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Multinational Business Finance by Eiteman – Exam And Quizzes

Multinational Business Finance by Eiteman – Exam And Quizzes

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Chapter 1 Current Multinational Challenges and the Global Economy

True/False

1) BRICs is a term used in international finance to represent assets that are considered to be inexpensive and sturdy, but fundamentally unsound and and incapable of coping with the upheavals now apparent in international financial markets.

2) Multinational enterprises (MNEs) are firms, both for profit companies and not-for-profit organizations, that have operations in more than one country, and conduct their business through foreign subsidiaries,
branches, or joint ventures with host country firms.

3) Ownership, control, and governance changes radically across the world. The publicly traded company is not the dominant global business organization—the privately held or family-owned business is the prevalent structure—and their goals and measures of performance differ dramatically.

Multiple Choice

1) A well-established, large U.S.-based MNE will probably NOT be able to overcome which of the following obstacles to maximizing firm value?
A) an open market place
B) high quality strategic management
C) access to capital
D) none of the above

2) A well-established, large China-based MNE will probably be most adversely affected by which of the following elements of firm value?
A) an open marketplace
B) high-quality strategic management
C) access to capital
D) access to qualified labor pool

3) A well-established, large, Brazil-based MNE will probably be most adversely affected by which of the following elements of firm value?
A) an open marketplace
B) high-quality strategic management
C) access to capital
D) access to qualified labor pool

True/False

1) Comparative advantage is one of the underlying principles driving the growth of global business.

2) Your authors suggest that one way to characterize the global financial marketplace is through its assets, institutions, and linkages.

3) Eurocurrencies are domestic currencies of one country on deposit in a second country.

4) A eurodollar deposit is a demand deposit.

5) Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity; and 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.

6) The key factor attracting both depositors and borrowers to the Eurocurrency loan market is the narrow interest rate spread within that market.

7) The Eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference. Recent events may lead to greater regulation.

Essay

1) List and explain three strategic motives why firms become multinationals and give an example of each.

Multiple Choice

1) The theory that suggests specialization by country can increase worldwide production is:
A) the theory of comparative advantage.
B) the theory of foreign direct investment.
C) the international Fisher effect.
D) the theory of working capital management.

2) Which of the following is NOT a reason governments interfere with comparative advantage?
A) Governments attempt to achieve full employment.
B) Governments promote economic development.
C) national self-sufficiency in defense-related industries
D) All are reasons governments interfere with comparative advantage.

3) Which of the following factors of production DO NOT flow freely between countries?
A) raw materials
B) financial capital
C) (non-military) technology
D) All of the above factors of production flow freely among countries.

4) Which of the following would NOT be a way to implement comparative advantage?
A) IBM exports computers to Egypt.
B) Computer hardware is designed in the United States but manufactured and assembled in Korea.
C) Water of the greatest purity is obtained from wells in Oregon, bottled, and exported worldwide.
D) All of the above are examples of ways to implement comparative advantage.

5) Of the following, which would NOT be considered a way that government interferes with comparative advantage?
A) tariffs
B) managerial skills
C) quotas
D) other non-tariff restrictions

True/False

1) The theory of comparative advantage owes it origins to Ben Bernanke as described in his book The Wealth of Bankers.

2) International trade might have approached the comparative advantage model in the 19th century, and it does so even more today.

3) Comparative advantage shifts over time as less developed countries become more developed and realize their latent opportunities.

4) Comparative advantage in the 21st century is based more on services and their cross border facilitation by telecommunications and the Internet.

5) Comparative advantage was once the cornerstone of international trade theory, but today it is archaic, simplistic, and irrelevant for explaining investment choices made by MNEs.

6) When discussing comparative advantage, it is apparent that today at least two of the factors of production, capital and technology, now flow directly and easily between countries, rather than only indirectly through traded goods and services.

7) It would be safe to make the statement that modern telecommunications now take business activities to labor rather than moving labor to the places of business.

Multiple Choice

1) Which of the following domestic financial instruments have NOT been modified for use in international financial management?
A) currency options and futures
B) interest rate and currency swaps
C) letters of credit
D) All of the above are domestic financial instruments that have also been modified for use in international financial markets.

True/False

1) MNEs must modify finance theories like cost of capital and capital budgeting because of foreign complexities.

2) Relative to MNEs, purely domestic firms tend to have GREATER political risk.

3) Domestic firms tend to make GREATER use of financial derivatives than MNEs because they can bear the greater risk presented by these financial instruments.

4) Because countries have different financial regulations and customs, it is common for MNEs to apply their domestic rules and regulations when doing financial business in a foreign country.

5) A number of financial instruments that are used in domestic financial management have been modified for use in international financial management. Examples are foreign currency options and futures, interest rate and currency swaps, and letters of credit.

Multiple Choice

1) In determining why a firm becomes multinational there are many reasons. One reason is that the firm is a market seeker. Which of the following is NOT a reason why market-seeking firms produce in foreign countries?
A) satisfaction of local demand in the foreign country
B) satisfaction of local demand in the domestic markets
C) political safety and small likelihood of government expropriation of assets
D) All of the above are market-seeking activities.

2) ________ investments are designed to promote and enhance the growth and profitability of the firm. ________ investments are designed to deny those same opportunities to the firm’s competitors.
A) Conservative; Aggressive
B) Defensive; Proactive
C) Proactive; Defensive
D) Aggressive; Proactive

True/False

1) For firms competing in a world characterized by oligopolistic competition, strategic motives can be subdivided into proactive and defensive investments.

2) Defensive measures are designed to enhance growth and profitability of the firm itself.

Multiple Choice

1) The phase of the globalization process characterized by imports from foreign suppliers and exports to foreign buyers is called the:
A) domestic phase.
B) multinational phase.
C) international trade phase.
D) import-export banking phase.

2) The authors describe the multinational phase of globalization for a firm as one characterized by the:
A) ownership of assets and enterprises in foreign countries.
B) potential for international competitors or suppliers even though all accounts are with domestic firms and are denominated in dollars.
C) imports from foreign suppliers and exports to foreign buyers.
D) requirement that all employees be multilingual.

3) A firm in the International Trade Phase of Globalization:
A) makes all foreign payments in foreign currency units and all foreign receipts in domestic currency units.
B) receives all foreign receipts in foreign currency units and makes all foreign payments in domestic currency units.
C) bears direct foreign exchange risk.
D) none of the above

4) Of the following, which was NOT mentioned by the authors as an increase in the demands of financial management services due to increased globalization by the firm?
A) evaluation of the credit quality of foreign buyers and sellers
B) foreign consumer method of payment preferences
C) credit risk management
D) evaluation of foreign exchange risk

5) Of the following, which was NOT mentioned by the authors as an increase in the demands of financial management services due to increased globalization by the firm?
A) evaluation of the credit quality of foreign buyers and sellers
B) foreign consumer method of payment preferences
C) credit risk management
D) evaluation of foreign exchange risk

6) The authors describe the multinational phase of globalization for a firm as one characterized by the:
A) ownership of assets and enterprises in foreign countries.
B) potential for international competitors or suppliers even though all accounts are with domestic firms and are denominated in dollars.
C) imports from foreign suppliers and exports to foreign buyers.
D) requirement that all employees be multilingual.

7) The twin agency problems limiting financial globalization are caused by these two groups acting in their own self-interests rather than the interests of the firm.
A) rulers of sovereign states and unsavory customs officials
B) corporate insiders and attorneys
C) corporate insiders and rulers of sovereign states
D) attorneys and unsavory customs officials

True/False

1) Typically, a firm in its domestic stage of globalization has all financial transactions in its domestic currency.

2) Typically, a “greenfield” investment abroad is considered a greater foreign investment having a greater foreign presence than a joint venture with a foreign firm.

3) The authors argue that financial inefficiency caused by influential insiders may prove to be an increasingly troublesome barrier to international finance.

4) The authors describe a process for development of a MNE that begins with a purely domestic phase, followed by the multinational phase, and topping out with the international trade phase.

5) Today it is widely assumed that there are NO LIMITS to financial globalization.

6) The growth in the influence and self-enrichment of organizational insiders is seen as an impediment to the growth of financial globalization in general.

7) The actions of corporate insiders and the actions of rulers of sovereign states are both agency costs that act as an impediment to the growth of globalization.

Chapter 2 Corporate Ownership, Goals, and Governance

Multiple Choice

1) Foreign stock markets are frequently characterized by controlling shareholders for the individual publicly traded firms. Which of the following is NOT identified by the authors as typical controlling shareholders?
A) the government (for example, privatized utilities)
B) institutions (such as banks in Germany)
C) family (such as in France)
D) All of the above were identified by the authors as controlling shareholders.

2) Which of the following is NOT typically associated with the public ownership of business organizations?
A) the state
B) the government
C) families
D) civil society

3) Which of the following is NOT typically associated with the private ownership of business organizations?
A) the government
B) families
C) individuals
D) publicly traded, widely-held organizations

4) State Owned Enterprises (SOEs):
A) are a form of public ownership.
B) are created for commercial activities rather than civil or social activities.
C) are the dominant form of business organization in some countries.
D) are all of the above.

5) The problems that may arise due to the separation of ownership and management in large business organizations is know as:
A) separation anxiety.
B) the agency problem.
C) corporate disconnect theory.
D) none of the above

6) Privatization is a term used to describe:
A) firms that are purchased by the government.
B) government operations that are purchased by corporations and other investors.
C) firms that do not use publicly available debt.
D) non-public meetings held by members of interlocking directorates.

True/False

1) In the U.S. and U.K. stock markets are characterized by ownership of firms concentrated in the hands of a few controlling shareholders. In contrast, the rest of the world tends to have more widespread ownership of shares.

2) State Owned Enterprises (SOEs) by their very name cannot be traded on stock exchanges because they are government owned.

3) In recent years the trend has been for markets to increasing focus on the shareholder wealth form of wealth maximization.

4) Non-Anglo-American markets are dominated by the “one-vote-one-share” rule.

5) According to recent research, family-owned firms in some highly-developed economies typically outperform publicly-owned firms.

Essay/Short Answer

1) What are the most important distinctions that make state owned enterprises (SOEs) different from other forms of government organizations?

Multiple Choice

1) “Maximize corporate wealth”:
A) is the primary objective of the non-Anglo-American model of management.
B) as a management objective treats shareholders on a par with other corporate stakeholders such as creditors, labor, and local community.
C) has a broader definition than just financial wealth.
D) all of the above

2) The Shareholder Wealth Maximization Model (SWM):
A) combines the interests and inputs of shareholders, creditors, management, employees, and society.
B) is being usurped by the Stakeholder Capitalism Model as those types of MNEs dominate their global industry segments.
C) clearly places shareholders as the primary stakeholder.
D) is the dominant form of corporate management in the European-Japanese governance system.

3) The Stakeholder Capitalism Model (SCM):
A) clearly places shareholders as the primary stakeholder.
B) combines the interests and inputs of shareholders, creditors, management, employees, and society.
C) has financial profit as its goal and is often termed impatient capital.
D) is the Anglo-American model of corporate governance.

4) In the Anglo-American model of corporate governance, the primary goal of management is to:
A) maximize the wealth of all stakeholders.
B) maximize shareholder wealth.
C) minimize costs.
D) minimize risk.

5) In finance, an efficient market is one in which:
A) prices are assumed to be correct.
B) prices adjust quickly and accurately to new information.
C) prices are the best allocators of capital in the macro economy.
D) all of the above

6) Systematic risk can be defined as:
A) the total risk to the firm.
B) the risk of the individual security.
C) the risk of the market in general.
D) the risk that can be systematically diversified away.

7) Unsystematic risk can be defined as:
A) the total risk to the firm.
B) the risk of the individual security.
C) the added risk that a firm’s shares bring to a diversified portfolio.
D) the risk of the market in general.

8) The study of how shareholders can motivate management to accept the prescriptions of the shareholder wealth maximization model is called:
A) market efficiency.
B) the SWM model.
C) agency theory.
D) the SCM model.

9) Under the Shareholder Wealth Maximization Model (SWM) of corporate governance, poor firm performance is likely to be faced with all but which of the following?
A) sale of shares by disgruntled current shareholders
B) shareholder activism to attempt a change in current management
C) as a maximum threat, initiation of a corporate takeover
D) prison time for executive management

10) Which of the following is a reason why managers act to maximize shareholder wealth in Anglo-American markets?
A) the use of stock options to align the goals of shareholders and managers
B) the market for corporate control that allows for outside takeover of the firm
C) performance based compensation for executive management
D) all of the above

11) Which of the following is NOT true regarding the stakeholder capitalism model?
A) Banks and other financial institutions are less important creditors than securities markets.
B) Labor unions are more powerful than in the Anglo-American markets.
C) Governments interfere more in the marketplace to protect important stakeholder groups.
D) All of the above are TRUE.

12) The stakeholder capitalism model:
A) typically avoids the flaw of impatient capital.
B) tries to meet the desires of multiple stakeholders.
C) may leave management without a clear signal about tradeoffs among the several stakeholders.
D) all of the above

13) Which of the following is generally NOT considered to be a viable operational goal for a firm?
A) maintaining a strong local currency
B) maximization of after-tax income
C) minimization of the firm’s effective global tax burden
D) correct positioning of the firm’s income, cash flows and available funds as to country and currency

14) Which of the following operational goals for the international firm may be incompatible with the others?
A) maintaining a strong local currency
B) maximization of after-tax income
C) minimization of the firm’s effective global tax burden
D) Each of these goals may be incompatible with one or more of the others.

15) The primary operational goal for the firm is to:
A) maximize after-tax profits in each country where the firm is operating.
B) minimize the total financial risk to the firm.
C) maximize the consolidated after-tax profits of the firm.
D) maximize the total risk to the firm.

16) Which of the following broad topics is NOT identified as an area to be established as good corporate governance practice by the Organization for Economic Cooperation and Development (OECD)?
A) protect the rights of shareholders
B) disclosure and transparency
C) the proper role of stakeholders in the governance of the firm
D) All of the above should be a concern of good corporate governance.

17) The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed:
A) corporate governance.
B) Anglo-American activism.
C) capital structure.
D) working capital management.

18) When discussing the structure of corporate governance, the authors distinguish between internal and external factors. ________ is an example of an internal factor, and ________ is an example of an external factor.
A) Equity markets; executive management
B) Debt markets; board of directors
C) Executive management; auditors
D) Auditors; regulators

19) Which of the following is NOT commonly associated with a government affiliated form of corporate governance regime?
A) no minority influence
B) lack of transparency
C) state ownership of enterprise
D) All are associated with this type of corporate governance regime.

20) Generally speaking, which of the following is NOT considered an important factor in the composition and control of corporate boards of directors?
A) the number of insider vs outside directors
B) the total number of directors on the board
C) the composition of the compensation committee
D) All of the above are important factors of board composition.

21) Signed into law on July 30, 2002, the ________ Act requires CEOs of publicly traded companies to vouch for the veracity of the firm’s published financial statements.
A) Smoot-Hawley
B) Humphrey-Hawkins
C) McCain-Merrill
D) Sarbanes-Oxley

22) The Sarbanes-Oxley Act, passed by the U.S. Congress in July 2002, was designed to:
A) reinstitute heavy tariffs on international trade.
B) reform corporate governance.
C) limit the Federal Reserve Board’s ability to engage in the buying and selling of gold.
D) limit trade with countries deemed lenient on terrorism.

23) Anglo-American markets is a term used to describe business markets in:
A) North, Central, and South America.
B) the United States, Canada, and Western Europe.
C) the United States, United Kingdom, Canada, Australia and New Zealand.
D) the United States, France, Britain, and Germany.

24) The deliberation of the of the process demonstrated in the European-Japanese system of corporate governance has sometimes been termed:
A) socialism.
B) impatient capital.
C) patient capital.
D) communism.

25) With shareholder wealth maximization as the manager’s goal, capital may be termed:
A) impatient.
B) patient.
C) borrowed.
D) bought.

26) Which of the following is NOT an important concept when distinguishing between international and domestic financial management?
A) corporate governance
B) culture, history, and institutions
C) political risk
D) All of the above are important distinguishing concepts.

27) The Board of Directors:
A) consists exclusively of the officers of the corporation.
B) is the legal body which is accountable for the governance of the corporation.
C) are not subject to the external forces of the marketplace.
D) is appointed by the Securities and Exchange Commission (SEC).

28) If share price rises from $12 to $15 per share, and pays a dividend of $1 per share, what was the rate of return to shareholders?
A) 26.67%
B) -13.33%
C) 33.33%
D) 16.67%

29) PolyProduction Inc. has two classes of common stock. Class A has 5 million shares with 10 votes per share. Class B has 5 million shares with 1 vote per share. If the dividends per share are equal for both class A and B stock, then Class A shareholders have ________ of the votes and ________ of the dividends.
A) 90.91%; 90.91%
B) 90.91%; 50.00%
C) 50.00%; 50.00%
D) 83.33%; 33.33%

30) The number of publicly traded firms:
A) peaked in the U.S. in 1996.
B) peaked worldwide in 1996.
C) increased significantly in 2009 as a result of the international financial crisis.
D) all of the above

31) Which of the following is NOT a possible and appropriate response by shareholders dissatisfied with existing firm management of a publicly traded firm?
A) Shareholders could sell their shares of stock.
B) Shareholders could remain quietly disgruntled.
C) Shareholders, perhaps with the help of others, could attempt to initiate a takeover.
D) All of these responses may be possible and appropriate.

True/False

1) The stakeholder capitalism model (SCM) holds that total risk (operational and financial) is more important than just systematic risk.

2) In recent years the trend has been for markets to increasing focus on the shareholder wealth form of wealth maximization.

3) Patient Capitalism is characterized by short-term focus by both management and investors.

4) Agency theory states that unsystematic risk can be eliminated through diversification.

5) The stakeholder capitalism model does not assume that equity markets are either efficient or inefficient.

6) The stakeholder capitalism model assumes that only systematic risk “counts” or is a prime concern for management.

7) Dividend yield is the change in the share price of stock as traded in the public equity markets.

8) Regarding comparative corporate governance regimes: Bank-based regimes characterized by government influence in bank lending and a lack of transparency is often found in countries such as Korea and Germany.

9) Investor protection is typically better in countries with codified civil law (the Code Napoleon) than in countries with a legal system based in English common law.

10) The relatively low cost of compliance with the Sarbanes-Oxley Act (SOX) has been a surprising benefit of the act.

11) According to recent research, family-owned firms in some highly-developed economies typically outperform publicly-owned firms.

12) The goal of all international corporations is to maximize shareholder wealth.

13) Systematic risk can be eliminated through portfolio diversification.

14) According to the authors, dual classes of voting stock are the norm in non-Anglo-American markets.

15) A recent study shows that privately held firms use less financial leverage and enjoy lower costs of debt than publicly traded firms.

16) U.S. listings of publicly traded firms as a percentage of worldwide listings of such firms INCREASED from 11% in 1996 to approximately 33% in 2010.

17) Having Anglo-Americans as members of the board of directors of a non-Anglo-American firm signals poor corporate governance in the firm.

18) In the stakeholder capitalism model (SCM) the assumption of market efficiency is absolutely critical.

Short Answer/ Essay

1) Describe the management objectives of a firm governed by the shareholder wealth maximization model and one governed by the stakeholder wealth maximization model. Give an example of how these two models may lead to different decision-making by executive management.

2) Define patient and impatient capitalism and discuss how each may lead to different decision-making in the shareholder wealth maximization model.

Chapter 3 The International Monetary System

Multiple Choice

1) Under the gold standard of currency exchange that existed from 1879 to 1914, an ounce of gold cost $20.67 in U.S. dollars and £4.2474 in British pounds. Therefore, the exchange rate of pounds per dollar under this fixed exchange regime was:
A) £4.8665/$.
B) £0.2055/$.
C) always changing because the price of gold was always changing.
D) unknown because there is not enough information to answer this question.

2) World War I caused the suspension of the gold standard for fixed international exchange rates because the war:
A) cost too much money.
B) interrupted the free movement of gold.
C) lasted too long.
D) used gold as the main ingredient in armament plating.

3) The post WWII international monetary agreement that was developed in 1944 is known as the:
A) United Nations.
B) League of Nations.
C) Yalta Agreement.
D) Bretton Woods Agreement.

4) Another name for the International Bank for Reconstruction and Development is:
A) the Recon Bank.
B) the European Monetary System.
C) the Marshall Plan.
D) the World Bank.

5) The International Monetary Fund (IMF):
A) in recent years has provided large loans to Russia, South Korea, and Brazil.
B) was created as a result of the Bretton Woods Agreement.
C) aids countries with balance of payment and exchange rate problems.
D) is all of the above.

6) Which of the following led to the eventual demise of the fixed currency exchange rate regime worked out at Bretton Woods?
A) widely divergent national monetary and fiscal policies among member nations
B) differential rates of inflation across member nations
C) several unexpected economic shocks to member nations
D) all of the above

7) Which of the following statements is NOT true?
A) The Gold Standard Era was characterized by growing openness in trade, but limited capital mobility.
B) The time period between world wars 1 and 2 (the inter war Years) witnessed significant reductions in trade barriers and a rapid acceleration in international trade.
C) The Bretton Woods Era (post WWII) realized the increasing benefits of open economies. Furthermore, trade was increasingly dominated by capital.
D) In fact, all of the above statements are true.

True/False

1) Under the terms of Bretton Woods, countries tried to maintain the value of their currencies to within 1% of a hybrid security made up of the U.S. dollar, British pound, and Japanese yen.

2) Members of the International Monetary Fund may settle transactions among themselves by transferring Special Drawing Rights (SDRs).

3) Today, the United States has been ejected from the International Monetary Fund for refusal to pay annual dues.

4) From the time of its creation through July 2012, the euro peaked versus the USD in April 2008 at around $1.60/€

Essay

1) Most Western nations were on the gold standard for currency exchange rates from 1876 until 1914. Today we have several different exchange rate regimes in use, but most larger economy nations have freely floating exchange rates today and are not obligated to convert their currency into a predetermined amount of gold on demand. Currently several parties still call for the “good old days” and a return to the gold standard. Develop an argument as to why this is a good idea.

Multiple Choice

1) Since 2009 the IMF’s exchange rate regime classification system uses a “de facto classification” methodology. Under this system, a country that has given up their own sovereignty over monetary
policy is considered to have:
A) a residual agreement.
B) hard pegs.
C) soft pegs.
D) floating arrangements.

2) Since 2009 the IMF’s exchange rate regime classification system uses a “de facto classification” methodology. Under this system, countries with “fixed exchange rates” are considered to have:
A) a residual agreement.
B) soft pegs.
C) hard pegs.
D) floating arrangements.

3) A small economy country whose GDP is heavily dependent on trade with the United States could use a(n) ________ exchange rate regime to minimize the risk to their economy that could arise due to unfavorable changes in the exchange rate.
A) pegged exchange rate with the United States
B) pegged exchange rate with the Euro
C) independent floating
D) managed float

4) Since 2009 the IMF’s exchange rate regime classification system uses a “de facto classification” methodology. Under this system, currencies that are predominantly market-driven are considered to be:
A) soft pegs.
B) hard pegs.
C) floating arrangements.
D) a residual agreement.

True/False

1) The euro is an example of a rigidly fixed system, acting as a single currency for its member countries. However, the euro itself is an independently floating currency against all other currencies.

2) Although the contemporary international monetary system is typically referred to as a “floating regime,” it is clearly not the case for the majority of the world’s nations.

Essay

1) The mobility of international capital flows is causing emerging market nations to choose between a free-floating currency exchange regime and a currency board (or taken to the limit, dollarization). Describe how each of the regimes would work and identify at least two likely economic results for each regime.

