
subsequent
event only. The date on which the last day of fieldwork occurred along with the date of the subsequent event.
No Yes No

D)
The date of the
original last day of
fieldwork only. The date of the
subsequent
event only. The date on which the last day of fieldwork occurred along with the date of the subsequent event.
No No Yes

Answer:
Terms: Subsequent event; report date
Diff: Challenging
Objective: LO 24-4
AACSB: Analytic skills

16) An auditor’s decision concerning whether or not to dual date an audit report is primarily based on the auditor’s decision to:
A) extend appropriate audit procedures.
B) assume responsibility for events after the date of the auditor’s report.
C) assume responsibility for event from fiscal year end to the date of the audit report.
D) roll the dice and hope for a successful outcome.
Answer:
Terms: Dual date audit report
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

17) The auditor’s responsibility for “reviewing the subsequent events” of a public company that is about to issue new securities is normally limited to the period of time:
A) beginning with the balance sheet date and ending with the date of the auditor’s report.
B) beginning with the start of the fiscal year under audit and ending with the balance sheet date.
C) beginning with the start of the fiscal year under audit and ending with the date of the auditor’s report.
D) beginning with the balance sheet date and ending with the date the registration statement becomes effective.
Answer:
Terms: Reviewing subsequent events; public company; issue new securities
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

18) Which of the following is not a reason why the auditor requests that the client provide a letter of representation?
A) Professional auditing standards require the auditor to obtain a letter of representation.
B) It impresses upon management its responsibility for the accuracy of the information in the financial statements.
C) It provides written documentation of the oral responses already received to inquiries of management.
D) It provides written documentation, which is a higher quality of evidence than management’s oral responses to inquiries.
Answer:
Terms: Letter of representation
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

19) Subsequent events affecting the realization of assets ordinarily will require adjustments of the financial statements under examination because such events typically represent the:
A) culmination of conditions that existed at the balance sheet date.
B) discovery of new conditions occurring in the subsequent events period.
C) final estimates of losses relating to casualties occurring in the subsequent events period.
D) preliminary estimate of losses relating to new events that occurred subsequent to the balance sheet date.
Answer:
Terms: Subsequent events; realization of assets
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

20) An auditor’s decision concerning whether or not to “dual date” the audit report is based upon the auditor’s willingness to:
A) extend auditing procedures and assume responsibility for a greater period of time.
B) accept responsibility for subsequent events.
C) permit inclusion of a footnote captioned: event (unaudited) subsequent to the date of the auditor’s report.
D) assume responsibility for events subsequent to the issuance of the auditor’s report.
Answer:
Terms: Dual date audit report
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

21) After an auditor has issued an audit report on a nonpublic entity, there is no obligation to make any further audit tests or inquiries with respect to the audited financial statements covered by that report unless:
A) material adverse events occur after the date of the auditor’s report.
B) final determination or resolution was made of a contingency which had been disclosed in the financial statements.
C) final determination or resolution was made on matters which had resulted in a qualification in the auditor’s report.
D) new information comes to the auditor’s attention concerning an event that occurred prior to the date of the auditor’s report that may have affected the auditor’s report.
Answer:
Terms: Issued audit report; further audit tests or inquiries
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

22) A client has a calendar year-end. Listed below are four events that occurred after December 31. Which one of these subsequent events might result in adjustment of the December 31 financial statements?
A) sale of a major subsidiary
B) adoption of accelerated depreciation methods
C) write-off of a substantial portion of inventory as obsolete
D) collection of 90% of the accounts receivable existing at December 31
Answer: C
Terms: Subsequent events
Diff: Challenging
Objective: LO 24-4
AACSB: Analytic skills

23) The auditor’s responsibility with respect to events occurring between the balance sheet date and the end of the audit examination is best expressed by which of the following statements?
A) The auditor is fully responsible for events occurring in the subsequent period and should extend all detailed procedures through the last day of fieldwork.
B) The auditor is responsible for determining that a proper cutoff has been made and performing a general review of events occurring in the subsequent period.
C) The auditor’s responsibility is to determine that a proper cutoff has been made and that transactions recorded on or before the balance sheet date actually occurred.
D) The auditor has no responsibility for events occurring in the subsequent period unless these events affect transactions recorded on or before the balance sheet date.
Answer:
Terms: Events occurring between balance sheet date and end of audit examination
Diff: Challenging
Objective: LO 24-4
AACSB: Reflective thinking skills

24) The fieldwork for the December 31, 2011 audit of Schmidt Corporation ended on March 17, 2012. The financial statements and auditor’s report were issued and mailed to stockholders on March 29, 2012. In each of the material situations (1 through 5) below, indicate the appropriate action (a, b, c, d, or e). The possible actions are as follows:

a. Adjust the December 31, 2011 financial statements.
b. Disclose the information in a footnote in the December 31, 2011 financial statements.
c. Request the client revise and reissue the December 31, 2011 financial statements. The revision should involve an adjustment to the December 31, 2011 financial statements.
d. Request the client revise and reissue the December 31, 2011 financial statements. The revision should involve the addition of a footnote, but no adjustment, to the December 31, 2011 financial statements.
e. No action is required.

The situations are as follows:

________ 1. On April 5, 2012, you discovered that, on February 16, 2012 a flood destroyed the entire uninsured inventory in one of Schmidt’s warehouses.

________ 2. On February 17, 2012, you discovered that, on February 16, 2012, a flood destroyed the entire uninsured inventory in one of Schmidt’s warehouses.

________ 3. On February 17, 2012, you discovered that, on November 30, 2011, a flood destroyed the entire uninsured inventory in one of Schmidt’s warehouses.

________ 4. On April 5, 2012, you discovered that, on March 30, 2012, a fire destroyed one of Schmidt’s 13 plants.

________ 5. On April 7, 2012, you discovered that a debtor of Schmidt went bankrupt on January 6, 2012, due to gradual declining financial health.

Answer:
1. d
2. b
3. a
4. e
5. c
Terms: Actions for subsequent events
Diff: Challenging
Objective: LO 24-2 and LO 24-4
AACSB: Analytic skills

25) The fieldwork for the December 31, 2007 audit of Treble Corporation ended on March 17, 2008. The financial statements and auditor’s report were issued and mailed to stockholders on March 29, 2008. In each of the material situations (1 through 5) below, indicate the appropriate action (a, b, c, d, or e). The possible actions are as follows:

a. Adjust the December 31, 2007 financial statements.
b. Disclose the information in a footnote in the December 31, 2007 financial statements.
c. Request the client revise and reissue the December 31, 2007 financial statements. The revision should involve an adjustment to the December 31, 2007 financial statements.
d. Request the client revise and reissue the December 31, 2007 financial statements. The revision should involve the addition of a footnote, but no adjustment, to the December 31, 2007 financial statements.
e. No action is required.

The situations are as follows:

________ 1. On January 16, 2008, a lawsuit was filed against Treble for a patent infringement action that allegedly took place in early 2005. In the opinion of Treble’s attorneys, there is a reasonable (but not probable) danger of a significant loss to Treble.

________ 2. On February 19, 2008, Treble settled a lawsuit out of court that had originated in 2002 and is currently listed as a contingent liability.

________ 3. On March 30, 2008, Treble settled a lawsuit out of court that had originated in 2004 and is currently listed as a contingent liability.

________ 4. On February 2, 2008, you discovered an uninsured lawsuit against Treble that had originated on August 30, 2007.

________ 5. On April 7, 2008, you discovered that a debtor of Treble went bankrupt on January 22, 2008, due to a major uninsured fire that occurred on January 2, 2008.
Answer:
1. b
2. a
3. e
4. b
5. d
Terms: Actions for subsequent events
Diff: Challenging
Objective: LO 24-2 and LO 24-4
AACSB: Analytic skills

26) The issuance of bonds by the client subsequent to year-end would require a footnote disclosure in, but no adjustment to, the financial statements under audit.
A) True
B) False
Answer:
Terms: Issuance of bonds by client subsequent to year-end
Diff: Easy
Objective: LO 24-4
AACSB: Reflective thinking skills

27) Subsequent events which require adjustment to the financial statements provide additional information about significant conditions/events which did not exist at the balance sheet date.
A) True
B) False
Answer:
Terms: Subsequent events
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills
28) Subsequent events for which disclosure, but no adjustment, is required provide information about significant events/conditions which existed at the balance sheet date.
A) True
B) False
Answer:
Terms: Subsequent events
Diff: Moderate
Objective: LO 24-4
AACSB: Reflective thinking skills