Multiple Choice

1) Based on the premise that, other things equal, countries would prefer a fixed exchange rate, which of the following statements is NOT true?
A) Fixed rates provide stability in international prices for the conduct of trade.
B) Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves for use in the occasional defense of the fixed rate.
C) Fixed rates are inherently inflationary in that they require the country to follow loose monetary and fiscal policies.
D) Stable prices aid in the growth of international trade and lessen exchange rate risks for businesses.

2) Which of the following is NOT an attribute of the “ideal” currency?
A) monetary independence
B) full financial integration
C) exchange rate stability
D) All are attributes of an ideal currency.

3) The authors discuss the concept of the “Impossible Trinity” or the inability to achieve simultaneously the goals of exchange rate stability, full financial integration, and monetary independence. If a country chooses to have a pure float exchange rate regime, which two of the three goals is a country most able to achieve?
A) monetary independence and exchange rate stability
B) exchange rate stability and full financial integration
C) full financial integration and monetary independence
D) A country cannot attain any of the exchange rate goals with a pure float exchange rate regime.

True/False

1) Based on the premise that, other things equal, countries would prefer a fixed exchange rate: Variable rates provide stability in international prices for the conduct of trade.

2) If exchange rates were fixed, investors and traders would be relatively certain about the current and near future exchange value of each currency.

Multiple Choice

1) Which of the following is NOT a required convergence criteria to become a full member of the European Economic and Monetary Union (EMU)?
A) National birthrates must be at 2.0 or lower per person.
B) The fiscal deficit should be no more than 3% of GDP.
C) Nominal inflation should be no more than 1.5% above the average inflation rate for the three members with the lowest inflation rates in the previous year.
D) Government debt should be no more than 60% of GDP.

2) According to the authors, what is the single most important mandate of the European Central Bank?
A) Promote international trade for countries within the European Union.
B) Price, in euros, all products for sale in the European Union.
C) Promote price stability within the European Union.
D) Establish an EMU trade surplus with the United States.

3) Which of the following is a way in which the euro affects markets?
A) Countries within the Euro zone enjoy cheaper transaction costs.
B) Currency risks and costs related to exchange rate uncertainty are reduced.
C) Consumers and business enjoy price transparency and increased price-based competition.
D) all of the above

4) For the three years from early 2002 to early 2005, the euro maintained a strong and steady rise in value against the U.S. dollar (USD). After a brief respite in 2005, the euro continued its climb against the USD into 2008. Which of the following were NOT a contributing factor in the assent of the euro and the decline in the dollar?
A) severe U.S. balance of payments deficits
B) a general weakening of the dollar after the attacks of September 11, 2001
C) large U.S. balance of payment surpluses
D) All of the above were contributing factors.

5) The countries that use the euro as their currency have:
A) agreed to use a single currency (exchange rate stability), allow the free movement of capital in and out of their economies (financial integration), but give up individual control of their own money supply (monetary independence).
B) gained control over their own money supply (monetary independence), allowed the free movement of capital in and out of their economies (financial integration), but give up exchange rate stability.
C) agreed to use a single currency (exchange rate stability), allow individual control of their own money supply (monetary independence), but give up the free movement of capital in and out of their economies (financial integration).
D) none of the above

True/False

1) The Euro currency is fixed against other currencies on the international currency exchange markets, but allows member country currencies to float against each other.

2) The European Central Bank is a strong and independent central bank that has completely replaced the individual central banks of the countries that use the euro as their currency.

3) The members of the EU do have relative freedom to set their own fiscal policies— government spending, taxation, and the creation of government surpluses or deficits. They are expected to keep deficit spending within limits.

Multiple Choice

1) Beginning in 1991 Argentina conducted its monetary policy through a currency board. In January 2002, Argentina abandoned the currency board and allowed its currency to float against other currencies. The country took this step because:
A) the Argentine Peso had grown too strong against major trading powers thus the currency board policies were hurting the domestic economy.
B) the United States required the action as a prerequisite to finalizing a free trade zone with all of North, South, and Central America.
C) the Argentine government lost the ability to maintain the pegged relationship as in fact investors and traders perceived a lack of equality between the Argentine Peso and the U.S. dollar.
D) all of the above

2) In January 2002, the Argentine Peso changed in value from Peso1.00/$ to Peso1.40/$, thus, the Argentine Peso ________ against the U.S. dollar.
A) strengthened
B) weakened
C) remained neutral
D) all of the above

3) In January 2000 Ecuador officially replaced its national currency, the Ecuadorian sucre, with the U.S. dollar. This practice is known as:
A) bi-currencyism.
B) sucrerization.
C) a Yankee bailout.
D) dollarization.

4) You have been hired as a consultant to the central bank for a country that has for many years suffered from repeated currency crises and depends heavily on the U.S. financial and product markets. Which of the following policies would have the greatest effectiveness for reducing currency volatility of the client country with the United States?
A) dollarization
B) an exchange rate pegged to the U.S. dollar
C) an exchange rate with a fixed price per ounce of gold
D) an internationally floating exchange rate

5) Which of the following is NOT an argument against dollarization?
A) Dollarization causes a loss of sovereignty over domestic monetary policy.
B) Dollarization removes currency volatility against the dollar.
C) Dollarization causes the country to lose the power of seignorage.
D) The central bank of the dollarized country loses the role of lender of last resort.

6) The ability of a country to profit from its ability to print money is known as:
A) profiteering.
B) dollarization.
C) seignorage.
D) inflation.

7) Which of the following factors make it difficult for emerging market economies to choose a specific currency regime?
A) weak fiscal, financial, and monetary institutions
B) the tendency for commerce to allow currency substitution and the denomination of liabilities in dollars
C) the emerging market’s vulnerability to sudden stoppages of outside capital flows
D) all of the above

True/False

1) A currency board exists when a country’s central bank commits to back its money supply entirely with foreign reserves at all times.

2) Dollarization is a common solution for countries suffering from currency revaluation.

3) By and large, high capital mobility is forcing emerging market nations to choose between the two extremes of a free floating regime or an exchange rate regime of dollarization of a currency board.

Multiple Choice

1) Of the following, which is NOT a trade-off that must be dealt with in any exchange rate regime?
A) cooperation vs independence
B) rules vs discretionary action
C) dollars vs pounds
D) All of the above are rate regime trade-offs.

True/False

1) All exchange rate regimes must deal with the trade-off between rules and discretion as well as between cooperation and independence.

2) Regime structures like the gold standard required no cooperative policies among countries, only the assurance that all would abide by the “rules of the game.”

3) Bretton Woods required less in the way of cooperation among countries than did the gold standard.

Chapter 4 The Balance of Payments

Multiple Choice

1) Which of the following is NOT a major subaccount of the Balance of Payments?
A) the financial account
B) the accounts payable
C) the capital account
D) the current account

2) Which of the following international transactions would NOT be counted as a balance of payments (BOP) transaction?
A) An American tourist purchases cheese in Milwaukee, Wisconsin.
B) The U.S. subsidiary of a British firm pays profits (dividends) back to its parent firm in London.
C) A Canadian lumber baron purchases a U.S. corporate bond through an investment broker in
Seattle.
D) All of the above are considered BOP transactions.

3) The balance of payments as applied to a course in international finance may be defined as:
A) the amount still owed by an exporting firm after making an initial down payment.
B) the amount still owed by governments to the International Monetary Fund.
C) the measurement of all international economic transactions between the residents of a country and foreign residents.
D) the amount of a country’s merchandise trade deficit or surplus.

4) Balance of payment (BOP) data may be important for any of the following reasons:
A) BOP data helps to forecast a country’s market potential, especially in the short run.
B) The BOP is an important indicator of a country’s foreign exchange rate.
C) Changes in a country’s BOP may signal a change in controls over payment of dividends and interest.
D) all of the choices provided above

5) A country experiencing a serious BOP ________ is more likely to ________ exports than otherwise.
A) surplus; contract
B) surplus; expand
C) deficit; expand
D) none of the above

6) Which of the following would NOT be considered a typical BOP transaction?
A) Toyota U.S.A. is a U.S. distributor of automobiles manufactured in Japan by its parent company.
B) The U.S. subsidiary of European financial giant, Credit Suisse, pays dividends to its parent in Zurich.
C) A U.S. tourist purchases gifts at a museum in London.
D) All are example of BOP transactions.

True/False

1) When the world went to a system of floating exchange rates, the Balance of Payments became a relic of a system of fixed exchange rates and is no longer watched by serious economic groups.

2) Changes in the BOP may predict the imposition or removal of foreign exchange controls.

3) A country experiencing a serious trade deficit is not as likely to expand imports as it would
be if running a surplus.

Multiple Choice

1) Which of the following is NOT a part of the Current Account of BOP?
A) net export/import of goods
B) balance of trade
C) net portfolio investment
D) net export/import of services

2) Which of the following is NOT part of the Financial Account of the BOP?
A) net foreign direct investment
B) net import/export of services
C) net portfolio investment
D) other Financial items

3) Which of the following is NOT an item to be considered in BOP calculations?
A) A foreign resident purchases a U.S. Treasury Bill.
B) A U.S.-based firm manages the development of an oil field in Kazakhstan.
C) A consumer buys a VCR made in Korea from a Florida Wal-Mart store.
D) A U.S. citizen living in Minnesota travels to Winnipeg, Canada, and buys a case of LaBatt’s Canadian beer.

4) The balance of payments:
A) determines the eligibility of countries for IMF aid.
B) adds up the value of all assets and liabilities of a country on a specific date.
C) records all international transactions for a country over a period of time.
D) all of the above

5) An American tourist purchases a leather jacket while in Italy. Which of the following statements is true?
A) The leather purchase would be considered an import for the U.S. BOP.
B) This transaction would be properly accounted for in the Current Account of the U.S. BOP.
C) The leather purchase is considered an import of a good, and thus, considered part of the balance of trade as well.
D) All of these statements are true.

True/False

1) The authors identify a tip for understanding BOP accounting. They recommend that you “follow the cash flow.”

2) The BOP must be in balance, but the current account need not be.

3) Expenditures by U.S. tourists in foreign countries for foreign goods or services are factored into BOP calculations.

4) Like a balance sheet, the Balance of Payments adds up the value of all assets and liabilities
of a country on a specific date.

Essay

1) What is a country’s balance of (merchandise) trade, and why is it so widely reported in the financial and popular press?

2) What is the Official Reserves Account (ORA), and why is it more important for countries under a fixed exchange rate regime than for ones under a floating exchange rate regime?

Multiple Choice

1) Which of the following is NOT part of the balance of payments account?
A) the current account
B) the financial/capital account
C) the official reserves account
D) All of the above are BOP accounts.

2) The ________ includes all international economic transactions with income or payment flows occurring within the year.
A) capital account
B) current account
C) financial account
D) IMF account

3) If your company were to import and export textiles, the transactions would be recorded in the current account subcategory of:
A) services trade.
B) income trade.
C) goods trade.
D) current transfers.

4) The travel services provided to international travelers by United Airlines would be recorded in the current account subcategory of:
A) services trade.
B) income trade.
C) goods trade.
D) current transfers.

5) Anaconda Copper Inc. created a subsidiary in Chile last year to mine copper ore. The proportion of net income paid back to the parent company as a dividend would be recorded in the current account subcategory of:
A) services trade.
B) income trade.
C) goods trade.
D) current transfers.

6) The subcategory that typically dominates the current account is:
A) goods (merchandise) trade.
B) services trade.
C) income trade.
D) transfer accounts.

7) In 2010 the United States posted a current account deficit of -$471 billion. The bulk of the negative value came from:
A) a net transfer deficit.
B) an income balance deficit.
C) a goods trade deficit.
D) an income trade deficit.

8) Over the last two decades the surplus on U.S. services trade has typically been ________ the deficit on U.S. goods trade.
A) greater than
B) equal to
C) less than
D) The relationship is constantly shifting from greater than to less than.

True/False

1) Because current and financial/capital account balances use double-entry bookkeeping it is unusual to find serious discrepancies in the debits and credits.

2) In general, as a country’s income increases, so does the demand for imports.

3) For at least the last decade, the United States has consistently run a surplus in services trade income.

4) Expenditures by U.S. students abroad and foreign students pursuing studies in the United States would be considered a services trade and part of the U.S. current account.

Multiple Choice

1) The ________ of the balance of payments measures all international economic transactions of financial assets.
A) current account
B) merchandise trade account
C) services account
D) capital and financial accounts

2) The financial account consists COMPLETELY of which four components?
A) stock investment, bond investment, derivative investment, and mutual fund investment
B) direct investment, stock investment, net financial derivatives, and bond investment
C) direct investment, portfolio investment, net financial derivatives, and other asset investment
D) mutual fund investment, portfolio investment, derivative investment, and stock investment

3) When categorizing investments for the financial account component of the balance of payments the ________ is an investment where the investor has no control whereas the ________ is an investment where the investor has control over the asset.
A) direct investment; portfolio investment
B) direct investment; indirect investment
C) portfolio investment; indirect investment
D) portfolio investment; direct investment

4) In general there is consensus that ________ should be free, but there is no such consensus that ________ should be free.
A) international investment; international goods trade
B) international investment; international trade
C) international trade; international goods trade
D) international trade; international investment

5) The two major concerns about foreign direct investment are:
A) national defense and taxes.
B) who controls the assets and who receives the profits.
C) who receives the profits and taxes.
D) who pays the taxes and who receives the taxes.

6) Portfolio investment is capital invested in activities that are ________ rather than made for ________.
A) short term; the long term
B) long term; profit
C) profit motivated; control
D) control motivated; profit

7) Under an international regime of fixed exchange rates, countries with a BOP ________ should consider ________ their currency while countries with a BOP ________ should consider ________ their currency.
A) deficit, revaluing; surplus, revaluing
B) deficit, devaluing; surplus, devaluing
C) surplus, devaluing; deficit, revaluing
D) surplus, revaluing; deficit, devaluing

8) Consider the following: A foreign automobile company builds a manufacturing plant in Tennessee and European investors buy U.S. Treasury Bonds.
A) Both activities would be considered direct investment.
B) Both activities would be considered portfolio investment.
C) The auto manufacturer in engaging in portfolio investment, and the European investors are engaged in direct investing.
D) The auto manufacturer in engaging in direct investment, and the European investors are engaged in portfolio investing.

True/False

1) International debt security purchases and sales are defined as portfolio investments for financial account purposes because by definition debt securities do not provide the buyer with ownership or control.

2) Significant amounts of United States Treasury issues are purchased by foreign investors, therefore the U.S. must earn foreign currency to repay this debt.

3) In the United States and most developed countries, the current account and the combined financial/capital accounts tend to be inversely related in that when one is positive, the other tends to be negative.

Multiple Choice

1) China is currently experiencing a surplus in its current account and its capital/financial accounts. Which of the following is NOT a contributing factor for this unusual situation?
A) The exceptional growth in the Chinese economy contributes to the current account surplus.
B) The positive prospects for China’s continued growth contribute to the capital/financial account surplus.
C) China’s inevitable acquisition of Taiwan is driving the market for Chinese investment.
D) All of the above are contributing factors for China’s twins surpluses.

2) If China wished to reduce their accumulation of foreign exchange reserves they could:
A) allow their currency, the yuan, to float freely in the market place.
B) reduce their current account surplus by importing more goods than they export.
C) undertake both of the activities identified in choices A and B.
D) dig a big hole and bury the reserves.

True/False

1) The biggest problem that China faces in maintaining a stable value for their currency, the yuan, is their lack of foreign exchange reserves.

2) As of year-end 2010, the United States still held the world’s largest foreign exchange reserve, but the total was rapidly being approached by China.

3) China’s current political plan includes reducing their foreign exchange reserve balance by allowing the yuan to float freely and by switching their goods balance from one of a net surplus to a net deficit.

4.6 The Balance of Payments in Total

Multiple Choice

1) The largest single component of the United States current account is:
A) current transfers.
B) income payments and receipts.
C) goods (merchandise) imports and exports.
D) services imports and exports.

2) Which of the following statements about the balance of payments is NOT true?
A) The BOP is the summary statement of all international transactions between one country and all other countries.
B) The BOP is a flow statement, summarizing all international transactions that occur across the geographic borders over a period of time, typically a year.
C) Although the BOP must always balance in theory, in practice there are substantial imbalances as a result of statistical errors and misreporting of current account and financial account flows.
D) All of the above are true.

True/False

1) An excess of merchandise exports over merchandise imports results in a balance of trade deficit.

2) The BOP should always balance.

3) The transition to floating exchange rate regimes in the 1970s (described in Chapter 3) changed the focus from the total BOP to its various subaccount like the current and financial account balances.

4.7 The Balance of Payments Interaction with Key Macroeconomic Variables

Multiple Choice

1) Use the following terms for this question:
C = consumption
I = capital investment spending
G = government spending
X = exports of goods and services
M = imports of goods and services
BOP = balance of payments
GDP = gross domestic product
NPV = net present value
INF = inflation
R = real rate of return

The static equation for the nations GDP is:
A) GDP = C + I + G + (X + M ) × INF
B) GDP = C + I + G + X + M
C) GDP = C + I + G + X – M
D) GDP = C + I + X – M + R

2) Imports have the potential to lower a country’s inflation rate because of each of the following EXCEPT:
A) the import of lower priced goods limits what domestic competitors can charge for goods.
B) the import of lower priced services limits what domestic competitors can charge for services.
C) the higher prices of foreign goods spurs domestic competitors to cut prices.
D) all of the above

3) Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is GREATER THAN ZERO, a ________ demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and ________ domestic currency for foreign currencies or gold so as to bring the BOP back near zero.
A) surplus; sell
B) surplus; buy
C) deficit; sell
D) deficit; buy

4) Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is LESS THAN ZERO, a ________ demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and ________ domestic currency for foreign currencies or gold so as to bring the BOP back near zero.
A) surplus; sell
B) surplus; buy
C) deficit; sell
D) deficit; buy

True/False

1) An increase in GDP should lead to a decrease in imports.

2) The effect of an imbalance in the BOP is the same for countries on a fixed exchange rate regime as for those on a floating exchange rate regime.

3) Under a floating exchange rate system, the government bears the responsibility to ensure that the BOP is near zero.

4) A country with a managed float that wishes to WEAKEN its currency may choose to raise domestic interest rates to attract additional capital from abroad.

5) A country’s overall level of interest rates should have an impact on the financial account of the BOP. Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies.

6) Imports have the potential to lower a country’s inflation rate. In particular, imports of HIGHER-priced goods and services place a limit on what domestic competitors charge for comparable goods and services.

4.8 Trade Balances and Exchange Rates

Multiple Choice

1) Of the following, which is NOT a part of J-Curve adjustment path?
A) the currency contract period
B) the exchange rate pass-through period
C) the quantity adjustment period
D) Each of the above is part of the J-Curve adjustment path.

2) Which of the following is NOT likely to occur in the quantity adjustment phase of the J-Curve adjustment path?
A) Imports become relatively more expensive.
B) Exports become relatively less expensive.
C) The balance of trade gets worse.
D) All of the above are true.

True/False

1) When a currency is devalued the immediate impact may be an increase in a country’s trade deficit. However, this situation tends to correct itself in 2 to 5 weeks.

Comment: This situation tends to correct itself in 3 to 12 MONTHS or more.

4.9 Capital Mobility

Multiple Choice

1) The authors identify four distinct periods of capital mobility since 1860. Which do they term as a “period of global economic destruction”?
A) 1860 – 1914
B) 1914 – 1945
C) 1945 – 1971
D) 1971 – 2007

2) ________ is the cross-border purchase of assets that are then managed in a way that hides the movement of money and its ownership.
A) Capital flight
B) Capital mobility
C) Irrational exuberance
D) Money laundering

3) This was an era dominated by industrialized nation economies that were dependent on gold convertibility to maintain confidence in the system.
A) The Gold Standard, 1860-1914
B) The Interwar Years , 1914-1945
C) The Bretton Woods Era, 1945-1971
D) The Floating Era, 1971-1997

4) This dollar-based fixed exchange rate system gave rise to a long period of economic recovery and growing openness of both international trade and capital flows in and out of more and more countries.
A) The Gold Standard, 1860-1914
B) The Interwar Years , 1914-1945
C) The Bretton Woods Era, 1945-1971
D) The Floating Era, 1971-1997

5) An era of retrenchment, in which major economic powers returned to policies of isolationism and protectionism, restricting trade and nearly eliminating capital mobility.
A) The Gold Standard, 1860-1914
B) The Interwar Years , 1914-1945
C) The Bretton Woods Era, 1945-1971
D) The Floating Era, 1971-1997

6) A ________ is any restriction that limits or alters the rate or direction of capital movement into or out of a country.
A) capital budget
B) capital control
C) balance of trade deficit
D) balance of trade surplus

True/False

1) The Bretton Woods era realized a great expansion of international trade in goods and services.

Essay/Short Answer

1) Dutch Disease is a term applied to a problem in the 1970 whereby the Netherlands were experiencing massive and sudden inflows of capital from abroad. What was the cause of this sudden influx of capital, and what types of potential problems did it have for the Dutch or could it have for any small single resource country?

Chapter 5 The Continuing Global Financial Crisis

5.1 The Credit Crisis of 2008-2009

Multiple Choice

1) Investment banks and stock brokerages have traditionally been regulated by the:
A) Federal Reserve System (FED).
B) Federal Deposit Insurance Corporation (FDIC).
C) Securities and Exchange Commission (SEC).
D) Internal Revenue Service (IRS).

2) The Glass-Steagall Act of 1933:
A) separated commercial banking activities from investment banking activities.
B) created the Federal Reserve System.
C) developed the system of commercial bank deposit insurance.
D) all of the above

3) Which of the following is NOT another term for a prime mortgage loan?
A) conventional loan
B) top-qual loan
C) conforming loan
D) All of the above are suitable terms for a prime mortgage loan.

4) The process of turning an illiquid asset into a liquid saleable asset is called:
A) swapping.
B) wrapping.
C) securitization.
D) creationism.

5) Asset-backed securities (ABSs) may be securitized based on:
A) auto loans.
B) home-equity loans.
C) credit card receivables.
D) all of the above

6) A ________ is a financial intermediation device that allowed the participant to borrow short and lend long.
A) sub-prime loan
B) structured investment vehicle
C) non-conforming loan
D) all of the above

7) A ________ is a securitized financial instrument that is sold to the market in tranches representing different levels of default risk.
A) guaranteed security asset (GSA)
B) mortgaged backed security (MBS)
C) credit default swap (CDS)
D) collateralized debt obligation (CDO)

8) Which of the following statements concerning credit default swaps is FALSE?
A) As of year-end 2008, CDSs are completely outside of regulatory boundaries.
B) A CDS is a derivative security that may be used for hedging risk or for speculative purposes.
C) In order be a party to a CDO, at least one of either the buyer or seller must own the underlying asset.
D) CDSs allow banks to severe their links to their borrowers, thereby reducing their incentive to screen and monitor the ability of borrowers to repay.

9) ________ is the method of making investments more attractive to prospective buyers by reducing their perceived risk.
A) Subordination
B) Credit enhancement
C) Derivation
D) Deregulation

True/False

1) Mortgage loans in the U.S. are classified by risk into one of three types: prime, alt-A, and sub-prime.

2) Alt-A mortgage loans are NOT eligible for sale to GSEs such as Fannie Mae or Freddie Mac.

3) The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 explicitly allowed corporate combinations of commercial banks with other types of financial institutions such as insurance companies and investment banking firms.

4) Subprime mortgages did not exceed 8% of all outstanding mortgage obligations by 2007, but by the end of 2008 they were the source of 65% of bankruptcy filings by homeowners in the United States.

5) Even though household debt as a percentage of disposable income rose rapidly in the United States in early 2000s, the rate was even greater in Britain, topping out at over 170% in 2008.

6) From 1990 through 2007, the amount of securitized loans outstanding dropped from over $25 trillion to less than $5 trillion and was a key element in the loss of market liquidity.