Learning Objective 24-5

1) The date of the management representation letter received from the client should coincide with which of the following?
A) date of latest subsequent event disclosed in the notes to the financial statements
B) date of the auditor’s report
C) balance sheet date
D) engagement agreement
Answer:
Terms: Management representation letter
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

2) Which of the following procedures and methods are important in assessing a company’s ability to continue as a going concern?
A)
Discussions with management regarding future plans related to sales activities,
cost controls, and marketing efforts. Reviewing quarter on the internal control questionnaire specifically asking the
client to evaluate the ability to continue.
Yes Yes

B)
Discussions with management regarding future plans related to sales activities,
cost controls, and marketing efforts. Reviewing quarter on the internal control questionnaire specifically asking the
client to evaluate the ability to continue.
No No

C)
Discussions with management regarding future plans related to sales activities,
cost controls, and marketing efforts. Reviewing quarter on the internal control questionnaire specifically asking the
client to evaluate the ability to continue.
Yes No

D)
Discussions with management regarding future plans related to sales activities,
cost controls, and marketing efforts. Reviewing quarter on the internal control questionnaire specifically asking the
client to evaluate the ability to continue.
No Yes

Answer: C
Terms: Going concern
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills
3) The letter of representation obtained from an audit client should be:
A) dated as of the end of the period under audit.
B) dated as of the audit report date.
C) dated as of any date decided upon by the client and auditor.
D) dated as of the issuance of the financial statement.
Answer:
Terms: Letter of representation
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

4) When should auditors generally assess a client’s ability to continue as a going concern?
A) upon completion of the audit
B) during the planning stages of the audit
C) throughout the entire audit process
D) during testing and completion phases of the audit
Answer: C
Terms: Going concern
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

5) Which of the following would the auditor expect to find in the client’s management representation letter?
A) management’s recommendations for internal control effectiveness improvements
B) management’s plans for improving product quality
C) management’s compliance with contractual arrangements that impact the financial statements
D) management’s goals for improving earnings per share
Answer: C
Terms: Management representation letter
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

6) Auditing standards (SAS No. 59) requires the auditor to evaluate whether there is a substantial doubt about a client’s ability to continue as a going concern for at least:
A) one quarter beyond the balance sheet date.
B) one quarter beyond the date of the auditor’s report.
C) one year beyond the balance sheet date.
D) one year beyond the date of the auditor’s report.
Answer: C
Terms: Auditing standards; Going-concern issues
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills
7) Auditing Standards (SAS No. 59) requires auditors to evaluate whether there is a substantial doubt about a client’s ability to continue as a going concern. One of the most important audit procedures to perform to assess the going concern question is:
A) analytical procedures.
B) confirmations of creditors.
C) statistical sampling procedures.
D) inquiries of client and its legal counsel.
Answer:
Terms: Audit procedures to assess going concern
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

8) Which of the following statements regarding the letter of representation is not correct?
A) It is prepared on the client’s letterhead.
B) It is addressed to the CPA firm.
C) It is signed by high-level corporate officials, usually the president and chief financial officer.
D) It is optional, not required, that the auditor obtain such a letter from management.
Answer:
Terms: Letter of representation
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

9) Refusal by a client to prepare and sign the representation letter would require the auditor to issue a:
A) qualified opinion or a disclaimer.
B) adverse opinion or a disclaimer.
C) qualified or an adverse opinion.
D) unqualified opinion with an explanatory paragraph.
Answer:
Terms: Refusal to prepare and sign the letter of representation
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

10) A client representation letter is:
A) prepared on the CPA’s letterhead.
B) addressed to the client.
C) signed by high-level officials (e.g., the president and chief financial officer).
D) dated as of the client’s year-end.
Answer: C
Terms: Client representation letter
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills
11) Which of the following would the auditor find most useful in relation to its previous audit procedures from the client representation letter?
A) to impress upon the audit firm its responsibility for the audit
B) to impress upon management its responsibility for the financial statement assertions
C) to remind management of potential misstatements or omissions in the financial statements
D) to document the responses from management to inquiries about various aspects of the audit
Answer:
Terms: Audit procedures; Client representation letter
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

12) Which of the following is not one of the categories of items included in the client letter of representation?
A) subsequent events
B) Completeness of information
C) recognition, measurement, and disclosure
D) materiality
Answer:
Terms: Client letter of representation
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

13) Auditing standards (SAS No. 99 and SAS No. 54) require the auditor to communicate all management frauds and illegal acts to the audit committee:
A) only if the act is immaterial.
B) only if the act is material.
C) only if the act is highly material.
D) regardless of materiality.
Answer:
Terms: Auditing standards; Frauds and illegal acts; Audit committee
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

14) Which of the following audit procedures would most likely assist an auditor in identifying conditions and events that may indicate there could be substantial doubt about an entity’s ability to continue as a going concern?
A) review compliance with the terms of debt agreements
B) confirmation of accounts receivable from principal customers
C) reconciliation of interest expense with debt outstanding
D) confirmation of bank balances
Answer:
Terms: Audit procedures; entity’s ability to continue as a going concern
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

15) Which of the following statements is correct?
A) A letter of representation is documentation of management’s acceptance of responsibility for the financial statements and is deemed to be reliable evidence.
B) A letter of representation is not deemed to be reliable evidence because of the potential incompetence of management.
C) A letter of representation is not deemed to be reliable evidence because of the lack of independence of the preparers.
D) A letter of representation is documentation of the CPA’s acceptance of responsibility for the audit of the financial statement and is deemed to be reliable.
Answer: C
Terms: Letter of representation
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

16) Which of the following auditing procedures is ordinarily performed last?
A) reading minutes of the board of directors’ meetings
B) confirming accounts payable
C) obtaining a client representation letter
D) testing the purchasing function
Answer: C
Terms: Audit procedure performed last
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

17) An auditor must obtain written client representations that might be signed by all but which of the following?
A) Treasurer
B) Chief financial officer
C) Vice president of operations
D) Chief executive officer
Answer: C
Terms: Client representations signed by
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

18) What two steps must an auditor do if they have reservations about the audit client continuing as a going concern?
Answer: 1. Evaluate management’s plan to avoid bankruptcy
2. Feasibility of management achieving those plans
Terms: Going concern
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

19) State the three purposes of the client letter of representation.
Answer:
• To impress upon management its responsibility for the assertions in the financial statements.
• To remind management of potential misstatements or omissions in the financial statements.
• To document the responses from management to inquiries about various aspects of the audit.
Terms: Client representation letter
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

20) List four specific matters that should be included in a client representation letter.
Answer:
• Management’s acknowledgment of its responsibility for the fair presentation in the statements of financial position, results of operations, and cash flows in conformity with applicable accounting standards.
• Availability of all financial records and related data.
• Completeness and availability of all minutes of meetings of stockholders, directors, and committees of directors.
• Management’s belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements.
• Information concerning fraud involving (a) management, (b) employees who have significant roles in internal control, or (c) others where fraud could have a material effect on the financial statements.
• Information concerning related-party transactions and related amounts receivable or payable.
• Unasserted claims or assessments that the entity’s lawyer has advised are probable of assertion and must be disclosed in accordance with accounting standards.
• Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date.
• A merger or acquisition after the balance sheet date.
Terms: Client representation letter
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

21) Besides the search for contingent liabilities and the review for subsequent events, the auditor has four important final evidence accumulation responsibilities, all of which are required by current professional auditing standards. Discuss each of these four responsibilities.
Answer:
• Final analytical procedures performed as a final review for material misstatements or financial problems and to help the auditor take a final objective look at the financial statements.
• Evaluate the going concern assumption.
• Obtain a client representation letter documenting management’s most important oral representations during the audit.
• Consider supplementary information included in published annual reports pertaining directly to the financial statements.
Terms: Final evidence accumulation responsibilities required by professional auditing standards
Diff: Challenging
Objective: LO 24-5
AACSB: Reflective thinking skills

22) Current professional auditing standards require the performance of analytical procedures during the planning and completion phases of the audit.
A) True
B) False
Answer:
Terms: Analytical procedures; Planning and completion phases of the audit
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

23) Current professional auditing standards mandate the use of analytical procedures during the testing phase of the audit.
A) True
B) False
Answer:
Terms: Professional auditing standards; Analytical procedures; Testing phase of audit
Diff: Easy
Objective: LO 24-5
AACSB: Reflective thinking skills

24) Auditing standards require the auditor’s assessment of going-concern issues.
A) True
B) False
Answer:
Terms: Auditing standards; Going-concern issues
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

25) Auditors are required to evaluate the going concern assumption as part of each audit.
A) True
B) False
Answer:
Terms: Going concern assumption
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