7) It is pretty clear after reading this chapter that securitization in and of itself is a poor financial idea.

8) Securitization may degrade credit quality because the process severs the link of lending and repayment (risk and reward) between the originator of the loan and the borrower.

9) The authors make it clear that the main source of market failure with collateralized debt obligations lay almost exclusively with the rating agencies.

10) Credit Default Swaps are highly regulated financial instruments as a result of the Commodity Futures Modernization Act of 2000.

Essay/Short Answer

1) What is a Collateralized Debt Obligation (CDO)? In your answer explain how CDOs are generally separated into one of three tranches. What types of mistakes were made by security rating agencies that contributed to the collapse of the CDO market?

5.2 Global Contagion

Multiple Choice

1) Which of the following is NOT identified by the authors as a “safe-haven” currency?
A) the euro
B) the British pound
C) the U.S. dollar
D) the Japanese yen

2) The accounting procedure whereby assets are revalued to market value basis on a daily basis is known as:
A) FASB rule 62.
B) market value accounting.
C) marked-to-market.
D) none of the above

3) The typical TED spread, the difference between the LIBOR and the interest rate swap index, is typically about ________ basis points.
A) 350
B) 180
C) 120
D) 80

4) The three stages of the global credit crisis of 2009-2009 were:
A) 1. The failure of commercial and investment financial institutions, 2. the failure of specific mortgage-backed securities, 3. a credit-induced global recession.
B) 1. The failure of specific mortgage-backed securities, 2. the failure of commercial and investment financial institutions, and 3. a credit-induced global recession.
C) 1. The failure of commercial and investment financial institutions, 2. a credit-induced global recession, 3. the failure of specific mortgage-backed securities credit-induced global recession.
D) 1. The failure of specific mortgage-backed securities, 2. a credit-induced global recession, 3. failure of commercial and investment financial institutions.

5) The British Bankers Association (BBA) estimates that LIBOR was used in the pricing of more than ________ in assets globally.
A) $100 billion
B) $360 billion
C) $360 trillion
D) $100 trillion

6) Which of the following pieces of U.S. legislation was developed and passed in response to the 2008-2009 international credit crisis?
A) Gramm-Leach-Bliley Financial Services Modernization Act
B) Dodd-Frank Wall Street Reform and Consumer Protection Act
C) Depository Institutions Deregulation and Monetary Control Act
D) The Glass-Steagall Act

True/False

1) Bear-Stearns is the largest single bankruptcy in U.S. history.

2) The international credit crisis began in full force in September 2008.

3) Near the end of the U.S. housing boom, many of the mortgages classified as Alt-A were in fact sub-prime.

4) LIBOR stand for the London Interbank Offered Rate.

5) The credit crisis was worsened by the destabilizing effects of speculators, in a variety of different institutions, betting that particular instruments or markets or securities would fail.

Essay/Short Answer

1) What is TARP? Provide an argument for why TARP was necessary and successful.

5.3 The European Debt Crisis of 2009-2012

Multiple Choice

1) Portfolio theory relies on combining assets with ________ return correlation exclusively to reduce risk.
A) highly positive
B) low
C) zero
D) none of the above

2) Future financial market regulation must include all of the following EXCEPT:
A) renewed regulatory requirements.
B) increased reporting.
C) greater transparency in pricing and valuation.
D) Regulation must include all of the above.

3) In finance, a liquid asset:
A) sells quickly.
B) sells at or near its market value.
C) both A and B
D) none of the above

4) Debt issued by the national government is called:
A) debenture debt.
B) municipal debt.
C) sovereign debt.
D) none of the above

5) The member nations of the European Union have relative freedom to set their own fiscal policies EXCEPT for which of the following?
A) government spending
B) government taxation
C) government surpluses or deficits
D) government printing of the euro currency

6) When the EU moved to a single currency with the adoption of the euro, its member states agreed to each of the following EXCEPT:
A) a single currency.
B) control of their own money supply.
C) free movement of capital in and out of their economies.
D) In fact, the member states agreed to ALL of the above.

7) As of 2011, the European countries with the highest debt/GDP ratio were, in order:
A) Greece, Italy, Portugal, and Slovenia.
B) Greece, Italy, France, and Germany.
C) Greece, Italy, Ireland, and Portugal.
D) Greece, Italy, Great Britain, and Portugal.

8) In October 2009, the new government of Greece estimated the size of the 2009 government budget deficit as 12.7% of GDP rather than the previously published:
A) 3.4%.
B) 6.7%.
C) 8.6%.
D) 10.2%.

True/False

1) The authors conclude the chapter with a specific road map for future financial regulation.

2) Baring the (hopefully temporary setback of 2008) capital is more mobile today than ever before.

3) Securitization is likely to be declared illegal in the U.S. though it may still exist elsewhere in the world.

4) Every EU member nation has the right to simply print more euros.

5) The members of the EU’s eurozone (euro participants) do NOT have the ability to conduct independent monetary policy.

6) The European Financial Stability Facility (EFSF) has a mandate to safeguard financial stability in Europe by providing financial assistance to euro area Member States.

7) Ireland and Greece had the same issues lead to their financial crises in 2009. In each case, the previous government had dramatically understated the size of their federal budget deficit as a percentage of GDP.

Chapter 6 The Foreign Exchange Theory and Markets

6.1 Geographical Extent of the Foreign Exchange Market

Multiple Choice

1) Which of the following is NOT true regarding the market for foreign exchange?
A) The market provides the physical and institutional structure through which the money of one country is exchanged for another.
B) The rate of exchange is determined in the market.
C) Foreign exchange transactions are physically completed in the foreign exchange market.
D) All of the above are true.

2) A/An ________ is an agreement between a buyer and seller that a fixed amount of one currency will be delivered at a specified rate for some other currency.
A) Eurodollar transaction
B) import/export exchange
C) foreign exchange transaction
D) interbank market transaction

3) While trading in foreign exchange takes place worldwide, the major currency trading centers are located in:
A) London, New York, and Tokyo.
B) New York, Zurich, and Bahrain.
C) Paris, Frankfurt, and London.
D) Los Angeles, New York, and London.

True/False

1) Because the market for foreign exchange is worldwide, the volume of foreign exchange currency transactions is level throughout the 24-hour day.

2) Business firms in countries with exchange controls, for example, China (mainland), often must surrender foreign exchange earned from exports to the central bank at the daily fixing price.

Essay

1) Define spot, forward, and swap transactions in the foreign exchange market and give an example of how each could be used.

6.2 Functions of the Foreign Exchange Market

Multiple Choice

1) The ________ is the mechanism by which participants transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.
A) futures market
B) federal open market
C) foreign exchange market
D) LIBOR

2) Which of the following is NOT a motivation identified by the authors as a function of the foreign exchange market?
A) the transfer of purchasing power between countries
B) obtaining or providing credit for international trade transactions
C) minimizing the risks of exchange rate changes
D) All of the above were identified as functions of the foreign exchange market.

True/False

1) Foreign exchange markets are a relatively recent phenomenon, beginning with the agreement at Bretton Woods.

6.3 Market Participants

Multiple Choice

1) The authors identify two tiers of foreign exchange markets:
A) bank and nonbank foreign exchange.
B) commercial and investment transactions.
C) interbank and client markets.
D) client and retail market.

2) It is characteristic of foreign exchange dealers to:
A) bring buyers and sellers of currencies together but never to buy and hold an inventory of currency for resale.
B) act as market makers, willing to buy and sell the currencies in which they specialize.
C) trade only with clients in the retail market and never operate in the wholesale market for foreign exchange.
D) All of the above are characteristics of foreign exchange dealers.

3) Which of the following may be participants in the foreign exchange markets?
A) bank and nonbank foreign exchange dealers
B) central banks and treasuries
C) speculators and arbitrageurs
D) all of the above

4) ________ seek to profit from trading in the market itself rather than having the foreign exchange transaction being incidental to the execution of a commercial or investment transaction.
A) Speculators and arbitrageurs
B) Foreign exchange brokers
C) Central banks
D) Treasuries

5) In the foreign exchange market, ________ seek all of their profit from exchange rate changes while ________ seek to profit from simultaneous exchange rate differences in different markets.
A) wholesalers; retailers
B) central banks; treasuries
C) speculators; arbitrageurs
D) dealers; brokers

6) Foreign exchange ________ earn a profit by a bid-ask spread on currencies they purchase and sell. Foreign exchange ________, on the other hand, earn a profit by bringing together buyers and sellers of foreign currencies and earning a commission on each sale and purchase.
A) central banks; treasuries
B) dealers; brokers
C) brokers; dealers
D) speculators; arbitrageurs

7) ________ are agents who facilitate trading between dealers without themselves becoming principals in the transaction.
A) Central banks
B) Foreign exchange brokers
C) Arbitrageurs
D) Foreign exchange dealers

True/False

1) Dealers in foreign exchange departments at large international banks act as market makers and maintain inventories of the securities in which they specialize.

2) Currency trading lacks profitability for large commercial and investment banks but is maintained as a service for corporate and institutional customers.

3) The primary motive of foreign exchange activities by most central banks is profit.

4) Banks, and a few nonbank foreign exchange dealers, operate ONLY in the interbank markets.

5) Dealers in the foreign exchange departments of large international banks often function as “market makers.” Such dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

6) Currency trading is a service center rather than a profit center for commercial and investment banks.

7) For individuals and firms involved in the import and export of goods and services ,using the foreign exchange market is necessary, but incidental, to their underlying commercial or investment purpose.

Essay/Short Answer

1) What are some of the reasons central banks and treasuries enter the foreign exchange markets, and in what important ways are they different from other foreign exchange participants?

6.4 Transactions in the Foreign Exchange Market

Multiple Choice

1) ________ are NOT one of the three categories reported for foreign exchange.
A) Spot transactions
B) Swap transactions
C) Strip transactions
D) Futures transactions

2) The greatest amount of foreign exchange trading takes place in the following three cities:
A) New York, London, and Tokyo.
B) New York, Singapore, and Zurich.
C) London, Frankfurt, and Paris.
D) London, Tokyo, and Zurich.

3) The four currencies that constitute about 80% of all foreign exchange trading are:
A) U.K pound, Chinese yuan, euro, and Japanese yen.
B) U.S. dollar, euro, Chinese yuan, and U.K. pound.
C) U.S. dollar, Japanese yen, euro, and U.K. pound.
D) U.S. dollar, U.K. pound, yen, and Chinese yuan.

4) A ________ transaction in the foreign exchange market requires an almost immediate delivery (typically within two days) of foreign exchange.
A) spot
B) forward
C) futures
D) none of the above

5) A ________ transaction in the foreign exchange market requires delivery of foreign exchange at some future date.
A) spot
B) forward
C) swap
D) currency

6) A forward contract to deliver British pounds for U.S. dollars could be described either as ________ or ________.
A) buying dollars forward; buying pounds forward
B) selling pounds forward; selling dollars forward
C) selling pounds forward; buying dollars forward
D) selling dollars forward; buying pounds forward

7) A common type of swap transaction in the foreign exchange market is the ________ where the dealer buys the currency in the spot market and sells the same amount back to the same bank in the forward market.
A) “forward against spot”
B) “forspot”
C) “repurchase agreement”
D) “spot against forward”

8) The ________ is a derivative forward contract that was created in the 1990s. It has the same characteristics and documentation requirements as traditional forward contracts except that they are only settled in U.S. dollars and the foreign currency involved in the transaction is not delivered.
A) nondeliverable forward
B) dollar only forward
C) virtual forward
D) internet forward

9) Which of the following is NOT true regarding nondeliverable forward (NDF) contracts?
A) NDFs are used primarily for emerging market currencies.
B) Pricing of NDFs reflects basic interest rate differentials plus an additional premium charged for dollar settlement.
C) NDFs can only be traded by central banks.
D) All of the above are true.

10) A ________ transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
A) spot
B) forward-forward
C) swap
D) futures

True/False

1) A spot transaction in the interbank market for foreign exchange would typically involve a two-day delay in the actual delivery of the currencies, while such a transaction between a bank and its commercial customer would not necessarily involve a two-day wait.

2) Swap and forward transactions account for an insignificant portion of the foreign exchange market.

3) Nondeliverable Forwards were originally envisioned as a method of currency speculation, but it is now estimated that 70% of NDFs are trading for hedging purposes.

4) In general, NDF markets normally develop for country currencies having large cross-border capital movements, but still subject to convertibility restrictions.

5) NDFs are traded and settled inside the country of the subject currency, and therefore are within the control of the country’s government.

6) A contract to deliver dollars for euros in six months is both “buying euros forward for dollars” and “selling dollars forward for euros.”

6.5 Size of the Foreign Exchange Market

Multiple Choice

1) Daily trading volume in the foreign exchange market was about ________ per ________ in 2010.
A) $3,200 billion; month
B) $1,000 billion; month
C) $3,200 billion; day
D) $1,000 billion; day

2) The greatest volume of daily foreign exchange transactions are:
A) spot transactions.
B) forward transactions.
C) swap transactions.
D) This question is inappropriate because the volume of transactions are approximately equal across the three categories above.

3) The United Kingdom and United States together make up nearly ________ of daily currency trading.
A) 25%
B) 35%
C) 45%
D) 55%

4) The top three currency pairs traded with the U.S. dollar are:
A) U.K. pound, Chinese Yuan, Japanese yen.
B) Swiss franc, euro, Japanese yen.
C) U.K. pound, euro, Japanese yen.
D) euro, Chinese Yuan, Japanese yen.

True/False

1) As you might expect, the foreign exchange daily trading volume in in New York City is roughly twice as large as the daily trading volume in London.

2) The low level of interest rates around the globe in recent years, combined with slowing economic growth and new debt issuances, has had a dampening impact on the swap market.

3) Since the global financial crisis of 2008-2009, the Chinese renminbi (yuan) has become the most widely traded currency with the U.S. dollar surpassing the euro, yen, and pound as dollar trading pairs.

6.6 Foreign Exchange Rates and Quotations

Multiple Choice

1) A foreign exchange ________ is the price of one currency expressed in terms of another currency. A foreign exchange ________ is a willingness to buy or sell at the announced rate.
A) quote; rate
B) quote; quote
C) rate; quote
D) rate; rate

2) Most foreign exchange transactions are through the U.S. dollar. If the transaction is expressed as the foreign currency per dollar this known as ________ whereas ________ are expressed as dollars per foreign unit.
A) European terms; indirect
B) American terms; direct
C) American terms; European terms
D) European terms; American terms

3) The following is an example of an American term foreign exchange quote:
A) $20/£
B) €0.85/$
C) ¥100/€
D) none of the above

4) American and British meanings differ for the word billion. Therefore, when traders refer to an American billion, they call it a/an:
A) Kiwi.
B) Loony.
C) Uncle Sam.
D) Yard.

5) From the viewpoint of a British investor, which of the following would be a direct quote in the foreign exchange market?
A) SF2.40/£
B) $1.50/£
C) £0.55/€
D) $0.90/€

6) A/an ________ quote in the United States would be foreign units per dollar, while a/an ________ quote would be in dollars per foreign currency unit.
A) direct; direct
B) direct; indirect
C) indirect; indirect
D) indirect; direct

7) If the direct quote for a U.S. investor for British pounds is $1.43/£, then the indirect quote for the U.S. investor would be ________ and the direct quote for the British investor would be ________.
A) £0.699/$; £0.699/$
B) $0.699/£; £0.699/$
C) £1.43/£; £0.699/$
D) £0.699/$; $1.43/£

8) ________ make money on currency exchanges by the difference between the ________ price, or the price they offer to pay, and the ________ price, or the price at which they offer to sell the currency.
A) Dealers; ask; bid
B) Dealers; bid; ask
C) Brokers; ask; bid
D) Brokers; bid; ask

TABLE 6.1
Use the table to answer following question(s).

9) Refer to Table 6.1. The current spot rate of dollars per pound as quoted in a newspaper is ________ or ________.
A) £1.4484/$; $0.6904/£
B) $1.4481/£; £0.6906/$
C) $1.4484/£; £0.6904/$
D) £1.4487/$; $0.6903/£

10) Refer to Table 6.1. The one-month forward bid price for dollars as denominated in Japanese yen is:
A) -¥20.
B) -¥18.
C) ¥129.74/$.
D) ¥129.62/$.

11) Refer to Table 6.1. The ask price for the two-year swap for a British pound is:
A) $1.4250/£.
B) $1.4257/£.
C) -$230.
D) -$238.

12) Refer to Table 6.1. According to the information provided in the table, the 6-month yen is selling at a forward ________ of approximately ________ per annum. (Use the mid rates to make your calculations.)
A) discount; 2.09%
B) discount; 2.06%
C) premium; 2.09%
D) premium; 2.06%

13) Given the following exchange rates, which of the multiple-choice choices represents a potentially profitable intermarket arbitrage opportunity?
¥129.87/$
€1.1226/$
€0.00864/¥
A) ¥115.69/€
B) ¥114.96/€
C) $0.8908/€
D) $0.0077/¥

14) The U.S. dollar suddenly changes in value against the euro moving from an exchange rate of $0.8909/euro to $0.08709/€. Thus, the dollar has ________ by ________.
A) appreciated; 2.30%
B) depreciated; 2.30%
C) appreciated; 2.24%
D) depreciated; 2.24%

15) A German firm is attempting to determine the euro/pound exchange rate and has the following exchange rate information: USD/pound = $1.5509/£ and the USD/euro rate = $1.2194/€. Therefore, the euro/pound rate must be:
A) £1.2719/€.
B) €1.2719/£.
C) €0.7316/£.
D) €0.7863/£.

True/False

1) The European and American terms for foreign currency exchange are square roots of one another.

2) When the cross rate for currencies offered by two banks differs from the exchange rate offered by a third bank, a triangular arbitrage opportunity exists.

3) Most transactions in the interbank foreign exchange trading are primarily conducted via telecommunication techniques and little is conducted face-to-face.

4) A confusing “quirk” of international exchange rates occurs when calculating the percentage change in spot rates from one period to another. The percent change in the spot rate from one period to another when quoted using foreign currency terms is always greater than the percent changes quoted when using home currency terms.

Chapter 7 International Parity Conditions

7.1 Prices and Exchange Rates

Multiple Choice

1) If an identical product can be sold in two different markets, and no restrictions exist on the sale or transportation costs, the product’s price should be the same in both markets. This is known as:
A) relative purchasing power parity.
B) interest rate parity.
C) the law of one price.
D) equilibrium.

2) The Economist publishes annually the “Big Mac Index” by which they compare the prices of the McDonald’s Corporation’s Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. If a Big Mac costs $2.54 in the United States and 294 yen in Japan, what is the estimated exchange rate of yen per dollar as hypothesized by the Hamburger index?
A) $0.0086/¥
B) ¥124/$
C) $0.0081/¥
D) ¥115.75/$

3) If the current exchange rate is 113 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $3.41, and the price of a Big Mac hamburger in Japan is 280 yen, then other things equal, the Big Mac hamburger in Japan is:
A) correctly priced.
B) under priced.
C) over priced.
D) There is not enough information to determine if the price is appropriate or not.

4) The price of a Big Mac in the U.S. is $3.41 and the price in Mexico is Peso 29.0. What is the implied PPP of the Peso per dollar?
A) Peso 8.50/$1
B) Peso 10.8/$1
C) Peso 11.76/$1
D) None of the above

5) Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:
A) overvalued.
B) undervalued.
C) correctly valued.
D) There is not enough information to answer this question.

6) According to the Big Mac Index, the implied PPP exchange rate is Mexican peso 8.50/$1 but the actual exchange rate is peso10.80/$1. Thus, at current exchange rates the peso appears to be ________ by ________.
A) overvalued; approximately 21%
B) overvalued; approximately 27%
C) undervalued; approximately 21%
D) undervalued; approximately 27%

7) Other things equal, and assuming efficient markets, if a Honda Accord costs $24,682 in the U.S., then at an exchange rate of $1.57/£, the Honda Accord should cost ________ in Great Britain.
A) £24,682
B) £38,751
C) £10,795
D) £15,721

8) One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1. Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately:
A) $0.96/C$
B) $1/C$
C) $1.04/C$
D) Relative PPP provides no guide for this type of question.

9) ________ states that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate.
A) The Fisher Effect
B) The International Fisher Effect
C) Absolute Purchasing Power Parity
D) Relative Purchasing Power Parity

10) Two general conclusions can be made from the empirical tests of purchasing power parity (PPP):
A) PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively low rates of inflation.
B) PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively high rates of inflation.
C) PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively low rates of inflation.
D) PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively high rates of inflation.

11) A country’s currency that strengthened relative to another country’s currency by more than that justified by the differential in inflation is said to be ________ in terms of PPP.
A) overvalued
B) over compensating
C) undervalued
D) under compensating

12) If we set the real effective exchange rate index between Canada and the United States equal to 100 in 1998, and find that the U.S. dollar has risen to a value of 112.6, then from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) very competitive.
D) There is not enough information to answer this question.

13) If we set the real effective exchange rate index between the United Kingdom and the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value of 91.4, then from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) equally valued.
D) There is not enough information to answer this question.

14) The government just released international exchange rate statistics and reported that the real effective exchange rate index for the U.S. dollar vs the Japanese yen decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal U.S. ________ to/from Japan think this is good news and U.S. ________ to/from Japan think this is bad news.
A) importers; exporters
B) importers; importers
C) exporters; exporters
D) exporters; importers

True/False

1) If a market basket of goods cost $100 is the US and €70 in France, then the PPP exchange rate would be $.70/€.

2) The assumptions for relative PPP are more rigid than the assumptions for absolute PPP.

3) Empirical tests prove that PPP is an accurate predictor of future exchange rates.

4) Consider the price elasticity of demand. If a product has price elasticity less than one it is considered to have relatively elastic demand.

Essay

1) The authors state that empirical tests of purchasing power parity “have, for the most part, not proved PPP to be accurate in predicting future exchange rates.” The authors then state that PPP does hold up reasonably well in two situations. What are some reasons why PPP does not accurately predict future exchange rates, and under what conditions might we reasonably expect PPP to hold?

7.2 Exchange Rate Pass-Through

Multiple Choice

1) ________ states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.
A) Absolute PPP
B) Relative PPP
C) The Law of One Price
D) The Fisher Effect

2) In its approximate form the Fisher effect may be written as ________. Where: i = the nominal rate of interest, r = the real rate of return and π = the expected rate of inflation.
A) i = (r)(π)
B) i = r + π + (r)(π)
C) i = r + π
D) i = r + 2π

3) Assume a nominal interest rate on one-year U.S. Treasury Bills of 2.60% and a real rate of interest of 1.00%. Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the U.S. over the next year?
A) 2.10%
B) 2.05%
C) 1.60%
D) 1.00%

4) Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.80% and a real rate of interest of 2.00%. Using the Fisher Effect Equation, what is the exact expected rate of inflation in the U.S. over the next year?
A) 1.84%
B) 1.80%
C) 1.76%
D) 1.72%

5) The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as:
A) absolute PPP.
B) the law of one price.
C) relative PPP.
D) the international Fisher Effect.

6) According to the international Fisher Effect, if an investor purchases a five-year U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the ________ to ________ at a rate of at least 1% per year over the next 5 years.
A) British pound; appreciate
B) British pound; revalue
C) U.S. dollar; appreciate
D) U.S. dollar; depreciate

7) ________ states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.
A) Fisher-open
B) Fisher-closed
C) The Fisher Effect
D) none of the above

8) Exchange rate pass-through may be defined as:
A) the bid/ask spread on currency exchange rate transactions.
B) the degree to which the prices of imported and exported goods change as a result of exchange rate changes.
C) the PPP of lesser-developed countries.
D) the practice by Great Britain of maintaining the relative strength of the currencies of the Commonwealth countries under the current floating exchange rate regime.

9) Phillips NV produces DVD players and exports them to the United States. Last year the exchange rate was $1.25/euro and Plillips charged 120 euro per player in Euroland and $150 per DVD player in the United States. Currently the spot exchange rate is $1.45/euro and Phillips is charging $160 per DVD player. What is the degree of pass through by Phillips NV on their DVD players?
A) 92%
B) 33.3%
C) 41.7%
D) 4.1%

10) Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the US for $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the US price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, and Jaguar has not hedged against currency changes, what is the amount the company will receive in pounds at the new exchange rate?
A) £22,803
B) £25,581
C) £27,363
D) £55,000

11) Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the US for $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the US price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, and Jaguar has not hedged against currency changes, what is the percentage margin the company will realize given the new exchange rate?
A) 20.0%
B) 15.3%
C) 12.4%
D) 7.2%

12) The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one. If the Japanese yen appreciates against the U.S. dollar by 10% and the price of the Sony DVD players in the U.S also rises by 10%, then other things equal, the total dollar sales revenues of Sony DVDs would:
A) decline.
B) increase.
C) stay the same.
D) insufficient information

True/False

1) The final component of the equation for the Fisher Effect, (r)(π), where r = the real rate of return and π = the expected rate of inflation, is often dropped from the equation because the number is simply too large for most Western economies.

2) Empirical studies show that the Fisher Effect works best for short-term securities.

3) The current U.S. dollar-yen spot rate is ¥125/$. If the 90-day forward exchange rate is ¥127/$ then the yen is at a forward premium.

4) The premium or discount on forward currency exchange rates between any two countries is visually obvious when you plot the interest rates of each country on the same yield curve. The currency of the country with the higher yield curve should be selling at a forward discount.

5) Use interest rate parity to answer this question. A U.S. investor has a choice between a risk-free one-year U.S. security with an annual return of 4%, and a comparable British security with a return of 5%. If the spot rate is $1.43/£, the forward rate is $1.44/£, and there are no transaction costs, the investor should invest in the U.S. security.

6) Both covered and uncovered interest arbitrage are risky operations in the sense that even without default in the securities, the returns are unknown until all transactions are complete.

7) All that is required for a covered interest arbitrage profit is for interest rate parity to not hold.

Essay/Short Answer

1) The authors describe an application of uncovered interest arbitrage (UIA) known as “yen carry trade.” Define UIA and describe the example of yen carry trade. Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?

2) The Fisher Effect is a familiar economic theory in the domestic market. In words, define the Fisher Effect and explain why you think it is also appropriately applied to international markets.

7.3 The Forward Rate

Multiple Choice

1) If the forward rate is an unbiased predictor of the expected spot rate, which of the following is NOT true?
A) The expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now.
B) The distribution of possible actual spot rates in the future is centered on the forward rate.
C) The future spot rate will actually be equal to what the forward rate predicts.
D) All of the above are true.

2) Which of the following is NOT an assumption of market efficiency?
A) Instruments denominated in other currencies are perfect substitutes for one another.
B) Transaction costs are low or nonexistent.
C) All relevant information is quickly reflected in both spot and forward exchange markets.
D) All of the above are true.

3) Empirical tests have yielded ________ evidence about market efficiency with a general consensus that developing foreign markets are ________.
A) conflicting; not efficient
B) conflicting; efficient
C) consistent; inefficient
D) none of the above

4) A ________ is an exchange rate quoted today for settlement at some time in the future.
A) spot rate
B) forward rate
C) currency rate
D) yield curve

5) Assume the current U.S. dollar-British spot rate is 0.6993£/$. If the current nominal one-year interest rate in the U.S. is 5% and the comparable rate in Britain is 6%, what is the approximate forward exchange rate for 360 days?
A) £1.42/$
B) £1.43/$
C) £0.6993/$
D) £0.7060/$

6) Assume the current U.S. dollar-yen spot rate is 90 ¥/$. Further, the current nominal 180-day rate of return in Japan is 1% and 2% in the United States. What is the approximate forward exchange rate for 180 days?
A) ¥89.12/$
B) ¥89.55/$
C) ¥90.89/$
D) ¥90.45/$

7) The current U.S. dollar-yen spot rate is 125¥/$. If the 90-day forward exchange rate is 127 ¥/$ then the yen is selling at a per annum ________ of ________.
A) premium; 1.57%
B) premium; 6.30%
C) discount; 1.57%
D) discount; 6.30%

8) The theory of ________ states that the difference in the national interest rates for securities of similar risk and maturity should be equal to but opposite in sign to the forward rate discount or premium for the foreign currency, except for transaction costs.
A) international Fisher Effect
B) absolute PPP
C) interest rate parity
D) the law of one price

9) With covered interest arbitrage:
A) the market must be out of equilibrium.
B) a “riskless” arbitrage opportunity exists.
C) the arbitrageur trades in both the spot and future currency exchange markets.
D) all of the above

10) Covered interest arbitrage moves the market ________ equilibrium because ________.
A) toward; purchasing a currency on the spot market and selling in the forward market narrows the differential between the two
B) toward; investors are now more willing to invest in risky securities
C) away from; purchasing a currency on the spot market and selling in the forward market increases the differential between the two
D) away from; demand for the stronger currency forces up interest rates on the weaker security

True/False

1) If exchange markets were not efficient, it would pay for a firm to spend resources on forecasting exchange rates.

2) If the forward exchange rate is an unbiased predictor of future spot rates, then future spot rates will always be equal to current forward rates.

3) COVERED interest arbitrage (CIA), is where investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “covered,” because the investor does not sell the higher yielding currency proceeds forward.

7.4 Prices, Interest Rates, and Exchange Rates in Equilibrium

Multiple Choice

1) According to the International Fisher Effect, the forecast change in the spot rate between two countries is equal to:
A) the current spot rate multiplied by the ratio of the inflation rates in the respective countries.
B) but the opposite sign to the difference between nominal interest rates.
C) but the opposite sign to the difference between inflation rates.
D) but the opposite sign to the difference between real interest rates.

True/False

1) In their approximate form, PPP, IRP, and forward rates as an unbiased predictor of the future spot rate lead to similar forecasts of the future spot rate.

Chapter 8 Foreign Currency Derivatives and Swaps

8.1 Foreign Currency Futures

Multiple Choice

1) Financial derivatives are powerful tools that can be used by management for purposes of:
A) speculation.
B) hedging.
C) human resource management.
D) A and B above

2) A foreign currency ________ contract calls for the future delivery of a standard amount of foreign exchange at a fixed time, place, and price.
A) futures
B) forward
C) option
D) swap

3) Which of the following is NOT a contract specification for currency futures trading on an organized exchange?
A) size of the contract
B) maturity date
C) last trading day
D) All of the above are specified.

4) About ________ of all futures contracts are settled by physical delivery of foreign exchange between buyer and seller.
A) 0%
B) 5%
C) 50%
D) 95%

5) Futures contracts require that the purchaser deposit an initial sum as collateral. This deposit is called a:
A) collateralized deposit.
B) marked market sum.
C) margin.
D) settlement.

6) A speculator in the futures market wishing to lock in a price at which they could ________ a foreign currency will ________ a futures contract.
A) buy; sell
B) sell; buy
C) buy; buy
D) none of the above

7) A speculator that has ________ a futures contract has taken a ________ position.
A) sold; long
B) purchased; short
C) sold; short
D) purchased; sold

8) Peter Simpson thinks that the U.K. pound will cost $1.43/£ in six months. A 6-month currency futures contract is available today at a rate of $1.44/£. If Peter was to speculate in the currency futures market, and his expectations are correct, which of the following strategies would earn him a profit?
A) Sell a pound currency futures contract.
B) Buy a pound currency futures contract.
C) Sell pounds today.
D) Sell pounds in six months.

9) Jack Hemmings bought a 3-month British pound futures contract for $1.4400/£ only to see the dollar appreciate to a value of $1.4250 at which time he sold the pound futures. If each pound futures contract is for an amount of £62,500, how much money did Jack gain or lose from his speculation with pound futures?
A) $937.50 loss
B) $937.50 gain
C) £937.50 loss
D) £937.50 gain

10) Which of the following statements regarding currency futures contracts and forward contracts is NOT true?
A) A futures contract is a standardized amount per currency whereas the forward contact is for any size desired.
B) A futures contract is for a fixed maturity whereas the forward contract is for any maturity you like up to one year.
C) Futures contracts trade on organized exchanges whereas forwards take place between individuals and banks with other banks via telecom linkages.
D) All of the above are true.

11) Which of the following is NOT a difference between a currency futures contract and a forward contract?
A) The futures contract is marked to market daily, whereas the forward contract is only due to be settled at maturity.
B) The counterparty to the futures participant is unknown with the clearinghouse stepping into each transaction, whereas the forward contract participants are in direct contact setting the forward specifications.
C) A single sales commission covers both the purchase and sale of a futures contract, whereas there is no specific sales commission with a forward contract because banks earn a profit through the bid-ask spread.
D) All of the above are true.

12) A foreign currency ________ gives the purchaser the right, not the obligation, to buy a given amount of foreign exchange at a fixed price per unit for a specified period.
A) future
B) forward
C) option
D) swap

13) A foreign currency ________ option gives the holder the right to ________ a foreign currency, whereas a foreign currency ________ option gives the holder the right to ________ an option.
A) call, buy, put, sell
B) call, sell, put, buy
C) put, hold, call, release
D) none of the above

14) The price at which an option can be exercised is called the:
A) premium.
B) spot rate.
C) strike price.
D) commission.

15) An ________ option can be exercised only on its expiration date, whereas a/an ________ option can be exercised anytime between the date of writing up to and including the exercise date.
A) American; European
B) American; British
C) Asian; American
D) European; American

16) An ________ option can be exercised only on its expiration date, whereas a/an ________ option can be exercised anytime between the date of writing up to and including the exercise date.
A) American; European
B) American; British
C) Asian; American
D) European; American

17) A call option whose exercise price exceeds the spot price is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) over-the-spot.

18) A call option whose exercise price is less than the spot price is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) under-the-spot.

19) An option whose exercise price is equal to the spot rate is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) on-the-spot.

20) The main advantage(s) of over-the-counter foreign currency options over exchange traded options is (are):
A) expiration dates tailored to the needs of the client.
B) amounts that are tailor made.
C) client desired expiration dates.
D) all of the above

21) As a general statement, it is safe to say that businesses generally use the ________ for foreign currency option contracts, and individuals and financial institutions typically use the ________.
A) exchange markets; over-the-counter
B) over-the-counter; exchange markets
C) private; government sponsored
D) government sponsored; private

TABLE 8.1
Use the table to answer following question(s).

April 19, 2009, British Pound Option Prices (cents per pound, 62,500 pound contracts).

22) Refer to Table 8.1. What was the closing price of the British pound on April 18, 2009?
A) $1.448/£
B) £1.448/$
C) $14.48/£
D) none of the above

23) Refer to Table 8.1. The exercise price of ________ giving the purchaser the right to sell pounds in June has a cost per pound of ________ for a total price of ________.
A) 1460; 0.68 cents; $425.00
B) 1440; 1.06 cents; $662.50
C) 1450; 1.02 cents; $637.50
D) 1440; 1.42 cents; $887.50

24) Refer to Table 8.1. The May call option on pounds with a strike price of 1440 mean:
A) $88/£ per contract.
B) $0.88/£.
C) $0.0088/£.
D) none of the above

25) Dash Brevenshure works for the currency trading unit of ING Bank in London. He speculates that in the coming months the dollar will rise sharply vs. the pound. What should Dash do to act on his speculation?
A) Buy a call on the pound.
B) Sell a call on the pound.
C) Buy a put on the pound.
D) Sell a put on the pound.

26) A put option on yen is written with a strike price of ¥105.00/$. Which spot price maximizes your profit if you choose to exercise the option before maturity?
A) ¥100/$
B) ¥105/$
C) ¥110/$
D) ¥115/$

27) A call option on euros is written with a strike price of $1.30/euro. Which spot price maximizes your profit if you choose to exercise the option before maturity?
A) $1.20/euro
B) $1.25/euro
C) $1.30/euro
D) $1.35/euro

28) A call option on UK pounds has a strike price of $2.05/£ and a cost of $0.02. What is the break-even price for the option?
A) $2.03/£
B) $2.07/£
C) $2.05/£
D) The answer depends upon if this is a long or a short call option.

29) Your U.S firm has an accounts payable denominated in UK pounds due in 6 months. To protect yourself against unexpected changes in the dollar/pound exchange rate you should:
A) buy a pound put option.
B) sell a pound put option.
C) buy a pound call option.
D) sell a pound call option.

30) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/$ and the 6-month forward rate is ¥128.53/$. Jasper thinks the yen will move to ¥128.00/$ in the next six months. Jasper should ________ at ________ to profit from changing currency values.
A) buy yen; the forward rate
B) buy dollars; the forward rate
C) sell yen; the forward rate
D) There is not enough information to answer this question.

31) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/$ and the 6-month forward rate is ¥128.53/$. Jasper thinks the yen will move to ¥128.00/$ in the next six months. If Jasper buys $100,000 worth of yen at today’s spot price and sells within the next six months at ¥128/$, he will earn a profit of:
A) $146.09
B) $101,460.94
C) $1460.94
D) nothing; he will lose money

32) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/$ and the 6-month forward rate is ¥128.53/$. Jasper thinks the yen will move to ¥128.00/$ in the next six months. If Jasper buys $100,000 worth of yen at today’s spot price her potential gain is ________ and her potential loss is ________.
A) $100,000; unlimited
B) unlimited; unlimited
C) $100,000; $100,000
D) unlimited; $100,000

33) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/$ and the 6-month forward rate is ¥128.53/$. Jasper thinks the yen will move to ¥128.00/$ in the next six months. If Jasper’s expectations are correct, then he could profit in the forward market by ________ and then ________.
A) buying yen for ¥128.00/$; selling yen at ¥128.53/$
B) buying yen for ¥128.53/$; selling yen at ¥128.00/$
C) There is not enough information to answer this question
D) He could not profit in the forward market.

34) The maximum gain for the purchaser of a call option contract is ________ while the maximum loss is ________.
A) unlimited; the premium paid.
B) the premium paid; unlimited.
C) unlimited; unlimited.
D) unlimited; the value of the underlying asset.

35) The buyer of a long call option:
A) has a maximum loss equal to the premium paid.
B) has a gain equal to but opposite in sign to the writer of the option.
C) has an unlimited maximum gain potential.
D) all of the above

36) Which of the following is NOT true for the writer of a call option?
A) The maximum loss is unlimited.
B) The maximum gain is unlimited.
C) The gain or loss is equal to but of the opposite sign of the buyer of a call option.
D) All of the above are true.

37) Which of the following is NOT true for the writer of a put option?
A) The maximum loss is limited to the strike price of the underlying asset less the premium.
B) The gain or loss is equal to but of the opposite sign of the buyer of a put option.
C) The maximum gain is the amount of the premium.
D) All of the above are true.

38) The buyer of a long put option:
A) has a maximum loss equal to the premium paid.
B) has a gain equal to but opposite in sign to the writer of the option.
C) has maximum gain potential limited to the difference between the strike price and the premium paid.
D) all of the above

39) The value of a European style call option is the sum of two components:
A) the present value plus the intrinsic value.
B) the time value plus the present value.
C) the intrinsic value plus the time value.
D) the intrinsic value plus the standard deviation.

True/False

1) Currency futures contracts have become standard fare and trade readily in the world money centers.

2) The major difference between currency futures and forward contracts is that futures contracts are standardized for ease of trading on an exchange market whereas forward contracts are specialized and tailored to meet the needs of clients.

3) The writer of the option is referred to as the seller, and the buyer of the option is referred to as the holder.

4) Foreign currency options are available both over-the-counter and on organized exchanges.

5) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/$ and the 6-month forward rate is ¥128.53/$. Jasper would earn a higher rate of return by buying yen and a forward contract than if he had invested her money in 6-month US Treasury securities at an annual rate of 2.50%.

6) Most option profits and losses are realized through taking actual delivery of the currency rather than offsetting contracts.

Essay

1) Why are foreign currency futures contracts more popular with individuals and banks while foreign currency forwards are more popular with businesses?

2) Compare and contrast foreign currency options and futures. Identify situations when you may prefer one vs. the other when speculating on foreign exchange.

8.2 Option Pricing and Valuation

Multiple Choice

1) Which of the following is NOT a factor in determining the premium price of a currency option?
A) the present spot rate
B) the time to maturity
C) the standard deviation of the daily spot price movement
D) All of the above are factors in determining the premium price.

2) The ________ of an option is the value if the option were to be exercised immediately. It is the option’s ________ value.
A) intrinsic value; maximum
B) intrinsic value; minimum
C) time value; maximum
D) time value; minimum

3) Assume that a call option has an exercise price of $1.50/£. At a spot price of $1.45/£, the call option has:
A) a time value of $0.04.
B) a time value of $0.00.
C) an intrinsic value of $0.00.
D) an intrinsic value of -$0.04.

4) The single largest interest rate risk of a firm is:
A) interest sensitive securities.
B) debt service.
C) dividend payments.
D) accounts payable.

5) ________ is the possibility that the borrower’s creditworthiness is reclassified by the lender at the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a financial contract rate is set.
A) Credit risk; Interest rate risk
B) Repricing risk; Credit risk
C) Interest rate risk; Credit risk
D) Credit risk; Repricing risk

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.

• Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.

6) Refer to Instruction 8.1. Choosing strategy #1 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

7) Refer to Instruction 8.1. Choosing strategy #2 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

8) Refer to Instruction 8.1. Choosing strategy #3 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

9) Refer to Instruction 8.1. Which strategy (strategies) will eliminate credit risk?
A) Strategy #1
B) Strategy #2
C) Strategy #3
D) Strategies #1 and #2

10) Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm’s credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)
A) Strategy #3
B) Strategy #2
C) Strategy #1
D) Strategy #1, #2, or #3; you are indifferent among the choices.

11) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #2 is: (Assume your firm is borrowing money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

12) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #3 is: (Assume your firm is borrowing money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

13) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #1? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

14) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #2? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

15) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

True/False

1) The time value is asymmetric in value as you move away from the strike price (i.e., the time value at two cents above the strike price is not necessarily the same as the time value two cents below the strike price).

8.3 Interest Rate Derivatives

Multiple Choice

1) An interbank-traded contract to buy or sell interest rate payments on a notional principal is called a/an:
A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

2) A/an ________ is a contract to lock in today interest rates over a given period of time.
A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

3) An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as a/an:
A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

4) The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect the firm against an unfavorable increase in interest rates she could:
A) sell an interest rate futures contract of a similar maturity to the loan.
B) buy an interest rate futures contract of a similar maturity to the loan.
C) swap the adjustable rate loan for another of a different maturity.
D) none of the above

5) An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an:
A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

6) An agreement to swap the currencies of a debt service obligation would be termed a/an:
A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

7) Which of the following would be considered an example of a currency swap?
A) exchanging a dollar interest obligation for a British pound obligation
B) exchanging a eurodollar interest obligation for a dollar obligation
C) exchanging a eurodollar interest obligation for a British pound obligation
D) All of the above are examples of a currency swap.

8) A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to:
A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

9) A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to:
A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

10) The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:
A) do nothing.
B) pay floating and receive fixed.
C) receive floating and pay fixed.
D) none of the above

11) The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called:
A) interest rate risk.
B) credit risk.
C) counterparty risk.
D) clearinghouse risk.

12) Which of the following is an unlikely reason for firms to participate in the swap market?
A) To replace cash flows scheduled in an undesired currency with cash flows in a desired currency.
B) Firms may raise capital in one currency but desire to repay it in another currency.
C) Firms desire to swap fixed and variable payment or receipt of funds.
D) All of the above are likely reasons for a firm to enter the swap market.

True/False

1) Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

2) Unlike the situation with exchange rate risk, there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk. Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.

3) Interest rate futures are relatively unpopular among financial managers because of their relative illiquidity and their difficulty of use.

4) A basis point is one-tenth of one percent.

5) A swap agreement may involve currencies or interest rates, but never both.

6) Some of the world’s largest and most financially sound firms may borrow at variable rates less than LIBOR.

7) Counterparty risk is greater for exchange-traded derivatives than for over-the-counter derivatives.

8) Swap rates are derived from the yield curves in each major currency.

Essay

1) Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

2) How does counterparty risk influence a firm’s decision to trade exchange-traded derivatives rather than over-the-counter derivatives?
Answer: With exchange-traded derivatives, the exchange is the clearinghouse. Thus, firms do not need to worry about the other party making good on its obligations and it is easier to trade the derivative products.

Chapter 9 Foreign Exchange Rate Determination and Forecasting

9.1 Exchange Rate Determination: The Theoretical Thread

Multiple Choice

1) An important thing to remember about foreign exchange rate determination is that parity conditions, asset approach, and balance of payments approaches are ________ theories rather than ________ theories.
A) competing; complementary
B) competing; contemporary
C) complementary; contiguous
D) complementary; competing

2) Which of the following did NOT contribute to the exchange rate collapse in emerging markets in the 1990s?
A) infrastructure weaknesses
B) speculation on the part of market participants
C) the sharp reduction of cross-border foreign direct investment
D) All of the above contributed to the emerging markets exchange rate collapse of the 1990s.

3) The ________ provides a means to account for international cash flows in a standardized and systematic manner.
A) parity conditions
B) asset approach
C) balance of payments
D) International Fisher Effect

4) The ________ approach argues that equilibrium exchange rates are achieved when the net inflow of foreign exchange arising from current account activities is equal to the net outflow of foreign exchange arising from financial account activities.
A) balance of payments
B) monetary
C) asset market
D) law of one price

5) The ________ approach states that the exchange rate is determined by the supply and demand for national currency stocks, as well as the expected future levels and rates of growth of monetary stock.
A) balance of payments
B) monetary
C) asset market
D) law of one price

6) The ________ approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets
A) balance of payments
B) monetary
C) asset market
D) law of one price

7) The ________ approach to the determination of spot exchange rates hypothesizes that the most important factors are the relative real interest rate and a country’s outlook for economic growth and profitability.
A) balance of payments
B) parity conditions
C) managed float
D) asset market

8) The asset market approach to forecasting assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations. These include all but which of the following choices?
A) relative real interest rates
B) capital market liquidity
C) political safety
D) All of the above are considered by investors in their decision process.

9) ________ is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics.
A) Speculation
B) Contagion
C) Capital market liquidity
D) Political science

10) Critics of the balance of payments approach to exchange rate determination point to the emphasis on ________ of currency and capital rather than ________ of money or financial assets.
A) flows; stocks
B) stocks; flows
C) import; export
D) export; import

11) Which of the following versions of PPP is thought to be the most relevant to possibly explaining what drives exchange rate values?
A) The Law of One Price
B) Absolute Purchasing Power Parity
C) Relative Purchasing Power Parity
D) The International Fisher Effect

True/False

1) It is safe to say that most determinants of the spot exchange rate are also affected by changes in the spot rate. i.e., they are linked AND mutually determined.

2) The balance of payments approach of exchange rate theory is largely dismissed by the academic community today, while the practitioner public still rely on different variations of the theory for their decision making.

3) Technical analysis of exchange rates developed in part due to the forecasting inadequacies of fundamental exchange rate theories.

4) The authors claim that theoretical and empirical studies appear to show that fundamentals do apply to the long-term for foreign exchange.

5) The authors claim that random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path.

6) The asset market approach to forecasting is not applicable to emerging markets.

7) Most theories of technical analysis differentiate fair value from market value.

Essay

1) Describe the asset market approach to exchange rate determination. How is this consistent with economic theory of (say, security) prices in general?