26) Although the letter of representation is typed on the client’s letterhead and signed by the client, it is common for the auditor to prepare the letter.
A) True
B) False
Answer:
Terms: Letter of representation
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

27) Auditors of public companies must obtain certain representations from management regarding internal control over financial reporting.
A) True
B) False
Answer:
Terms: Representations from management regarding internal control
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills
Topic: Public

28) At the completion of the audit, management is typically asked to make a written statement as a part of the engagement letter that it is aware of no undisclosed contingent liabilities.
A) True
B) False
Answer:
Terms: Completion of audit; written statement by management; undisclosed liabilities
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

29) Auditors are required to obtain a letter of representation that describes management’s planned solutions to all internal control weaknesses identified during an audit.
A) True
B) False
Answer:
Terms: Letter of representation
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

30) The letter of representation is prepared on the CPA firm’s letterhead, addressed to the client’s chief executive officer, and signed by the audit engagement partner.
A) True
B) False
Answer:
Terms: Letter of representation
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

31) If the client refuses to prepare and sign a letter of representation, the auditor would be required to issue either a qualified opinion or a disclaimer of opinion.
A) True
B) False
Answer:
Terms: Letter of representation; issue opinion
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills
32) Because a client representation letter is a written statement from a non-independent source, it cannot be regarded as reliable evidence.
A) True
B) False
Answer:
Terms: Client representation letter; reliable evidence
Diff: Moderate
Objective: LO 24-5
AACSB: Reflective thinking skills

Learning Objective 24-6

1) Match seven of the terms (a-p) with the description/definitions provided below (1-7):

a. Commitments
b. Completing the engagement checklist
c. Contingent liability
d. Dual-dated audit report
e. Financial statement disclosure checklist
f. Independent review
g. Inquiry of client’s attorneys
h. Letter of representation
i. Other information in annual reports
j. Review for subsequent events
k. Subsequent events
l. Unadjusted misstatement worksheet
m. Management letter
n. Pending claim
o. Unasserted claim
p. Audit documentation review

________ 1. A review of the financial statements and the entire set of audit files by an independent reviewer to whom the audit team must justify the evidence accumulated and the conclusions reached.

________ 2. A potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place.

________ 3. A written communication from the client to the auditor formalizing statements that the client has made about matters pertinent to the audit.

________ 4. A potential legal claim against a client where the condition for a claim exists but no claim has been filed.

________ 5. Transactions that occurred after the balance sheet date, which affect the fair presentation or disclosure of the statements being audited.

________ 6. Agreements that the entity will hold to a fixed set of conditions, such as the purchase or sale of merchandise at a stated price.

________ 7. The use of one audit report date for normal subsequent events and a later date for one or more subsequent events.

Answer:
1. f
2. c
3. h
4. o
5. k
6. a
7. d
Terms: Independent review; Contingent liability; Letter of representation; Unasserted claim; Subsequent events; Commitments; Dual-dated audit report
Diff: Moderate
Objective: LO 24-2 through LO 24-6
AACSB: Reflective thinking skills

2) An independent review must be performed of all audits.
A) True
B) False
Answer:
Terms: Independent review
Diff: Easy
Objective: LO 24-6
AACSB: Reflective thinking skills

3) If, during the completion phase of the audit, the auditor determines that he or she has not obtained sufficient evidence to draw a conclusion about the fairness of the client’s financial statements, there are two choices: accumulate additional evidence or issue either a qualified or an adverse opinion.
A) True
B) False
Answer:
Terms: Sufficient evidence to draw a conclusion
Diff: Moderate
Objective: LO 24-6
AACSB: Reflective thinking skills

Learning Objective 24-7

1) The auditor is responsible for communicating significant internal control deficiencies to the audit committee, or those charged with governance. This communication:
A) may be oral or written.
B) must be oral.
C) must be written.
D) must be oral via direct communication.
Answer: C
Terms: Communicate significant internal control deficiencies
Diff: Easy
Objective: LO 24-7
AACSB: Reflective thinking skills
2) Which of the following statements is most correct about an auditor’s required communication with management and those charged with corporate governance?
A) The auditor is required to inform those charged with governance about significant errors discovered and subsequently corrected by management.
B) Any significant matter reported to those charged with governance must also be communicated to management.
C) Communication is required before the audit report is issued.
D) Auditor does not have any requirement to communicate with anyone other than the company’s senior management.
Answer:
Terms: Required communication with management; corporate governance
Diff: Moderate
Objective: LO 24-7
AACSB: Reflective thinking skills