9.2 Currency Market Intervention

Multiple Choice

1) ________ is the active buying and selling of the domestic currency against foreign currencies.
A) Indirect Intervention
B) Direct Intervention
C) Foreign Direct Investment
D) Federal Funding

2) Which of the following is NOT a technique used by governments or central banks to impact domestic currency valuation?
A) Indirect Intervention
B) Direct Intervention
C) Capital Controls
D) All of the above are techniques used to control currency valuation.

3) Which of the following is NOT a motivation for a government or central bank to manipulate domestic currency valuation?
A) fight inflation
B) slow too rapid economic growth
C) spur too slow economic growth
D) All of the above are motivations for the government or central bank to manipulate currency values.

True/False

1) Slow economic growth and continued unemployment problems are common reasons for central banks to hold currency values down.

2) The fall in the value of the domestic currency will sharply reduce the purchasing power of foreign tourists in the country whose currency values are falling.

3) The International Monetary Fund, as one of its basic principles (Article IV), encourages members to pursue “currency manipulation” to gain competitive advantages over other members as opposed to engaging in military action to achieve the same advantage.

4) If a central bank wishes to “defend its currency,” it might follow an expansive monetary policy, which would drive real rates of interest up.

5) A country wishing for its currency to fall in value, particularly when confronted with a continual appreciation of its value against major trading partner currencies, the central bank may work to lower real interest rates, reducing the returns to capital.

6) Indirect intervention for domestic currency valuation typically uses tools of monetary policy as opposed to using tools of fiscal policy.

7) Direct intervention for currency valuation involves limiting the ability to exchange domestic currency for foreign currency.

Essay

1) Explain how a central bank would engage in direct intervention to decrease the value of its domestic currency. Since the 1970s it has been difficult for central banks alone to engage in direct intervention to alter the value of their domestic currency. Identify and explain at least two other activities in which a central bank could engage to alter the value of their domestic currency.

9.3 Disequilibrium: Exchange Rates in Emerging Markets

Multiple Choice

1) Which of the following was NOT an international currency crisis in the 1990s and early 2000s?
A) the Asian Crisis
B) the Canadian Crisis
C) the Argentine Crisis
D) All of the above were currency crises in the 1990s and 2000s.

2) The Asian Currency crisis appeared to begin in:
A) South Korea.
B) Taiwan.
C) Thailand.
D) Japan.

3) The “tequila effect” is a slang term used to describe a form of financial panic called:
A) run on the market.
B) speculation.
C) contrary investing.
D) contagion.

4) Prior to July 2, 1997, the Thai government:
A) allowed the Thai Bhat to float against major currencies.
B) fixed the Bhat’s value against the Korean won only.
C) fixed the Bhat’s value against major currencies especially the U.S. dollar.
D) none of the above

5) The authors did NOT identify which of the following as a root of the Asian currency crisis?
A) the collapse of some Asian currencies
B) the rate of inflation in the United States
C) corporate socialism
D) banking stability and management

6) The authors refer to the practice of many Asian firms being largely controlled by families of groups related to the governing body of the country as:
A) illegal.
B) insider trading.
C) cronyism.
D) not in my back yard.

7) The principle focus of the IMF bailout efforts during the Asian financial crisis was:
A) banking liquidity.
B) shareholder’s wealth.
C) reestablishing fixed currency exchange rates in Asia.
D) dollarization of Asian currencies.

8) The ________ is the Argentine currency unit.
A) peso
B) dollar
C) real
D) peseta

9) A currency board is:
A) a structure, rather than a mere commitment, to limiting the growth of the money supply in the economy.
B) a recipe for conservative and prudent financial management.
C) designed to eliminate the power of politicians to exercise judgment by relying on an automatic and unbendable rule.
D) all of the above

10) Argentina’s economic performance in the 1990s while their peso was pegged to the U.S. dollar can be characterized as ________ rates of inflation and ________ rates of unemployment.
A) high; high
B) low; low
C) low; high
D) high; low

11) Which of the following did NOT contribute to the Russian currency crisis of 1998?
A) an accelerated flight of capital
B) generally deteriorating economic conditions
C) a surprisingly healthy government surplus that was neither funding internal investment nor external debt service
D) all of the above

True/False

1) In 1991 the Argentine peso was fixed to the value of the U.S. dollar on a one-to-one basis.

2) Leading up to the Russian currency collapse of 1998, Russia followed a currency policy of managed float that allowed their currency to slide daily at a 1.5% per month rate.

9.4 Forecasting in Practice

Multiple Choice

1) ________, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future.
A) Mappists
B) Trappist monks
C) Filibusters
D) Technical analysts

2) Examples of a business motivation for long-run exchange rate forecasts include all but which of the following?
A) a major capital investment in a foreign country
B) the desire to hedge a 90-day security
C) a portfolio manager considering investing in foreign securities
D) All of the above are examples of a business motivation for long-run exchange rate forecast.

3) Short-term foreign exchange forecasts are often motivated by such activities as ________ whereas long-term forecasts are more likely motivated by ________.
A) long-term investment; long-term capital appreciation
B) long-term capital appreciation; desire to hedge a receivable
C) the desire to hedge a payable; the desire for long-term investment
D) the desire for long-term investment; the desire to hedge a payable

4) A major U.S. multinational firm has forecast the euro/dollar rate to be €1.10/$ one year hence, and an exchange rate of $1.40 for the British pound (£) in the same time period. What does this imply the company’s expected rate for the euro per pound to be in one year?
A) €1.40/£
B) £1.40/€
C) £1.54/€
D) €1.54/£

True/False

1) The longer the time horizon of the technical analyst the more accurate the prediction of foreign exchange rates is likely to be.

Comment: The shorter the time horizon of the technical analyst the more accurate the prediction of foreign exchange rates is likely to be.

2) The single most important element of technical analysis is that future exchange rates are based on the current exchange rate.

3) The more efficient the foreign exchange market is, the more likely it is that exchange rate movements are random walks.

4) Technical analysts, traditionally referred to as chartists, focus on fundamental data to determine past trends that are expected to continue into the future.

Essay

1) Foreign exchange forecasting can be either long-term, or short-term in duration. Compare and contrast the motivation for and the techniques a forecaster might use for each of the time periods.
Answer: Short-run forecasts are usually more tactical in nature as a firm may desire to reduce exchange rate risk associated with foreign receivable or payables. Technical factors and short-term market expectations are often more important for short-run forecasters than long-run parity or fundamental economic conditions.
Long-run forecasts are more strategic in nature as firms make key decisions about entering new foreign markets. Longer time horizons tend to be less accurate but also require less accuracy. What forecasters typically desire is a general long-run understanding of the relationships between markets. Fundamental analysis and parity conditions tend to be more important than technical factors in this type of forecasting.

Chapter 10 Transaction Exposure

10.1 Types of Foreign Exchange Exposure

Multiple Choice

1) ________ exposure deals with cash flows that result from existing contractual obligations.
A) Operating
B) Transaction
C) Translation
D) Economic

2) ________ exposure measures the change in the present value of the firm resulting from unexpected changes in exchange rates.
A) Operating
B) Transaction
C) Translation
D) Accounting

3) Each of the following is another name for operating exposure EXCEPT:
A) economic exposure.
B) strategic exposure.
C) accounting exposure.
D) competitive exposure.

4) Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that ________ exposure deals with cash flows already contracted for, while ________ exposure deals with future cash flows that might change because of changes in exchange rates.
A) transaction; operating
B) operating; transaction
C) operating; accounting
D) none of the above

5) ________ exposure is the potential for accounting-derived changes in owner’s equity to occur because of the need to translate foreign currency financial statements into a single reporting currency.
A) Transaction
B) Operating
C) Economic
D) Accounting (aka translation)

6) Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses may reduce taxes over a series of years.
A) accounting; Operating
B) operating; Transaction
C) transaction; Operating
D) transaction; Accounting

7) Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses are not cash losses and therefore, are not tax deductible.
A) transaction; Operating
B) accounting; Operating
C) accounting; Transaction
D) transaction; Translation

8) MNE cash flows may be sensitive to changes in which of the following?
A) exchange rates
B) interest rates
C) commodity prices
D) all of the above

9) Assuming no transaction costs (i.e., hedging is “free”), hedging currency exposures should ________ the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should ________.
A) increase; not change
B) decrease; not change
C) not change; increase
D) not change; not change

10) Which of the following is NOT cited as a good reason for hedging currency exposures?
A) Reduced risk of future cash flows is a good planning tool.
B) Reduced risk of future cash flows reduces the probability that the firm may not meet required cash flows.
C) Currency risk management increases the expected cash flows to the firm.
D) Management is in a better position to assess firm currency risk than individual investors.

11) Which of the following is cited as a good reason for NOT hedging currency exposures?
A) Shareholders are more capable of diversifying risk than management.
B) Currency risk management through hedging does not increase expected cash flows.
C) Hedging activities are often of greater benefit to management than to shareholders.
D) All of the above are cited as reasons NOT to hedge.

12) The stages in the life of a transaction exposure can be broken into three distinct time periods. The first time period is the time between quoting a price and reaching an actual sale agreement or contract. The next time period is the time lag between taking an order and actually filling or delivering it. Finally, the time it takes to get paid after delivering the product. In order, these stages of transaction exposure may be identified as:
A) backlog, quotation, and billing exposure.
B) billing, backlog, and quotation exposure.
C) quotation, backlog, and billing exposure.
D) quotation, billing, and backlog exposure.

13) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. The U.S. firm is at risk today of a loss if:
A) the exchange rate changes to $1.52/£.
B) the exchange rate changes to $1.58/£.
C) the exchange rate doesn’t change.
D) all of the above

14) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. If the exchange rate changes to $1.58/£ the U.S. firm will realize a ________ of ________.
A) loss; $4,500
B) gain; $4,500
C) loss; £4,500
D) gain; £4,500

15) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. If the exchange rate changes to $1.52/£ the U.S. firm will realize a ________ of ________.
A) loss; $4,500
B) gain; $4,500
C) loss; £4,500
D) gain; £4,500

16) ________ is NOT a commonly used contractual hedge against foreign exchange transaction exposure.
A) Forward market hedge
B) Money market hedge
C) Options market hedge
D) All of the above are contractual hedges.

17) A ________ hedge refers to an offsetting operating cash flow such as a payable arising from the conduct of business.
A) financial
B) natural
C) contractual
D) futures

True/False

1) As a generalized rule, only realized foreign exchange losses are deductible for tax purposes.

2) Many MNE s manage foreign exchange exposure centrally, thus gains or losses are always matched with the country of origin.

3) Hedging, or reducing risk, is the same as adding value or return to the firm.

4) There is considerable question among investors and managers about whether hedging is a good and necessary tool.

5) The key arguments in opposition to currency hedging such as market efficiency, agency theory, and diversification do not have financial theory at their core.

6) The structure of a money market hedge is similar to a forward hedge. The difference is the cost of the money market hedge is determined by the differential interest rates, while the forward hedge is a function of the forward rates quotation.

7) In efficient markets, interest rate parity should assure that the costs of a forward hedge and money market hedge should be approximately the same.

8) Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally LESS risk averse than are shareholders.

9) Managers CAN outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be POSITIVE.

10) Shareholders are LESS capable of diversifying currency risk than is the management of the firm.

11) Hedging can be advantageous to shareholders because management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm value through selective hedging.

12) TRANSACTION exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

13) Transaction exposure could arise when borrowing or lending funds when repayment is to be made in the firm’s domestic currency.

Essay

1) Does foreign currency exchange hedging both reduce risk and increase expected value? Explain, and list several arguments in favor of currency risk management and several against.

2) Currency risk management techniques include forward hedges, money market hedges, and option hedges. Draw a diagram showing the possible outcomes of these hedging alternatives for a foreign currency receivable contract. In your diagram, be sure to label the X and Y-axis, the put option strike price, and show the possible results for a money market hedge, a forward hedge, a put option hedge, and an uncovered position. (Note: Assume the forward currency receivable is British pounds and the put option strike price is $1.50/£, the price of the option is $0.04 the forward rate is $1.52/£ and the current spot rate is $1.48/£.)

10.2 Trident’s Transaction Exposure

Multiple Choice

Instruction 10.2:
Use the information for the following problem(s).

Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.

• The spot exchange rate is $1.250/euro
• The six month forward rate is $1.22/euro
• CVT’s cost of capital is 11%
• The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
• The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
• The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
• The U.S. 6-month lending rate is 6% (or 3% for 6 months)
• December call options for euro 750,000; strike price $1.28, premium price is 1.5%
• CVT’s forecast for 6-month spot rates is $1.27/euro
• The budget rate, or the highest acceptable purchase price for this project, is
$3,900,000 or $1.30/euro

1) Refer to Instruction 10.2. If CVT chooses NOT to hedge their euro payable, the amount they pay in six months will be:
A) $3,500,000.
B) $3,900,000.
C) €3,000,000.
D) unknown today

2) Refer to Instruction 10.2. If CVT chooses to hedge its transaction exposure in the forward market, it will ________ euro 3,000,000 forward at a rate of ________.
A) buy; $1.22
B) buy; $1.25
C) sell; $1.22
D) sell; €1.25

3) Refer to Instruction 10.2. CVT chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be:
A) $3,000,000.
B) $3,660,000.
C) $3,750,000.
D) $3,810,000.

4) Refer to Instruction 10.2. If CVT locks in the forward hedge at $1.22/euro, and the spot rate when the transaction was recorded on the books was $1.25/euro, this will result in a “foreign exchange accounting transaction ________ of ________.
A) loss; $90,000.
B) loss; €90,000.
C) gain; $90,000.
D) gain; €90,000.

5) Refer to Instruction 10.2. CVT would be ________ by an amount equal to ________ with a forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had been correct.
A) better off; $150,000
B) better off; €150,000
C) worse off; $150,000
D) worse off; €150,000

6) Refer to Instruction 10.2. What is the cost of a call option hedge for CVT’s euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm’s cost of capital as the appropriate interest rate for calculating future values.)
A) $57,600
B) $59,904
C) $62,208
D) $63,936

7) Refer to Instruction 10.2. The cost of a put option to CVT would be:
A) $52,500.
B) $55,388.
C) $58,275.
D) There is not enough information to answer this question.

8) ________ are transactions for which there are, at present, no contracts or agreements between parties.
A) Backlog exposure
B) Quotation exposure
C) Anticipated exposure
D) none of the above

9) According to a survey by Bank of America, the type of foreign exchange risk most often hedged by firms is:
A) translation exposure.
B) transaction exposure.
C) contingent exposure.
D) economic exposure.

True/False

1) When attempting to manage an account payable denominated in a foreign currency, the firm’s only choice is to remain unhedged.

2) The treasury function of most firms, the group typically responsible for transaction exposure management, is NOT usually considered a profit center.

3) According to the authors, firms that employ proportional hedges increase the percentage of forward-cover as the maturity of the exposure lengthens.

4) Remaining unhedged is NOT an option when dealing with foreign exchange transaction exposure.

5) A forward hedge involves a put or call option contract and a source of funds to fulfill that contract.

6) Like a forward market hedge, a money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement.

7) Hedging transaction exposure with option contracts allows the firm to benefit if exchange rates are favorable but protects the firm if exchange rates turn unfavorable.

8) A firm’s risk tolerance is a combination of management’s philosophy toward transaction exposure and the specific goals of treasury activities.

9) Although rarely acknowledged by the firms themselves, selective hedging is essentially speculation.

Chapter 11 Translation Exposure

11.1 Overview of Translation

Multiple Choice

1) Translation exposure may also be called ________ exposure.
A) transaction
B) operating
C) accounting
D) currency

2) ________ exposure is the potential for an increase or decrease in the parent company’s net worth and reported net income caused by a change in exchange rates since the last transaction.
A) Transaction
B) Operating
C) Currency
D) Translation

3) Translation exposure measures:
A) changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.
B) the potential for an increase or decrease in the parent company’s net worth and reported net income caused by a change in exchange rates since the last consolidation of international operations.
C) an unexpected change in exchange rates impact on short run expected cash flows.
D) none of the above

4) According to your authors, the main purpose of translation is:
A) to prepare consolidated financial statements.
B) to help management assess the performance of foreign subsidiaries.
C) to act as an interpreter for managers without foreign language skills.
D) none of the above

5) Historical exchange rates may be used for ________, while current exchange rates may be used for ________.
A) fixed assets and current assets; income and expense items
B) equity accounts and fixed assets; current assets and liabilities
C) current assets and liabilities; equity accounts and fixed assets
D) equity accounts and current liabilities; current assets and fixed assets

6) If an imbalance results from the accounting method used for translation, the imbalance is taken either to ________ or ________.
A) the bank; the post office
B) depreciation; the market for foreign exchange swaps
C) current income; equity reserves
D) current liabilities; equity reserves

7) Generally speaking, translation methods by country define the translation process as a function of what two factors?
A) size; location
B) a firm’s functional currency; location
C) location; foreign subsidiary independence
D) foreign subsidiary independence; a firm’s functional currency

8) A/An ________ subsidiary is one in which the firm operates as an extension of the parent company with cash flows highly interrelated with the parent.
A) self-sustaining foreign
B) integrated foreign entity
C) foreign
D) none of the above

9) Consider two different foreign subsidiaries of Georgia-Pacific Wood Products Inc. The first subsidiary mills trees in Canada and ships its entire product to the Georgia-Pacific U.S. The second subsidiary is also owned by the parent firm but is located in Japan and retails tropical hardwood furniture that it buys from many different sources. The first subsidiary is likely a/an ________ foreign entity with most of its cash flows in U.S. dollars, and the second subsidiary is more of a/an ________ foreign entity.
A) domestic; integrated
B) self-sustaining; domestic
C) integrated; self-sustaining
D) self-sustaining; integrated

10) A foreign subsidiary’s ________ currency is the currency used in the firm’s day-to-day operations.
A) local
B) integrated
C) notational dollar
D) functional

11) The ________ determines accounting policy for U.S. firms.
A) Securities and Exchange Commission (SEC)
B) Federal Reserve System (Fed)
C) Financial Accounting Standards Board (FASB)
D) General Agreement on Tariffs and Trade (GATT)

True/False

1) It is possible to use different exchange rates for different line items on a financial statement.

2) If the same exchange rate were used to remeasure every line on a financial statement, then there would be no imbalances from remeasuring.

3) A foreign subsidiary”s functional currency is the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows.

4) It is highly unusual for a multinational firm to have both integrated foreign entities AND self-sustaining foreign entities.

11.2 Translation Methods

Multiple Choice

1) The two basic methods for the translation of foreign subsidiary financial statements are the ________ method and the ________ method.
A) current rate; temporal
B) temporal; proper timing
C) current rate; future rate
D) none of the above

2) Gains or losses caused by translation adjustments when using the current rate method are reported separately on the:
A) consolidated statement of cash flow.
B) consolidated income statement.
C) consolidated balance sheet.
D) none of the above

3) The basic advantage of the ________ method of foreign currency translation is that foreign nonmonetary assets are carried at their original cost in the parent’s consolidated statement while the most important advantage of the ________ method is that the gain or loss from translation does not pass through the income statement.
A) monetary; current rate
B) temporal; current rate
C) temporal; monetary
D) current rate; temporal

4) Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars:
A) translation is accomplished through the current rate method.
B) translation is accomplished through the temporal method.
C) translation is not required.
D) the translation method to be used is not obvious.

5) Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in the local currency, and the local currency is the functional currency, then:
A) the translation method to be used is not obvious.
B) translation is accomplished through the temporal method.
C) translation is not required.
D) translation is accomplished through the current rate method.

6) Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in the local currency, and the U.S. dollar is the functional currency, then:
A) translation is not required.
B) translation is accomplished through the current rate method.
C) translation is accomplished through the temporal method.
D) none of the above

7) If the European subsidiary of a U.S. firm has net exposed assets of €750,000, and the euro drops in value from $1.30/euro to $1.20/€ the U.S. firm has a translation:
A) gain of $75,000.
B) loss of $75,000.
C) gain of $625,000.
D) loss of €576,923.

8) If the European subsidiary of a U.S. firm has net exposed assets of €200,000, and the euro increases in value from $1.22/€ to $1.26/€ the U.S. firm has a translation:
A) gain of $8,000.
B) loss of $8,000.
C) gain of $252,000.
D) loss of €252,000.

9) If the British subsidiary of a European firm has net exposed assets of £125,000, and the pound increases in value from €1.40/£ to €1.44/£, the European firm has a translation:
A) gain of €5,000.
B) loss of €5,000.
C) gain of £5,000.
D) loss of £5,000.

10) If the British subsidiary of a European firm has net exposed assets of £250,000, and the pound drops in value from €1.35/£ to €1.30/£, the European firm has a translation:
A) gain of €12,500.
B) loss of €12,500.
C) loss of £12,500.
D) gain of £12,500.

True/False

1) Exchange rate imbalances that are passed through the balance sheet affect a firm’s reported income, but imbalances transferred to the income statement do not.

2) The current rate method is the most prevalent method today for the translation of financial statements.

3) The temporal rate method is the most prevalent method today for the translation of financial statements.

4) The biggest advantage of the current rate method of reporting translation adjustments is the fact that the gain or loss goes directly to the reserve account on the consolidated balance sheet and does not pass through the consolidated income statement.

5) Under the temporal rate method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation.

6) The temporal method of foreign currency translation gains or losses resulting from remeasurement are carried directly to current consolidated income and thus introduces volatility to consolidated earnings.

7) : The current rate method and the temporal method are two basic methods for translation that are employed worldwide

Essay

1) The two methods for the translation of foreign subsidiary financial statements are the current rate and temporal methods. Briefly, describe how each of these methods translates the foreign subsidiary financial statements into the parent company’s consolidated statements. Identify when each technique should be used and the major advantage(s) of each.

11.3 U.S. Translation Procedures

Multiple Choice

1) Under U.S. accounting and translation practices, use of the current rate method is termed ________ while use of the temporal method is termed ________.
A) translation; the same
B) translation; remeasurement
C) remeasurement; the same
D) remeasurement; translation

2) Which of the following primary principles of U.S. translation procedures in NOT true?
A) If the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars, translation is not required.
B) If the financial statements of the foreign subsidiary are maintained in the local currency and the local currency is the functional currency, they are translated by the temporal method.
C) If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method.
D) All of the above are true.

True/False

1) Under U.S. accounting and translation practices, use of the current rate method is termed “translation” while use of the temporal method is termed “remeasurement.”

2) If the financial statements of the foreign subsidiary are maintained in the local currency and the U.S. dollar is the functional currency, they are remeasured by the temporal method.

11.4 Trident Corporation’s Translation Exposure

Multiple Choice

1) ________ occur as a result of changes in the value of currency, whereas ________ occur as a result of ongoing business activities.
A) Operating gains or losses; translation gains or losses
B) Swap losses; translation gains or losses
C) Translation gains or losses; operating gains or losses
D) all of the above

True/False

1) Translation gains or losses can be quite different from operating gains or losses not only in magnitude but also in sign.

11.5 Trident Corporation’s Translation Exposure: Income

Multiple Choice

1) The main technique to minimize translation exposure is called a/an ________ hedge.
A) balance sheet
B) income statement
C) forward
D) translation

2) A balance sheet hedge requires that the amount of exposed foreign currency assets and liabilities:
A) have a 2:1 ratio of assets to liabilities.
B) have a 2:1 ratio of liabilities to assets.
C) have a 2:1 ratio of liabilities to equity.
D) be equal.

3) If a firm’s balance sheet has an equal amount of exposed foreign currency assets and liabilities and the firm translates by the temporal method, then:
A) the net exposed position is called monetary balance.
B) the change is value of liabilities and assets due to a change in exchange rates will be of equal but opposite direction.
C) Both A and B are true.
D) none of the above

4) If a firm’s subsidiary is using the local currency as the functional currency, which of the following is NOT a circumstance that could justify the use of a balance sheet hedge?
A) The foreign subsidiary is about to be liquidated, so that the value of its Cumulative Translation Adjustment (CTA) would be realized.
B) The firm has debt covenants or bank agreements that state the firm’s debt/equity ratio will be maintained within specific limits.
C) The foreign subsidiary is operating is a hyperinflationary environment.
D) All of the above are appropriate reasons to use a balance sheet hedge.

5) If the parent firm and all subsidiaries denominate all exposed assets and liabilities in the parent’s reporting currency this will ________ exposure but each subsidiary would have ________ exposure.
A) maximize translation; no transaction
B) eliminate translation; transaction
C) maximize transaction; no translation
D) eliminate transaction; translation

6) A Canadian subsidiary of a U.S. parent firm is instructed to bill an export to the parent in U.S. dollars. The Canadian subsidiary records the accounts receivable in Canadian dollars and notes a profit on the sale of goods. Later, when the U.S. parent pays the subsidiary the contracted U.S. dollar amount, the Canadian dollar has appreciated 10% against the U.S. dollar. In this example, the Canadian subsidiary will record a:
A) 10% foreign exchange loss on the U.S. dollar accounts receivable.
B) 10% foreign exchange gain on the U.S. dollar accounts receivable.
C) Since the Canadian firm is a U.S. subsidiary, neither a gain nor loss will be recorded.
D) Any gain or loss will be recorded only by the parent firm.

7) ________ gains and losses are “realized” whereas ________ gains and losses are only “paper.”
A) Translation; transaction
B) Transaction; translation
C) Translation; operating
D) none of the above

True/False

1) It is possible that efforts to decrease translation exposure may result in an increase in transaction exposure.

2) One possible reason for a balance sheet hedge could be because the foreign subsidiary is about to be liquidated, so that value of its Cumulative Translation Adjustment (CTA)would be realized.

3) One possible reason for a balance sheet hedge could be because the firm has debt covenants or bank agreements that state the firm”s debt/equity ratios will be maintained within specific limits.

4) If management expects a foreign currency to depreciate, it could minimize translation exposure by increasing net exposed assets.

5) If management anticipates an appreciation of the foreign currency, it should decrease net exposed assets to benefit from a gain.

Essay

1) Describe a balance sheet hedge and give at least two examples of when such a hedge could be justified.
balance sheet hedge attempts to equalize the amount of assets and liabilities of a foreign subsidiary exposed to translation risk. Thus, the gain to the firm from a change in exchange rates will be perfectly offset by an equal and opposite loss. Firms may engage in balance sheet hedges under conditions of hyperinflation, or when the subsidiary is about to be liquidated and the value of the CTA account would be realized. The author on page 16 lists other examples.

Chapter 12 Operating Exposure

12.1 Trident Corporation: A Multinational’s Operating Exposure

Multiple Choice

1) Another name for operating exposure is ________ exposure.
A) economic
B) competitive
C) strategic
D) all of the above

2) What type of international risk exposure measures the change in present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates?
A) transaction exposure
B) accounting exposure
C) operating exposure
D) translation exposure

3) ________ cash flows arise from intracompany and intercompany receivables and payments, while ________ cash flows are payments for the use of loans and equity.
A) Financing; operating
B) Operating; financing
C) Operating; accounting
D) Accounting; financing

4) Which of the following is NOT an example of a financial cash flow?
A) parent invested equity capital
B) interest on intrafirm lending
C) payment for goods and services
D) intrafirm principal payments

5) Which of the following is NOT an example of an operating cash flow?
A) management fees and distributed overhead
B) royalties and license fees
C) rent and lease payments
D) dividend paid to parent company

6) ________ exposure is far more important for the long-run health of a business than changes caused by ________ or ________ exposure.
A) Operating; translation; transaction
B) Transaction; operating; translation
C) Accounting; translation; transaction
D) Translation; operating; transaction

7) Simpson Sign Company based in Frostbite Falls, Minnesota has a 6-month C$100,000 contract to complete sign work in Winnipeg, Manitoba, Canada. The current spot rate is $1.02/C$ and the forward rate is $1.01/C$. Under conditions of equilibrium, management would use ________ today when preparing operating budgets.
A) $102,000
B) $101,000
C) $100,000
D) none of the above

8) When considering the phases of adjustment and response to operating exposure in the LONG RUN, price changes tend to be ________ and volume changes tend to be ________.
A) fixed/contracted; contracted.
B) fixed/contracted; completely flexible.
C) completely flexible; completely flexible.
D) completely flexible; contracted.

True/False

1) The goal of operating exposure analysis is to identify strategic operating techniques the firm might adopt to enhance value in the face of unanticipated exchange rate changes.

2) Operating cash flows may occur in different currencies and at different times, but financing cash flows may occur only in a single currency.

Comment: Financing of cash flows may also be in several currencies.

3) Expected changes in foreign exchange rates should already be factored into anticipated operating results by management and investors.

4) Moral hazard may occur when a firm or individual takes on more risk when it knows that someone else will “pick up the tab.”

5) Even though contracts are often fixed in the short run, as time passes, prices and costs can be changed to reflect the new competitive realities caused by a change in exchange rates.

12.2 Measuring Operating Exposure: Trident Germany

Multiple Choice

1) Recently the British Pound suffered an unexpected depreciation in value. Which of the following actions being considered by Coventry Furniture of London, a purely domestic furniture manufacturer and retailer, would be considered a highly unlikely response to the depreciation of the pound?
A) Coventry might choose to maintain its domestic sales prices constant in pound terms.
B) Coventry might try to raise domestic prices because competing imports are now priced higher in England.
C) Coventry might try to lower domestic prices because competing imports are now priced higher in England.
D) none of the above

2) Recently the Canadian dollar realized an unexpected appreciation in value. Which of the following actions being considered by Tall Timber Exports, a Canadian logging firm specializing in exporting raw forest products, would be considered a highly unlikely response to the appreciation of the Canadian dollar?
A) Tall Timber Exports might lower export prices in an effort to maintain market share.
B) Tall Timber Exports might raise export prices only slightly in an effort to increase market share.
C) Tall Timber Exports might leave export prices as they are and wait to determine what actions to take if any in the future.
D) all of the above

3) For a firm that competes internationally to sell its products, a depreciation of its domestic currency relative to markets where the firm exports goods, should eventually result in ________ sales at home and ________ sales abroad, other things equal.
A) fewer; greater
B) fewer; fewer
C) greater; greater
D) greater; fewer

4) Brimmo Motorcycles Inc., a U.S.-based firm, manufactures and sells electric motorcycles both domestically and internationally. A sudden and unexpected appreciation of the U.S. dollar should allow sales to ________ at home and ________ abroad. (Assume other factors remain unchanged.)
A) increase; increase
B) decrease; decrease
C) increase; decrease
D) decrease; increase

True/False

1) The strategy management undertakes in response to unexpected changes in exchange rates depends to a large measure on their opinion about the price elasticity of demand.

2) Unexpected changes in exchange rates is never good news for a firm’s operating income.

12.3 Strategic Management of Operating Exposure

Multiple Choice

1) Which of the following is NOT an example of diversifying operations?
A) diversifying sales
B) diversifying location of operations
C) raising funds in more than one country
D) sourcing raw materials in more than one country

2) Which of the following is NOT an example of diversification in financing?
A) raising funds in more than one market
B) raising funds in more than one country
C) diversifying sales
D) All of the above qualify.

3) When disequilibria in international markets occur, management can take advantage by:
A) doing nothing if they are already diversified and able to realize beneficial portfolio effects.
B) recognizing disequilibria faster than purely domestic competitors.
C) shifting operational of financing activities to take advantage of the disequilibria.
D) all of the above

4) Purely domestic firms will be at a disadvantage to MNEs in the event of market disequilibria because:
A) domestic firms lack comparative data from its own sources.
B) international firms are already so large.
C) all of the domestic firm’s raw materials are imported.
D) None of the above; domestic firms are not at a disadvantage.

5) Which of the following is probably NOT an advantage of foreign exchange risk management?
A) the reduction of the variability of cash flows due to domestic business cycles
B) increased availability of capital
C) reduced cost of capital
D) All of the above are potential advantages of foreign exchange risk management.

6) Which of the following is NOT an example of a form of political risk that might be avoided or reduced by foreign exchange risk management?
A) expropriation of assets
B) destruction of raw materials through natural disaster
C) war
D) unfavorable legal changes

True/False

1) Management must be able to predict disequilibria in international markets to take advantage of diversification strategies.

2) If a firm diversifies its financing sources, it will be pre-positioned to take advantage of temporary deviations from the International Fisher Effect.

3) Diversifying the financing base means diversifying sales, location of production facilities, and raw material sources.

4) The variability of a firm’s operating cash flows is probably reduced by international diversification of its production, sourcing, and sales because exchange rate changes under disequilibrium conditions are likely to increase the firm”s competitiveness in some markets while reducing it in others.

Essay

1) Diversification is possibly the best technique for reducing the problems associated with international transactions. Provide one example each of international financial diversification and international operational diversification and explain how the action reduces risk.

12.4 Proactive Management of Operating Exposure

Multiple Choice

1) Which of the following is NOT identified by your authors as a proactive management technique to reduce exposure to foreign exchange risk?
A) matching currency cash flows
B) cross-currency swaps
C) remaining a purely domestic firm
D) parallel loans

2) Which one of the following management techniques is likely to best offset the risk of long-run exposure to receivables denominated in a particular foreign currency?
A) Borrow money in the foreign currency in question.
B) Lend money in the foreign currency in question.
C) Increase sales to that country.
D) Increase sales in this country.

3) Which one of the following management techniques is likely to best offset the risk of long-run exposure to payables denominated in a particular foreign currency?
A) Borrow money in the foreign currency in question.
B) Lend money in the foreign currency in question.
C) Rely on the Federal Reserve Board to enact monetary policy favorable to your exposure risk.
D) none of the above

4) The particular strategy of trying to offset stable inflows of cash from one country with outflows of cash in the same currency is known as:
A) hedging.
B) diversification.
C) matching.
D) balancing.

5) Which of the following is NOT an acceptable hedging technique to reduce risk caused by a relatively predictable long-term foreign currency inflow of Japanese yen?
A) Import raw materials from Japan denominated in yen to substitute for domestic suppliers.
B) Pay suppliers from other countries in yen.
C) Import raw materials from Japan denominated in dollars.
D) Acquire debt denominated in yen.

6) An MNE has a contract for a relatively predictable long-term inflow of Japanese yen that the firm chooses to hedge by seeking out potential suppliers in Japan. This hedging strategy is referred to as:
A) a natural hedge.
B) currency-switching.
C) matching.
D) diversification.

7) An MNE has a contract for a relatively predictable long-term inflow of Japanese yen that the firm chooses to hedge by paying for imports from Canada in Japanese yen. This hedging strategy is known as:
A) a natural hedge.
B) currency-switching.
C) matching.
D) diversification.

8) A U.S. timber products firm has a long-term contract to import unprocessed logs from Canada. To avoid occasional and unpredictable changes in the exchange rate between the U.S. dollar and the Canadian dollar, the firms agree to split between the two firms the impact of any exchange rate movement. This type of agreement is referred to as:
A) risk-sharing.
B) currency-switching.
C) matching.
D) a natural hedge.

9) A ________ occurs when two business firms in separate countries arrange to borrow each other’s currency for a specified period of time.
A) natural hedge loan
B) forward loan
C) currency switch loan
D) back-to-back loan

10) A Canadian firm with a U.S. subsidiary and a U.S. firm with a Canadian subsidiary agree to a parallel loan agreement. In such an agreement, the Canadian firm is making a/an ________ loan to the ________ subsidiary while effectively financing the ________ subsidiary.
A) indirect; U.S.; Canadian
B) indirect; Canadian; U.S.
C) direct; U.S.; Canadian
D) direct; Canadian; U.S.

11) Which of the following is NOT an important impediment to widespread use of parallel loans?
A) difficulty in finding an appropriate counterparty
B) the risk that one of the parties will fail to return the borrowed funds when agreed
C) the process does not avoid exchange rate risk
D) All of the above are significant impediments.

12) A ________ resembles a back-to-back loan except that it does not appear on a firm’s balance sheet.
A) forward loan
B) currency hedge
C) counterparty
D) currency swap

13) A ________ is the term used to describe a foreign currency agreement between two parties to exchange a given amount of one currency for another, and after a period of time, to give back the original amounts.
A) matched flow
B) currency swap
C) back-to-back loan
D) none of the above

14) A British firm and a U.S. Corporation each wish to enter into a currency swap hedging agreement. The British firm is receiving U.S. dollars from sales in the U.S. but wants pounds. The U.S. firm is receiving pounds from sales in Britain but wants dollars. Which of the following choices would best satisfy the desires of the firms?
A) The British firm pays dollars to a swap dealer and receives pounds from the dealer. The U.S. firm pays pounds to the swap dealer and receives dollars.
B) The U.S. firm pays dollars to a swap dealer and receives pounds from the dealer. The British firm pays pounds to the swap dealer and receives dollars.
C) The British firm pays pounds to a swap dealer and receives pounds from the dealer. The U.S. firm pays dollars to the swap dealer and receives dollars.
D) The British firm pays dollars to a swap dealer and receives dollars from the dealer. The U.S. firm pays pounds to the swap dealer and receives pounds.

15) Reinvoicing centers provide the following benefit(s):
A) aid in the management of foreign exchange exposure.
B) effectively guarantee the exchange rate for future orders.
C) help manage intra-subsidiary cash flows.
D) all of the above

16) NorthRim Inc. (NRI), imports extreme condition outdoor wear and equipment from the Allofit Territories Company (ATC) located in Canada. With the steady decline of the U.S dollar against the Canadian dollar NRI is finding a continued relationship with ATC to be an increasingly difficult proposition. In response to NRI’s request, ATC has proposed the following risk-sharing arrangement. First, set the current spot rate as the base rate. As long as spot rates stay within 5% (up or down) NRI will pay at the base rate. Any rate outside of the 5% range, ATC will share equally with NRI the difference between the spot rate and the base rate. If the current spot rate is C$1.20/$, what are the upper and lower limits for trading to take place at C$1.20?
A) C$1.205/$ – C$1.195/$
B) C$1.15/$ – C$1.25/$
C) C$1.14/$ – C$1.26/$
D) none of the above

17) NorthRim Inc. (NRI), imports extreme condition outdoor wear and equipment from The Allofit Territories Company (ATC) located in Canada. With the steady decline of the U.S dollar against the Canadian dollar NRI is finding a continued relationship with ATC to be an increasingly difficult proposition. In response to NRI’s request, ATC has proposed the following risk-sharing arrangement. First, set the current spot rate as the base rate. As long as spot rates stay within 5% (up or down) NRI will pay at the base rate. Any rate outside of the 5% range, ATC will share equally with NRI the difference between the spot rate and the base rate. If NRI has a payable of C$100,000 due today and the current spot rate is C$1.17/$, how much does LBC owe in U.S. dollars?
A) $83,333
B) $85,470
C) $85,837
D) $117,000

18) Costs associated with the purchase of sizeable put options positions include each of the following EXCEPT:
A) the purchase price of the options.
B) the opportunity cost of buying the options rather than diversifying operations to reduce risk.
C) executive salaries of having corporate offices in more than one country.
D) none of the above

True/False

1) Currency swaps are exclusively for periods of time under one year.

2) Most swap dealers arrange swaps so that each firm that is a party to the transaction does not know who the counterparty is.

3) Most swap dealers arrange swaps so that each firm that is a party to the transaction knows who the counterparty is.

4) Swap agreements are treated as off-balance sheet transactions via U.S. accounting methods.

5) Swap agreements are treated as line items on the balance sheet via U.S. accounting methods.

6) After being introduced in the 1980s, currency swaps have remained a relatively insignificant financial derivative instrument.

7) After being introduced in the 1980s, currency swaps have gained increasing importance as financial derivative instruments.

8) The empirical evidence strongly supports the proposition that contractual hedges can effectively eliminate operating exposure.

Essay

1) A British firm has a subsidiary in the U.S., and a U.S. firm, known to the British firm, has a subsidiary in Britain. Define and then provide an example for each of the following management techniques for reducing the firm’s operating cash flows. The following are techniques to consider:
a) matching currency cash flows
b) risk-sharing agreements
c) back-to-back or parallel loans

Chapter 13 The Global Cost and Availability of Capital

13.1 Financial Globalization and Strategy

Multiple Choice

1) If a firm lies within a country with ________ or ________ domestic capital markets, it can achieve lower global cost and greater availability of capital with a properly designed and implemented strategy to participate in international capital markets.
A) liquid; segmented
B) liquid; large
C) illiquid; segmented
D) large; illiquid

2) Other things equal, a firm that must obtain its long-term debt and equity in a highly illiquid domestic securities market will probably have a:
A) relatively low cost of capital.
B) relatively high cost of capital.
C) relatively average cost of capital.
D) cost of capital that we cannot estimate from this question.

3) Relatively high costs of capital are more likely to occur in:
A) highly illiquid domestic securities markets.
B) highly liquid domestic securities markets.
C) unsegmented domestic securities markets.
D) none of the above

4) Reasons that firms may find themselves with relatively high costs of capital include:
A) The firms reside in emerging countries with undeveloped capital markets.
B) The firms are too small to easily gain access to their own national securities market.
C) The firms are family owned and they choose not to access public markets and lose control of the firm.
D) all of the above

5) Which of the following is NOT a contributing factor to the segmentation of capital markets?
A) excessive regulatory control
B) perceived political risk
C) anticipated foreign exchange risk
D) All of the above are contributing factors.

6) Which of the following is NOT a contributing factor to the segmentation of capital markets?
A) lack of transparency
B) asymmetric availability of information
C) insider trading
D) All of the above are contributing factors.

7) The weighted average cost of capital (WACC) is:
A) the required rate of return for all of a firm’s capital investment projects.
B) the required rate of return for a firm’s average risk projects.
C) not applicable for use by MNE.
D) equal to 13%.

8) The capital asset pricing model (CAPM) is an approach:
A) to determine the price of equity capital.
B) used by marketers to determine the price of saleable product.
C) that can be applied only to domestic markets.
D) none of the above

9) Which of the following is NOT a key variable in the equation for the capital asset pricing model?
A) the risk-free rate of interest
B) the expected rate of return on the market portfolio
C) the marginal tax rate
D) All are important components of the CAPM.

10) ________ risk is a function of the variability of expected returns of the firm’s stock relative to the market index and the measure of correlation between the expected returns of the firm and the market.
A) Systematic
B) Unsystematic
C) Total
D) Diversifiable

11) Systematic risk:
A) is the standard deviation of a security’s return.
B) is measured with beta.
C) is measured with standard deviation.
D) none of the above

12) Which of the following is generally unnecessary in measuring the cost of debt?
A) a forecast of future interest rates
B) the proportions of the various classes of debt a firm proposes to use
C) the corporate income tax rate
D) All of the above are necessary for measuring the cost of debt.

13) The after-tax cost of debt is found by:
A) dividing the before-tax cost of debt by (1 – the corporate tax rate).
B) subtracting (1 – the corporate tax rate) from the before-tax cost of debt.
C) multiplying the before-tax cost of debt by (1 – the corporate tax rate).
D) subtracting the corporate tax rate from the before-tax cost of debt.

14) A firm whose equity has a beta of 1.0:
A) has greater systematic risk than the market portfolio.
B) stands little chance of surviving in the international financial market place.
C) has less systematic risk than the market portfolio.
D) None of the above is true.

15) The difference between the expected (or required) return for the market portfolio and the risk-free rate of return is referred to as:
A) beta.
B) the geometric mean.
C) the market risk premium.
D) the arithmetic mean.

16) In general the geometric mean will be ________ the arithmetic mean for a series of returns.
A) less than
B) greater than
C) equal to
D) greater than or equal to

17) The beginning share price for a security over a three-year period was $50. Subsequent year-end prices were $62, $58 and $64. The arithmetic average annual rate of return and the geometric average annual rate of return for this stock was:
A) 9.30% and 8.58% respectively.
B) 9.30% and 7.89% respectively.
C) 9.30% and 7.03% respectively.
D) 9.30% and 6.37% respectively.

18) If a company fails to accurately predict it’s cost of equity, then:
A) the firm’s wacc will also be inaccurate.
B) the firm may not be using the proper interest rate to estimate NPV.
C) the firm may incorrectly accept or reject projects based on decisions made using the cost of capital computed with an incorrect cost of equity.
D) All of the above are true.

19) Which of the following statements is NOT true regarding beta?
A) Beta will have a value of less than 1.0 if the firm’s returns are less volatile than the market.
B) Beta will have a value of greater than 1.0 if the firm’s returns are more volatile than the market.
C) Beta will have a value of equal to 1.0 if the firm’s returns are of equal volatility to the market.
D) All of the statements above are true.

20) Which of the following will NOT affect a firm’s beta?
A) the choice of the market portfolio against which to compare the variability of a firm’s returns
B) the choice of the risk-free security
C) the choice of the time period used to calculate the firm’s beta
D) None of the above, because each of them affects the calculation of a firm’s beta.

True/False

1) A national securities market is segmented if the required rate of return on securities in that market differs from comparable securities traded in other, unsegmented markets.

2) Other things equal, an increase in the firm’s tax rate will increase the WACC for a firm that has both debt and equity financing.

3) If a firm’s expected returns are more volatile than the expected return for the market portfolio, it will have a beta less than 1.0.

4) The WACC is usually used as the risk-adjusted required rate of return for new projects that are of the same average risk as the firm’s existing projects.

5) One of the elegant beauties of international equity markets is that over the last 100 or so years, the average market risk premium is almost identical across major industrial countries.

6) Firms acquire debt in either the form of loans from commercial banks, or by selling new common stock.

7) When estimating an average corporate after-tax cost of capital, the component cost of equity is multiplied by (1-t) to allow for the tax-deductibility of dividend payments.

8) International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta, and the market risk premium, must then reflect this global portfolio.

9) Use of the International CAPM (ICAPM) assures that the WACC will be lower than if a purely domestic market portfolio had been used in the estimation of the cost of equity.

10) A global portfolio is an index of all the securities in the world, whereas a world portfolio represents those securities actually available to an investor.

11) The CAPM has now become very widely accepted in global business as the preferred method of calculating the cost of equity for a firm. As a result of this, there is now little debate over what numerical values should be used in its application.

12) The geometric mean will, in all but a few extreme circumstances, yield a larger return than the arithmetic mean return.

Essay

1) What are the components of the weighted average cost of capital (WACC) and how do they differ for an MNE compared to a purely domestic firm?

13.2 The Demand for Foreign Securities: The Role of International Portfolio Investors

Multiple Choice

1) The primary goal of both domestic and international portfolio managers is:
A) to maximize return for a given level of risk, or to minimize risk for a given level of return.
B) to minimize the number of unique securities held in their portfolio.
C) to maximize their WACC.
D) all of the above

2) Which of the following is NOT a portfolio diversification technique used by portfolio managers?
A) diversify by type of security
B) diversify by the size of capitalization of the securities held
C) diversify by country
D) All of the above are diversification techniques.

3) If all capital markets are fully integrated, securities of comparable expected return and risk should have the same required rate of return in each national market after adjusting for:
A) time of day and language requirements.
B) political risk and time lags.
C) foreign exchange risk and political risk.
D) foreign exchange risk and the spot rate.

4) Capital market segmentation is a financial market imperfection caused mainly by:
A) government constraints.
B) institutional practices.
C) investor perceptions.
D) all of the above

5) Capital market imperfections leading to financial market segmentation include:
A) asymmetric information between domestic and foreign-based investors.
B) high securities transaction costs.
C) foreign exchange risks.
D) all of the above

6) Capital market imperfections leading to financial market segmentation include:
A) political risks.
B) corporate governance differences.
C) regulatory barriers.
D) all of the above

7) The authors refer to companies that have access to a ________ as MNEs, and firms without such access are identified as ________.
A) global cost and availability of capital; domestic firms.
B) large domestic capital market; geographically challenged.
C) world financial markets; antiquated.
D) none of the above

8) The MNE can ________ its ________ by gaining access to markets that are more liquid and/or less segmented than its own.
A) increase; MCC.
B) decrease; MCC.
C) maintain; MRR.
D) none of the above

True/False

1) Internationally diversified portfolios often have a lower rate of return and almost always have a higher level of portfolio risk than their domestic counterparts.