3) While there is no professional requirement to do so on audit engagements, CPAs frequently issue a formal “management” letter to clients. The primary purpose of this letter is to provide:
A) evidence indicating whether the auditor is reasonably certain that internal accounting control is operating as prescribed.
B) a permanent record of the internal accounting control work performed by the auditor during the course of the engagement.
C) a written record of discussions between auditor and client concerning the auditor’s observations and suggestions for improvements.
D) a summary of the auditor’s observations that resulted from the auditor’s special study of internal control.
Answer: C
Terms: Management letter purpose
Diff: Moderate
Objective: LO 24-7
AACSB: Reflective thinking skills

4) Which of the following is not required to be communicated to the audit committee or similarly designated body under auditing standards?
A) Disagreements with the company over two acceptable accounting treatments for a significant transaction.
B) Disagreements with management about the scope of the audit, applicability of accounting principles, or wording of the audit report.
C) Difficulties encountered in performing the audit, such as lack of availability of client personnel and failure to provide necessary information.
D) Auditor’s responsibilities under generally accepted auditing standards, including responsibility for evaluating internal control and the concept of reasonable rather than absolute assurance.
Answer:
Terms: Communicated to the audit committee or designate body
Diff: Challenging
Objective: LO 24-7
AACSB: Reflective thinking skills
5) Discuss the three matters which Sarbanes-Oxley requires auditors of public companies to report to the audit committee.
Answer: The three items that must be reported to the audit committee are:
• all fraud and illegal acts,
• significant internal control deficiencies and material weaknesses in the design or operation of internal control to those charged with governance, and
• additional information such as all alternative treatments of financial information within requirements of accounting standards that have been discussed with management, ramifications of the alternative disclosures and treatments, and the treatment preferred by the auditor; initial selection of and changes in significant accounting policies or their application during the current audit period, as well as reasons for any changes; and methods used to account for any significant unusual transactions and the effect of significant accounting policies in controversial emerging areas.
Terms: Sarbanes-Oxley; Auditors required to report to audit committee
Diff: Moderate
Objective: LO 24-7
AACSB: Reflective thinking skills
Topic: SOX

6) Auditors are required to communicate either orally or in writing with the audit committee about internal control weaknesses.
A) True
B) False
Answer:
Terms: Auditors required to communicate with audit committee; Internal control weaknesses
Diff: Moderate
Objective: LO 24-7
AACSB: Reflective thinking skills

7) Auditors must communicate in writing about internal control weaknesses to the audit committee or those charged with governance.
A) True
B) False
Answer:
Terms: Auditors communicate internal control weaknesses
Diff: Moderate
Objective: LO 24-7
AACSB: Reflective thinking skills

8) Client representation letters are required by professional auditing standards, whereas management letters are optional.
A) True
B) False
Answer:
Terms: Client representation letters; Management letters; Auditing standards
Diff: Moderate
Objective: LO 24-5 and LO 24-7
AACSB: Reflective thinking skills
Learning Objective 24-8

1) The audit firm issues an audit report for its client. The auditor’s have NO obligation to make further inquiries with respect to the client’s audited financial statements unless:
A) a development occurs that may affect the company’s long term viability as a company.
B) final resolution was made on disclosed contingency for which no liability needed to be accrued.
C) new information comes to the auditor’s attention concerning an event that occurred prior to the date of the audit report that, if known, would have impacted the audit opinion.
D) a lawsuit, in which the risk of loss was considered remote, was resolved in the company’s favor.
Answer: C
Terms: Audit report; Further inquiries
Diff: Moderate
Objective: LO 24-8
AACSB: Analytic skills

2) If an auditor discovers that previously issued financial statements are misleading, the most desirable approach to follow is to request that the client issue an immediate revision of the financial statements containing an explanation of the reasons for the revision.
A) True
B) False
Answer:
Terms: Auditor discovers that previously issued financial statements are misleading
Diff: Easy
Objective: LO 24-8
AACSB: Reflective thinking skills

3) Subsequent discoveries of facts requiring the reissuance of financial statements arise from events occurring after the date of the auditor’s report.
A) True
B) False
Answer:
Terms: Events that occur after the date of the auditor’s report
Diff: Moderate
Objective: LO 24-8
AACSB: Reflective thinking skills