2) Empirical tests of market efficiency fail to show that most major national markets are reasonably efficient.

3) A MNEs marginal cost of capital is constant for considerable ranges in its capital budget, but this statement cannot be made for most domestic firms.

4) Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions.

5) Since the 1980s and 1990s, segmentation in global financial markets has been reduced. As a result of this, the correlation among securities markets has increased, thereby reducing, but not eliminating, the benefits of international portfolio diversification.

13.3 The Cost of Capital for MNEs Compared to Domestic Firms

Multiple Choice

1) Theoretically, most MNEs should be in a position to support higher ________ than their domestic counterparts because their cash flows are diversified internationally.
A) equity ratios
B) debt ratios
C) temperatures
D) none of the above

2) According to your authors, diversifying cash flows internationally may help MNEs reduce the variability of cash flows because:
A) of a lack of competition among international firms.
B) of an offset to cash flow variability caused by exchange rate variability.
C) returns are not perfectly correlated between countries.
D) none of the above

3) Which of the following statements is NOT true regarding MNEs when compared to purely domestic firms?
A) MNEs tend to rely more on short and intermediate term debt.
B) MNEs have greater foreign exchange risk.
C) MNEs have greater costs of asymmetric information.
D) MNEs have higher agency costs.

4) Empirical research has found that systematic risk for MNEs is greater than that for their domestic counterparts. This could be due to:
A) the fact that the increase in the correlation of returns between the market and the firm is less than the increase in the standard deviation of returns of the firm.
B) the fact that the decrease in the correlation of returns between the market and the firm is greater than the increase in the standard deviation of returns of the firm.
C) the reduction in the correlation of returns between the firm and the market is less than the increase in the variability of returns caused by factors such as asymmetric information, foreign exchange risk, and the like.
D) None of the above; systematic risk is less for MNEs than for their domestic counterparts.

5) The optimal capital budget:
A) occurs where the marginal cost of capital equals the marginal rate of return of the opportunity set of projects.
B) is typically larger for purely domestic firms than for MNEs.
C) is an illusion found only in international finance textbooks.
D) none of the above

6) Empirical studies indicate that MNEs have higher costs of capital than purely domestic firms. This could be due to higher levels of:
A) political risk.
B) exchange rate risk.
C) agency costs.
D) all of the above

7) Despite the theoretical elegance of this hypothesis, empirical studies have come to the opposite conclusion.Despite the favorable effect of international diversification of cash flows, bankruptcy risk was only about the same for MNEs as for domestic firms. However, MNEs faced higher costs for each of the following EXCEPT:
A) agency costs.
B) political risk.
C) asymmetric information.
D) In fact, each of these costs were higher for the MNE than for the domestic firm.

True/False

1) Because of the international diversification of cash flows, the risk of bankruptcy for MNEs is significantly lower than that for purely domestic firms.

2) The opportunity set of projects is typically smaller for MNEs than for purely domestic firms because international markets are typically specialized niches.

3) Surprisingly, empirical studies find that MNEs have a higher level of systematic risk than their domestic counterparts.

Essay

1) What do theory and empirical evidence say about capital structure and the cost of capital for MNEs versus their domestic counterparts?

13.4 The Riddle: Is the Cost of Capital Higher for MNEs?

Multiple Choice

1) Empirical studies indicate that WACC for an MNE is higher than for their domestic competitors. Reasons cited for this increased cost include all of the following EXCEPT:
A) agency costs.
B) foreign exchange risk.
C) political risk.
D) All of the above are cited as reasons for an MNE’s increased WACC.

True/False

1) Empirical studies indicate that MNEs have a lower debt/capital ratio than domestic counterparts, indicating that MNEs have a lower cost of capital.

Chapter 14 Raising Equity and Debt Globally

14.1 Designing a Strategy to Source Capital Globally

Multiple Choice

1) The choice of when and how to source capital globally is usually aided early on by the advice of:
A) an investment banker.
B) your stock broker.
C) a commercial banker.
D) an underwriter.

2) Investment banking services include which of the following?
A) advising when a security should be cross-listed
B) preparation of stock prospectuses
C) help to determine the price of the issue
D) all of the above

3) Which of the following is the typical order of sourcing capital abroad?
A) an international bond issue, then cross listing the outstanding issues on other exchanges, then an international bond issue in the target market
B) an international bond issue in the target market, then cross listing the outstanding issues on other exchanges, then an international bond issue
C) an international bond issue in less prestigious markets, then an international bond issue in the target market, and ultimately a eurobond issue
D) cross listing the outstanding issues on other exchanges, then an international bond issue, then an international bond issue in the target market

4) By cross listing and selling its shares on a foreign stock exchange, a firm typically tries to accomplish which of the following?
A) improve the liquidity of its existing shares
B) increase its share price
C) increase the firm’s visibility
D) all of the above

True/False

1) Most firms raise their initial capital in foreign markets.

14.2 Optimal Financial Structure

Multiple Choice

1) Which financial economists are most closely associated with the financial theory of optimal capital structure?
A) Modigliani and Miller
B) Fama, Fisher, Jensen, and Roll
C) Black and Scholes
D) Markowitz and Sharpe

2) For most firms, the cost of capital decreases to a low point as the firm ________ debt financing. At some point beyond this optimal level, the cost of capital increases as the amount of debt ________.
A) decreases; increases
B) decreases; decreases
C) increases; increases
D) increases; decreases

3) One of the most important factors in making debt less expensive than equity is:
A) the tax deductibility of depreciation.
B) the tax deductibility of equity.
C) the tax deductibility of dividends.
D) the tax deductibility of interest.

4) One of the most important factors in making debt less expensive than equity is:
A) the seniority of equity obligations to debt claims.
B) the tax deductibility of dividends.
C) the tax deductibility of equity.
D) the seniority of debt obligations to equity claims.

5) Which of the following is NOT a factor offsetting the tax advantage of debt as a source of financing?
A) increased agency costs
B) increased probability of financial distress (bankruptcy) due to fixed interest payments
C) alternative tax shields to those supplied by interest payments
D) All of the above offset the tax advantage of debt as a source of financing.

6) Most financial theorists believe that the optimal capital structure is a ________ with a debt to total value ratio somewhere around ________.
A) point; 50%
B) point; 25%
C) range; 30%-60%
D) range; 10%-40%

7) Not all firms have the same optimal capital structure. Factors that might influence a firm’s capital structure include:
A) the industry in which it operates.
B) the volatility of its sales and operating income.
C) the collateral value of its assets.
D) all of the above

8) MNEs situated in countries with small illiquid and segmented markets are most like:
A) small domestic U.S. firms in that they must rely on internally generated funds and bank borrowing.
B) large U.S. MNEs in that they are all MNEs and have worldwide markets and sources of financing.
C) small domestic U.S. firms in that they have a strong niche market in the U.S.
D) None of the above is true.

9) In theory, the MNE should support ________ debt ratios than a purely domestic firm because their cash flows are ________.
A) lower; more stable due to international diversification
B) lower; less stable due to international diversification
C) higher; more stable due to international diversification
D) higher; less stable due to international diversification

10) TropiKana Inc., a U.S firm, has just borrowed $1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 6.00% per year, how much interest will they pay in the first year?
A) $6,000
B) $60,000
C) $600,000
D) €60,000

11) TropiKana Inc., a U.S firm, has just borrowed euro 1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 5.50% per year and the Euro depreciates against the dollar from $1.40/€ at the time the loan was made to $1.35/€ at the end of the first year, how much interest will TropiKana pay at the end of the first year (rounded)?
A) $55,000
B) €74,250
C) $74,250
D) $77,000

12) TropiKana Inc., a U.S firm, has just borrowed euro 1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 5.50% per year and the Euro appreciates against the dollar from $1.40/€ at the time the loan was made to $1.45/€ at the end of the first year, how much interest will TropiKana pay at the end of the first year (rounded)?
A) $55,000
B) $79,750
C) $77,000
D) $37,931

13) TropiKana Inc., a U.S firm, has just borrowed euro 1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 5.50% per year and the Euro appreciates against the dollar from $1.40/€ at the time the loan was made to $1.45/€ at the end of the first year, how much interest and principle will TropiKana pay at the end of the first year if they repay the entire loan plus interest (rounded)?
A) $1,529,750
B) €1,529,750
C) $1,055,000
D) $1,477,000

14) TropiKana Inc., a U.S firm, has just borrowed euro 1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 5.50% per year and the Euro depreciates against the dollar from $1.40/€ at the time the loan was made to $1.35/€ at the end of the first year, how much interest and principle will TropiKana pay at the end of the first year if they repay the entire loan plus interest (rounded)?
A) $1,477,000
B) $1,055,000
C) €1,424,250
D) $1,424,250

15) TropiKana Inc., a U.S firm, has just borrowed euro 1,000,000 to make improvements to an Italian fruit plantation and processing plant. If the interest rate is 5.50% per year and the Euro appreciates against the dollar from $1.40/€ at the time the loan was made to $1.45/€ at the end of the first year, what is the before tax cost of capital if the firm repays the entire loan plus interest (rounded)?
A) 1.73%
B) 5.50%
C) 10.50%
D) 9.27%

True/False

1) Financial theory has at last provided us with a single optimal capital structure for domestic firms.

2) Financial practice suggests that there is a range for an optimal capital structure for a firm within an industry rather than a specific optimal ratio of debt to equity.

3) In part because of access to global markets, MNEs are better able than their domestic counterparts to maintain their desired debt ratio even when raising new capital.

4) When a firm borrows in a foreign currency, the effective cost is the foreign interest rate plus an adjustment for changes in the exchange rate.

5) The domestic theory of optimal capital structure does not need to be modified for MNEs.

6) Portfolio diversification of domestic firms reduces risk because cash flows are not perfectly correlated. The same reasoning is often argued for MNEs diversifying into international markets.

7) A significant advantage of borrowing foreign currency-denominated bonds is that the borrower need not worry about relative changes in the value of the home currency.

8) For firms to raise capital in international markets, it is more important to adhere to capital structure ratios similar to those found in the United States and United Kingdom than to those in the firm’s home country.

14.3 Raising Equity Globally

Multiple Choice

1) The stock exchange with the greatest value of shares traded is:
A) NYSE.
B) Tokyo.
C) Nasdaq.
D) London.

2) The number of foreign firms traded on the London exchange is ________ than the number traded on the NYSE, and the costs of listing and disclosure in London are ________ those for the NYSE.
A) less than; less than
B) less than; greater than
C) greater than; less than
D) greater than; greater than

True/False

1) The Tokyo exchange is the number one choice of firms looking to gain liquidity by cross-listing their equity securities.

2) The least liquid stock markets as identified by the authors offer little liquidity for their own domestic firms, and are of little value to foreign firms.

14.4 Depositary Receipts

Multiple Choice

1) ________ are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank.
A) Negotiable CDs
B) International mutual funds
C) Depositary receipts
D) Eurodeposits

2) Depositary receipts traded outside the United States are called ________ depositary receipts.
A) Euro
B) Global
C) American
D) none of the above

3) Each ADR represents ________ of the shares of the underlying foreign stock.
A) a multiple
B) 100
C) 1
D) ADRs have nothing to do with foreign stocks.

4) Which of the following is NOT an advantage of ADRs to U.S. shareholders?
A) Transfer of ownership is done in the U.S. in accordance with U.S. laws.
B) In the event of the death of the shareholder, the estate does not go through a foreign court.
C) Settlement for trading is generally faster in the United States.
D) All of the above are advantages of ADRs.

5) ADRs that are created at the request of a foreign firm wanting its shares traded in the United States are:
A) facilitated.
B) unfacilitated.
C) sponsored.
D) unsponsored.

6) Who pays the costs of creating a sponsored ADR?
A) the foreign firm whose stocks underlie the ADR
B) the U.S. bank creating the ADR
C) both the U.S. bank and the foreign firm
D) the SEC since they require the regulation

7) Level I ADRs trade primarily:
A) on the New York Stock Exchange.
B) on the American Stock Exchange.
C) over the counter or pink sheets.
D) Level I ADRs typically do not trade at all, but instead are privately issued and held until maturity.

8) Level II ADRs must meet:
A) U.S. GAAP standards.
B) home country accounting standards.
C) both U.S. GAAP and home country standards.
D) none of the above

9) Level ________ is the easiest standard to satisfy for issuing ADRs.
A) 144a
B) III
C) II
D) I

10) Level III ADR commitment applies to:
A) firms that want to list existing shares on the NYSE.
B) banks issuing foreign mutual funds.
C) ADR issues of under $25,000.
D) the sale of a new equity issued in the United States.

True/False

1) ADRs cannot be exchanged for the underlying shares of the foreign stock, therefore, arbitrage cannot keep the prices in line with the foreign price of the stock.

2) An unsponsored ADR may be initiated without the approval of the foreign firm with the underlying stock.

3) ADRs are considered an effective way for firms to improve the liquidity of their stock, especially if the home market is small and illiquid.

Essay

1) ADRs are a popular investment tool for many U.S. investors. In recent years several alternatives for investing in foreign equity securities have become available for U.S. investors, yet ADRs remain popular. Define what an ADR is and provide at least three examples of the advantages they may hold over alternative foreign investment vehicles for U.S. investors.

14.5 Private Placement

Multiple Choice

1) Which of the following were NOT identified by the authors as an alternative instrument to source equity in global markets?
A) sale of a directed public share issue to investors in a target market
B) private placements under SEC rule 144a
C) sale of shares to private equity funds
D) All of the above are alternatives to source equity instruments.

2) A/An ________ is defined as one that is targeted at investors in a single country and underwritten in whole or part by investment institutions from that country.
A) SEC rule 144a placement
B) directed public share issue
C) Euroequity public issue
D) strategic alliance

3) The term “euro” as used in the euro equity market implies:
A) the issuers are located in Europe.
B) the investors are located in Europe.
C) both A and B
D) none of the above

4) Private equity funds (PEF) differ from traditional venture capital (VC) funds in that:
A) VC operates mainly in lesser-developed countries while PEF do not.
B) VC typically invests in family business whereas PEF do not.
C) VC is almost unavailable to emerging markets while PEF capital is available.
D) All of the above are true.

5) Strategic alliances are normally formed by firms that expect to gain synergies from which of the following?
A) economies of scale
B) economies of scope
C) complementary marketing
D) all of the above

True/False

1) SEC rule 144A permits institutional buyers to trade privately placed securities without the previous holding periods restrictions and without requiring SEC registration.

14.6 Foreign Equity Listing and Issuance

Multiple Choice

1) Your authors note several empirical studies that have found:
A) no share price effect for foreign firms that cross-list on major U.S. exchanges.
B) a positive share price effect for foreign firms that cross-list on major U.S. exchanges.
C) a negative share price effect for foreign firms that cross-list on major U.S. exchanges.
D) none of the above

2) Empirical evidence shows that new issues of equity by domestic firms in the U.S. market typically has a ________ stock price reaction and new equity issues in the U.S. markets by foreign firms with segmented domestic markets have a ________ stock price reaction.
A) negative; negative
B) positive; negative
C) negative; positive
D) positive; positive

3) In addition to gaining liquidity, which of the following could also be considered a legitimate reason for cross-listing equity?
A) enhance a firm’s local image
B) become more familiar with the local financial community
C) get better local press coverage
D) all of the above

4) Another school of thought about the worldwide trend toward fuller and more standardized disclosure rules is that the cost of U.S. level equity capital disclosure:
A) chases away potential listers of equity.
B) is an onerous costly burden.
C) leads to fewer foreign firms cross listing in U.S. equity markets.
D) all of the above

5) According to the U.S. school of thought, the worldwide trend toward fuller and more standardized disclosure rules should ________ the cost of equity capital.
A) increase
B) decrease
C) have no impact on
D) none of the above

6) For the most part, U.S. SEC disclosure requirements are ________ other, non-U.S. equity market rules.
A) more stringent than
B) less stringent than
C) equally stringent to
D) none of the above

True/False

1) The combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross-listing alone.

2) Because of stringent SEC rules, American companies typically do not find foreign disclosure rules to be overly onerous.

Essay

1) What are the two schools of thought regarding the worldwide trend toward increased financial disclosure by publicly traded firms. Explain which school of thought you hold to and why.

14.7 Raising Debt Globally

Multiple Choice

1) ________ are domestic currencies of one country on deposit in a second country.
A) LIBORs
B) Eurocurrencies
C) Federal funds
D) Discount window deposits

2) Of the following, which was NOT cited by the authors as a valuable function provided by the Eurocurrency market?
A) Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity.
B) Eurocurrency deposits are a tool used by the Federal Reserve to regulate the money supply of countries that peg their currency against the U.S. dollar.
C) The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs.
D) All of the above were cited by the authors.

3) Eurobanks are:
A) banks where Eurocurrencies are deposited.
B) major world banks that conduct a Eurocurrency business in addition to normal banking activities.
C) financial intermediaries that simultaneously bid for time deposits in and make loans in a currency other than that of the currency of where it is located.
D) All of the above are descriptions of a Eurobank.

4) Eurocredits are:
A) bank loans to MNEs and others denominated in a currency other than that of the country where the bank is located.
B) typically variable rate and tied to the LIBOR.
C) usually for maturities of six months or less.
D) All of the above are true.

5) In general, which has the shorter maturity and is more appropriate for funding short-term inventory needs?
A) commercial paper
B) Euro-Medium-Term notes (EMTNs)
C) the international bond market
D) all of the above

6) Foreign bonds sold in the United States are nicknamed “Yankee bonds,” foreign bonds sold in Japan are called “Samurai bonds.” What are foreign bonds sold in the United Kingdom nicknamed?
A) “Union Jacks”
B) “Royalty”
C) “Bulldogs”
D) “Churchill’s”

7) A ________ is a bond underwritten by a syndicate from a single country, sold within in that country, denominated in that country’s currency, but the issuer is from outside that country.
A) foreign bond
B) Eurobond
C) domestic bond
D) none of the above

True/False

1) Eurocurrencies are NOT the same as the euro developed for the common European currency.

2) The Eurocurrency market continues to thrive because it is a large international money market relatively free of governmental regulation and interference.

3) Moody’s rates international bonds at the request of the issuer with the stipulation that Moody’s will publish the ratings even if the ratings are unfavorable.

Essay

1) The Euro-medium-term-note (EMTN) has filled a substantial niche market in global financing. What are the distinguishing characteristics of the EMTN and why is it such a popular form of financing for MNEs?

Chapter 15 Multinational Tax Management

15.1 Tax Principles

Multiple Choice

1) The issue of ethics in the reporting of income and the payment of taxes is a considerable one. The authors state that most MNEs operating in foreign countries tend to follow the general principle of:
A) “when in Rome, do as the Romans do.”
B) full disclosure to the tax authorities.
C) maintain a competitive playing field by cheating as much as the local competition, no more, no less.
D) none of the above

2) Which of the following is an unlikely objective of U.S. government policy for the taxation of foreign MNEs?
A) to raise revenues
B) to provide an incentive for U.S. private investment in developing countries
C) to improve the U.S. balance of payments
D) All of the above are objectives.

3) A ________ tax policy is one that has no impact on private decision-making, while a ________ policy is designed to encourage specific behavior.
A) flat; tax incentive
B) neutral; flat
C) neutral; tax incentive
D) none of the above

4) Which of the following is NOT an example of a tax incentive policy?
A) The federal government gives a tax credit to MNEs that make domestic capital improvements but not foreign capital improvements.
B) Corporations are allowed to take a direct tax credit for each dollar of matching donations they make to institutions of higher education.
C) A tax law is passed that makes interest on property non tax-deductible, but interest payments on durable goods are.
D) All are examples of a tax incentive policy.

5) Toyota Motor Company operates in many different countries and pays taxes at many different rates. However, they always pay the same rate as their local competitors. Toyota Motor Company is operating in an environment of ________ tax policy.
A) domestic neutrality
B) foreign neutrality
C) territorial approach
D) none of the above

6) The United States taxes the domestic and remitted foreign earnings of U.S. based MNEs no matter where the earnings occurred. This is an example of a/an ________ approach to levying taxes.
A) worldwide
B) territorial
C) neutral
D) equitable

7) The United States taxes all earnings on U.S. soil by both domestic and foreign firms. This is an example of a ________ approach to levying taxes.
A) worldwide
B) neutral
C) territorial
D) none of the above

8) Bacon Signs Inc. is based in a country with a territorial approach to taxation but generates 100% of its income in a country with a worldwide approach to taxation. The tax rate in the country of incorporation is 25%, and the tax rate in the country where they earn their income is 50%. In theory, and barring any special provisions in the tax codes of either country, Bacon should pay taxes at a rate of:
A) 75%.
B) 62.5%.
C) 0%.
D) 50%.

9) The territorial approach to taxation policy is also termed the ________ approach.
A) source
B) ethical
C) greedy
D) location

10) A tax that is effectively a sales tax at each stage of production is defined as a/an ________ tax.
A) flat
B) equitable
C) value-added tax
D) none of the above

11) What is the total value of taxes paid in the following example if the value added tax is 10%? A farmer raises wheat that he sells for $1.50 to the grain company. The grain company sells to the processor for $2.00 per bushel. The processor turns the wheat into a breakfast cereal and wholesales it for $3.00 per bushel. The retailer sells the cereal for $4.00 per bushel.
A) $0.15
B) $0.20
C) $0.30
D) $0.40

TABLE 15.1
Use the information to answer following question(s).

BayArea Designs Inc., located in Northern California, has two international subsidiaries, one located in the Ukraine, the other in Korea. Consider the information below to answer the next several questions.

12) Refer to Table 15.1. If BayArea pays out 50% of its earnings from each subsidiary, what are the additional U.S. taxes due on the foreign sourced income from the Ukraine and Korea respectively.
A) Ukraine = $0; Korea = ($30,000)
B) Ukraine = $100,000; Korea = $0
C) Ukraine = $0; Korea = $66,250
D) none of the above

13) Refer to Table 15.1. The additional U.S. taxes due on the repatriation of income from the Ukraine to the United States, alone, assuming a 50% payout rate, is:
A) excess foreign tax credits of $110,000.
B) additional U.S. taxes due of $97,000.
C) additional U.S. taxes due of $36,500.
D) excess foreign tax credits of $18,500.

14) Refer to Table 15.1. How much in additional U.S. taxes would be due if BayArea averaged the tax credits and liabilities of the two foreign units, assuming a 50% payout rate from each?
A) $3,750
B) $13,750
C) $2,500
D) $0

15) Refer to Table 15.1. If BayArea set the payout rate from the Ukraine subsidiary at 25%, how should BayArea set the payout rate of the Korean subsidiary (approximately) to more efficiently manage its total foreign tax bill?
A) 28.5%
B) 24.5%
C) 42.6%
D) 82.3%

16) Refer to Table 15.1. What is the minimum effective tax rate that BayArea can achieve on its foreign-sourced income?
A) 26%
B) 35%
C) 40%
D) 0%

17) Tax-haven subsidiaries are typically established in a country that can meet the following requirements:
A) a low tax on foreign investment or sales income earned by resident corporations and a low dividend withholding tax on dividends paid to the parent firm.
B) the facilities to support financial services, for example, good communications, professional qualified office workers, and reputable banking services.
C) a stable government that encourages the establishment of foreign-owned financial and service facilities within its borders.
D) all of the above

18) A tax that is a form of social redistribution of income is defined as a/an ________ tax.
A) un-American
B) transfer
C) flat
D) none of the above

19) A ________ is a direct reduction of taxes whereas a ________ reduces the taxable income before taxes.
A) foreign tax credit; domestic tax credit
B) tax deduction; tax credit
C) tax credit; tax deduction
D) none of the above

Instruction 15.1:
Use the information to answer the following question(s).

Green Valley Exporters USA has $100,000 of before tax foreign income. The host country has a corporate income tax rate of 25% and the U.S. has a corporate income tax rate of 35%.

20) Refer to Instruction 15.1. If the U.S. has no bilateral trade agreement with the host country, what is the total amount of income taxes Green Valley Exporters will pay?
A) $25,000
B) $35,000
C) $51,250
D) $60,000

21) Refer to Instruction 15.1. If the U.S. has a bilateral trade agreement with the host country that calls for the total tax paid to be equal to the maximum amount that could be paid in the highest taxing country, what is the total amount of income taxes Green Valley Exporters will pay to the host country, and how much will they pay in U.S income taxes on the foreign earned income?
A) $25,000; $10,000
B) $25,000; $26,250
C) $35,000; $0
D) none of the above

22) Refer to Instruction 15.1. If the U.S. treated the taxes paid on income earned in the host country as a tax-deductible expense, then Green Valley’s total U.S. corporate tax on the foreign earnings would be:
A) $10,000.
B) $26,250.
C) $35,000.
D) $51,250.

23) Refer to Instruction 15.1. If the U.S. treated the taxes paid on income earned in the host country as a tax-credit, then Green Valley’s total U.S. corporate tax on the foreign earnings would be:
A) $51,250.
B) $35,000.
C) $26,250.
D) $10,000.

24) Tax treaties typically result in ________ between the two countries in question.
A) lower property taxes for U.S. citizens overseas
B) elimination of differential tax rates
C) increased double taxation
D) reduced withholding tax rates

25) Transfer pricing is a strategy that may be used by MNEs to:
A) reduce consolidated corporate income taxes.
B) partially finance a subsidiary in another country.
C) transfer funds from a subsidiary to the parent corporation.
D) all of the above

26) ________ is the pricing of goods, services, and technology between related companies.
A) Among pricing
B) Retail pricing
C) Transfer pricing
D) Wholesale pricing

True/False

1) The primary objective of multinational tax planning is to minimize the firm’s worldwide tax burden.

2) A country CANNOT have both a territorial and a worldwide approach as a national tax policy.

3) Tax treaties generally have the effect of increasing the withholding taxes between the countries that are negotiating the treaties.

4) A value-added tax has gained widespread usage in Western Europe, Canada, and parts of Latin America.

5) All indications are that the value-added tax will soon be the dominant form of taxation in the U.S.

6) Among the G7 nations, the U.S. has a below average corporate income tax rate that makes it attractive for other countries to invest in the U.S.

7) In the mid 1980s the U.S. led the way to higher corporate income tax rates worldwide. Today, most of the G7 nations have surpassed the U.S. and have higher corporate income tax rates than the U.S.

8) The ideal tax should not only raise revenue efficiently but also have as few negative effects on economic behavior as possible.

9) The worldwide approach, also referred to as the residential or national approach to tax policy, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad).

10) The territorial approach, also referred to as the source approach to tax policy, levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad).

11) Of the OECD 30 countries, most employ a worldwide approach to tax policy, but a few, including the United States, use the worldwide approach.

12) FEW governments rely on income taxes, both personal and corporate, for their primary revenue source.

13) Between 2006 – 2012, global corporate tax rates have trended upward.

14) Tax credits are LESS valuable on a dollar-for-dollar basis than are deductible expenses.

15) Tax treaties typically result in reduced withholding tax rates between the two signatory countries.

16) Tax credits are less valuable on a dollar-for-dollar basis than are tax-deductible expenses.

17) The U.S. Internal Revenue Service can reallocate revenues and expenses between parent corporations and their subsidiaries to more clearly reflect a proper allocation of income. In such instances it is the responsibility of the corporation to prove that the IRS has been arbitrary in its decision-making, thus establishing a “guilty until proved innocent” tax approach.

18) Tax haven subsidiaries of MNEs are categorically referred to as international offshore financial centers.

Essay

1) Explain the worldwide and territorial approaches of national taxation. The authors state that the United States uses both approaches. How can this be? Give an example of each taxation approach.

2) What is a value-added tax? Where is this type of tax in wide usage? Why do you suppose this form of taxation has NOT been widely accepted in the United States?

Chapter 16 International Portfolio Theory and Diversification

16.1 International Diversification and Risk

Multiple Choice

1) Beta may be defined as:
A) the measure of systematic risk.
B) a risk measure of a portfolio.
C) the ratio of the variance of the portfolio to the variance of the market.
D) all of the above

2) ________ risk is measured with beta.
A) Systematic
B) Unsystematic
C) International
D) Domestic

3) A fully diversified domestic portfolio has a beta of:
A) 0.0
B) 1.0
C) -1.0
D) There is not enough information to answer this question.

4) Unsystematic risk:
A) is the remaining risk in a well-diversified portfolio.
B) is measured with beta.
C) can be diversified away.
D) all of the above

5) A well-diversified portfolio has about ________ of the risk of the typical individual stock.
A) 8%
B) 19%
C) 27%
D) 52%

6) An internationally diversified portfolio:
A) should result in a portfolio with a lower beta than a purely domestic portfolio.
B) has the same overall risk shape as a purely domestic portfolio.
C) is only about 12% as risky as the typical individual stock.
D) all of the above

7) In some respects, internationally diversified portfolios are the same in principle as a domestic portfolio because:
A) the investor is attempting to combine assets that are perfectly correlated.
B) investors are trying to reduce systematic risk.
C) investors are trying to reduce the total risk of the portfolio.
D) all of the above

8) In some respects, internationally diversified portfolios are different from a domestic portfolio because:
A) investors may also acquire foreign exchange risk.
B) international portfolio diversification increases expected return but does not decrease risk.
C) investors must leave the country to acquire foreign securities.
D) all of the above

Instruction 16.1:
Use the information to answer the following question(s).

In September 2009 a U.S. investor chooses to invest $500,000 in German equity securities at a then current spot rate of $1.30/euro. At the end of one year the spot rate is $1.35/euro.

9) Refer to Instruction 16.1. How many euros will the U.S. investor acquire with his initial $500,000 investment?
A) €650,000
B) €370,370
C) €500,000
D) €384,615

10) Refer to Instruction 16.1. At an average price of €60/share, how many shares of stock will the investor be able to purchase?
A) 8333 shares
B) 6410 shares
C) 6173 shares
D) 10,833 shares

11) Refer to Instruction 16.1. At the end of the year the investor sells his stock that now has an average price per share of €57. What is the investor’s average rate of return before converting the stock back into dollars?
A) 5.0%
B) -3.0%
C) -5.0%
D) 3.0%

12) Refer to Instruction 16.1. At the end of the year the investor sells his stock that now has an average price per share of €57. What is the investor’s average rate of return after converting the stock back into dollars?
A) -1.35%
B) 5.0%
C) -5.0%
D) -7.24%

13) A U.S. investor makes an investment in Britain and earns 14% on the investment while the British pound appreciates against the U.S. dollar by 8%. What is the investor’s total return?
A) 22.00%
B) 23.12%
C) 6.00%
D) 4.88%

14) Which of the following statements is NOT true?
A) International diversification benefits induce investors to demand foreign securities.
B) An international security adds value to a portfolio if it reduces risk without reducing return.
C) Investors will demand a security that adds value.
D) All of the above are true.

True/False

1) Portfolio diversification can eliminate 100% of risk.

2) Increasing the number of securities in a portfolio reduces the unsystematic risk but not the systematic risk.

3) International diversification benefits may induce investors to demand foreign securities.

4) If the addition of a foreign security to the portfolio of the investor aids in the reduction of risk for a given level of return, then the security adds value to the portfolio.

5) If the addition of a foreign security to the portfolio of the investor decreases the expected return for a given level of risk, then the security adds value to the portfolio.

16.2 Internationalizing the Domestic Portfolio

Multiple Choice

1) Portfolio theory assumes that investors are risk-averse. This means that investors:
A) cannot be induced to make risky investments.
B) prefer more risk to less for a given return.
C) will accept some risk, but not unnecessary risk.
D) All of the above are true.

2) The efficient frontier of the domestic portfolio opportunity set:
A) runs along the extreme left edge of the opportunity set.
B) represents optimal portfolios of securities that represent minimum risk for a given level of expected portfolio return.
C) contains the portfolio of risky securities that the logical investor would choose to hold.
D) all of the above

3) The addition of foreign securities to the domestic portfolio opportunity set shifts the efficient frontier:
A) down and to the left.
B) up and to the right.
C) up and to the left.
D) down and to the right.

4) Relative to the efficient frontier of risky portfolios, it is impossible to hold a portfolio that is located ________ the efficient frontier.
A) to the left of
B) to the right of
C) on
D) to the right or left of

5) The ________ connects the risk-free security with the optimal domestic portfolio.
A) security market line
B) capital asset pricing model
C) capital market line
D) none of the above

Instruction 16.2:
Use the information to answer the following question(s).

A U.S. investor is considering a portfolio consisting of 60% invested in the U.S. equity index fund and 40% invested in the British equity index fund. The expected returns for the funds are 10% for the U.S. and 8% for the British, standard deviations of 20% for the U.S. and 18% for the British, and a correlation coefficient of 0.15 between the U.S. and British equity funds.

6) Refer to Instruction 16.2. What is the expected return of the proposed portfolio?
A) 9.2%
B) 9.0%
C) 19.2%
D) 19%

7) Refer to Instruction 16.2. What is the standard deviation of the proposed portfolio?
A) 38.00
B) 19.20
C) 19.00
D) 14.45

True/False

1) The graph for the efficient frontier has beta on the vertical axis and standard deviation of the horizontal axis.

2) The portfolio with the least risk among all those possible in the domestic portfolio opportunity set is called the minimum risk domestic portfolio.

3) The optimal domestic portfolio of risky securities is always the portfolio of minimum risk.

4) The standard deviation of a portfolio is the sum of the weighted average standard deviations of the individual assets.

5) The optimal domestic portfolio combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier.

6) The internationally diversified portfolio opportunity set shifts TO THE RIGHT of the purely domestic opportunity set.

Essay

1) Draw the curve representing the Optimal Domestic Efficient Frontier. Be sure to draw and label the following: The vertical axis and the horizontal axis, the risk-free security, the minimum risk portfolio, the domestic portfolio opportunity set, the optimal domestic portfolio, and the capital market line. Choose a point along the domestic portfolio opportunity set between the optimal domestic portfolio and the minimum risk domestic portfolio and explain why that point is not the optimal risky domestic portfolio for investors to hold.

16.3 National Markets and Asset Performance

Multiple Choice

1) The authors present a comparison of correlation coefficients between major global equity markets over a variety of different periods. The comparison yields a number of conclusions listed here EXCEPT:
A) the correlation between equity markets for the full twentieth century shows quite low levels of correlation between some of the largest markets (close to 0.50 in some cases).
B) that same century of data, however, yields a high correlation between the U.S. and Canada (0.80).
C) the correlation coefficients between those same equity markets for selected sub periods over the last quarter of the twentieth century, however, show significantly different correlation coefficients.
D) None of the answers listed are inaccurate conclusions.

True/False

1) Capital markets around the world are on average less integrated today than they were 20 years ago.

2) In an empirical study on national market returns in the 20th century, Dimson, Marsh, and Staunton (2002) determined that the equity returns in the United States out-performed the other 15 countries in the study.

3) In an empirical study on national market returns in the 20th century, Dimson, Marsh, and Staunton (2002) found that just under one-half of the 16 countries in the study had negative average returns in their equity markets.

4) In an empirical study on national market returns in the 20th century, Dimson, Marsh, and Staunton (2002) determined that due to high levels of correlation or returns between countries, there is almost NO BENEFIT to international portfolio diversification.

5) Of the major trading partners with the United States, Canada has among the LOWEST correlation of returns with the U.S.

Essay

1) If an investor is able to determine a global beta for his portfolio and holds a portfolio that is well-diversified with international investments, which performance measure is more appropriate, the Sharpe Measure or the Treynor Measure? Why? Explain each performance measure.

16.4 Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures

Multiple Choice

1) The Sharpe measure uses ________ as the measure of risk and the Treynor measure uses ________ as the measure of risk.
A) standard deviation; variance
B) beta; variance
C) standard deviation; beta
D) beta; standard deviation

TABLE 16.1
Use the information to answer following question(s).

2) Refer to Table 16.1. What is the value of the Sharpe Measure for France?
A) 0.113
B) 0.0071
C) either A or B
D) neither A nor B

3) Refer to Table 16.1. What is the value of the Treynor Measure for the Netherlands?
A) 0.197
B) 0.0109
C) either A or B
D) neither A nor B

4) Refer to Table 16.1. ________ appears to have the greatest amount of risk as measured by monthly standard deviation, but ________ has the best return per unit of risk according to the Sharpe Measure.
A) United States; Austria
B) France; Austria
C) United States; Netherlands
D) France; Netherlands

5) The Sharpe and Treynor Measures tend to be consistent in their ranking of portfolios when the portfolios:
A) are poorly diversified.
B) are properly diversified.
C) contain only U.S. equity investments.
D) none of the above

True/False

1) The Sharpe and Treynor measures are each measures of return per unit of risk.

2) Good financial advice would suggest that investors should examine returns by the amount of return per unit of risk accepted, rather than in isolation.

3) The denominator of the Treynor measure is portfolio risk as measured by the standard deviation of the portfolio.

4) The denominator of the Sharpe measure is portfolio risk as measured by the standard deviation of the portfolio.

5) The denominator of the Sharpe measure is the portfolio’s beta, the systematic risk of the portfolio, as measured against the world market portfolio.

6) The denominator of the Treynor measure is the portfolio’s beta, the systematic risk of the portfolio, as measured against the world market portfolio.

Chapter 17 Foreign Direct Investment and Political Risk

17.1 Sustaining and Transferring Competitive Advantage

Multiple Choice

1) An example of economies of scale in financing include:
A) being able to access the Euroequity, Eurobond, and Eurocurrency markets.
B) being able to ship product in shiploads or carloads.
C) being able to use large-scale plant and equipment.
D) all of the above

2) Which of the following is NOT a factor of Porter’s “diamond of national advantage”?
A) factor conditions
B) demand conditions
C) related and supporting industries
D) All of the above are factors of the diamond of national advantage.

3) The OLI paradigm is an attempt to create a framework to explain why MNEs choose ________ rather than some other form of international venture.
A) licensing
B) joint ventures
C) foreign direct investment
D) strategic alliances

4) The O in OLI refers to an advantage in a firm’s home market that is:
A) operator independent.
B) owner-specific.
C) open-market.
D) official designation.

5) The owner-specific advantages of OLI must be:
A) firm-specific.
B) not easily copied.
C) transferable to foreign subsidiaries.
D) all of the above

6) A/An ________ would be an example of an owner-specific advantage for an MNE.
A) patent
B) economy of scale
C) economy of scope
D) all of the above

7) The L in OLI refers to an advantage in a firm’s home market that is a:
A) liability in the domestic market.
B) location-specific advantage.
C) longevity in a particular market.
D) none of the above

8) A/An ________ would be an example of a location-specific advantage for an MNE.
A) patent
B) economy of scale
C) unique source of raw materials
D) possession of proprietary information

9) The I in OLI refers to an advantage in a firm’s home market that is an:
A) internalization.
B) industry-specific advantage.
C) international abnormality.
D) none of the above

10) A/An ________ would be an example of an internalization advantage for an MNE.
A) patent
B) economy of scale
C) unique source of raw materials
D) possession of proprietary information

True/False

1) MNEs that are resident in liquid and unsegmented capital markets are more likely to be able to demonstrate financial strength by achieving and maintaining a global cost and availability of capital.

2) A strongly competitive home market tends to dull the competitive advantage relative to firms located in less competitive home markets.

3) The authors were unable to identify in lesser developed countries specific firms that are nearing the status of global MNE.

Essay

1) List and explain three strategic motives why firms become multinationals and give an example of each.

2) What does the OLI Paradigm propose to explain? Define each component and provide an example of each.

17.2 Deciding Where to Invest

Multiple Choice

1) Which of the following is NOT true regarding behavioral observations of firms making a decision to invest internationally?
A) MNEs initially invest in countries with a similar “national psychic.”
B) Firms eventually take greater risks in terms of the national psychic of countries in which they invest.
C) Initial investments tend to be much larger than subsequent ones.
D) All of the above have been observed.

True/False

1) In practice, when expanding into other countries, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.

2) As a general rule, the decision about where to invest abroad for the first time is the same as the decision about where to reinvest abroad.

17.3 How to Invest Abroad: Modes of Foreign Involvement

Multiple Choice

1) Which of the following is NOT an advantage to exporting goods to reach international markets rather than entering into some form of FDI?
A) fewer political risks
B) greater agency costs
C) lower front-end investment
D) All of the above are advantages.

2) Which of the following is an advantage to exporting goods to reach international markets rather than entering into some form of FDI?
A) fewer agency costs
B) fewer direct advantages from research and development
C) a greater risk of losing markets to copycat goods producers
D) an inability to exploit R&D as effectively as if also invested abroad

3) Which of the following is NOT a form of FDI?
A) wholly-owned affiliate
B) joint venture
C) exporting
D) greenfield investment

4) With licensing the ________ is likely to be lower than with FDI because of lower profits; however, the ________ is likely to be higher due to a greater return per dollar invested.
A) IRR; NPV
B) NPV; IRR
C) cost of capital; NPV
D) IRR; cost of capital

5) Which of the following is NOT a potential disadvantage of licensing relative to FDI?
A) possible loss of quality control
B) establishment of a potential competitor in third-country markets
C) possible improvement of the technology by the local licensee, which then enters the original firm’s home market
D) All of the above are potential disadvantages to licensing.

6) A ________ is a shared ownership in a foreign business.
A) licensing agreement
B) greenfield investment
C) joint venture
D) wholly-owned affiliate

7) Which of the following is NOT an advantage to a joint venture?
A) Possible loss of opportunity to enter the foreign market with FDI later.
B) The local partner understands the customs and mores of the foreign market.
C) The local partner can provide competent management at many levels.
D) May be a realistic alternative when 100% foreign ownership is not allowed.

8) Greenfield investments are typically ________ and ________ than cross-border acquisition.
A) slower; more uncertain
B) faster; of greater certainty
C) slower; of greater certainty
D) faster; more uncertain

9) All of the following may be justification for a strategic alliance EXCEPT:
A) takeover defense.
B) a joint venture to pool resources for research and development.
C) joint marketing and serving agreements.
D) All of the above are legitimate reasons for strategic alliances.

True/False

1) Licensing is a popular form of foreign investment because it does not need a sizable commitment of funds, and political risk is often minimized.

2) MNEs typically used licensing with independent firms rather than with their own foreign subsidiaries.

3) Joint ventures are a more common FDI than wholly owned subsidiaries.

4) Local partners in a foreign country and in a joint venture with an MNE are likely to make decisions that maximize the value of the subsidiary. Such actions probably will not maximize the value of the entire firm.

17.4 Political Risk

Multiple Choice

1) ________ risks are those that affect the MNE at the local or project level, but originate at the country level.
A) Country-specific
B) Firm-specific
C) Global-specific
D) none of the above

2) Which of the following is NOT an example of a country-specific risk?
A) transfer risk
B) war and ethnic strife
C) cultural and religious heritage
D) All of the above are examples of country-specific risk.

3) According to your authors, MNEs can anticipate government regulations that are discriminatory or wealth depriving from a/an ________ or ________ level view.
A) foreign; domestic
B) micro; macro
C) internal; external
D) local; global

4) ________ is the ability to exercise effective control over a foreign subsidiary within a country’s legal and political environment.
A) Political risk
B) Portfolio risk
C) Interest rate risk
D) Governance risk

5) Of the following, which would NOT be considered an issue for an investment agreement prior to investing in a foreign country?
A) the basis for setting transfer prices
B) the right to export to third-country markets
C) provision for arbitration of disputes
D) All of the above could be negotiated prior to investing.

6) OPIC stands for:
A) Organization for the Prevention of Insufficient Capitalization.
B) Organization of Petroleum Importing Countries.
C) Overseas Private Investment Corporation.
D) Overseas Public Insurance Commission.

7) ________ is a type of political risk that OPIC does NOT cover.
A) Inconvertibility
B) Expropriation
C) War
D) OPIC covers all of the above.

8) ________ is the risk that the host government will take specific steps that prevent the foreign affiliate from exercising control over the firm’s assets.
A) Inconvertibility
B) Expropriation
C) Business income risk
D) none of the above

9) ________ is NOT one of the three main country-specific risks as outlined by your authors.
A) Transfer risk
B) Cultural differences
C) Thin equity base
D) Protectionism

10) Of the following, which was NOT identified by the authors as a type of cultural difference that MNEs must consider when expanding to foreign countries?
A) differences in human resource norms
B) differences in religious heritage
C) differences in allowable ownership structures
D) All of the above must be considered.

11) An alternative strategy to engaging in bribery in international investments include:
A) refuse bribery outright.
B) retain local advisors to diffuse requests for bribes.
C) educate management and local employees about the firm’s bribery policy.
D) all of the above

12) ________ industries are NOT typically “protected” by government policy.
A) Textiles
B) Defense
C) Agriculture
D) “Infant” industries

13) Forming regional alliances is one way to help mitigate the practice of government protectionism. Which of the following is NOT a regional trade organization formed by government treaty?
A) EU
B) NAFTA
C) NATO
D) MERCOSUR

14) Terrorism, cyber attacks, and the anti-globalization movement are each examples of ________ risks.
A) firm-specific
B) country-specific
C) institutional
D) global-specific

15) Governance risk due to goal conflict between an MNE and its host government is the main political ________ risk.
A) firm-specific
B) country-specific
C) global-specific
D) cultural-specific

16) The speed at which inventory moves through a manufacturing process is known as:
A) supply chain management.
B) working capital management.
C) inventory velocity.
D) warp speed.

17) As a result of the terrorist attacks of September 11, 2001, many firms have employed a wide range of tactics to ensure continued flow of inventory in the face of government steps to curb terrorism. Which of the following is an inventory sourcing strategy response (as opposed to an inventory management response, or a transportation response)?
A) carrying more inventory on-hand
B) minimizing cross-border exposure from suppliers
C) shifting to air cargo shipments instead of co-habitation of products and passengers on commercial air flights
D) increasing the on-hand supply of critical parts

18) Blocked funds are cash flows that:
A) come in regular intervals in standardized amounts or blocks.
B) have been restricted in transfer out of a local country.
C) come from a certain sector or region of the world.
D) none of the above

19) A ________ loan, also known as ________ is a parent-to-affiliate loan channeled through a financial intermediary such as a large commercial bank.
A) fronting; link financing
B) parallel; a back-to-back loan
C) fronting; a back-to-back loan
D) link financing; parallel loan

20) Which of the following is NOT a typical characteristic of a fronting loan made to an international subsidiary?
A) The parent makes a deposit equal to the size of the desired loan into a large commercial bank.
B) The bank lends to the subsidiary firm an amount equal to the parent deposit at a slightly higher interest rate.
C) The lending bank is located in the subsidiary’s country.
D) All of the above are typical characteristics of a fronting loan.

21) Which of the following could be considered an example of forced reinvestment if the blockage of funds was expected to be temporary?
A) vertical reinvestment by an automobile manufacturer to buy parts suppliers and showrooms
B) A lumber cutting company subsequently builds a paper mill with blocked funds.
C) purchase of local money market instruments and short-term loans
D) all of the above

True/False

1) When faced with additional risk from a foreign investment, firms typically account for the additional risk by adjusting the discount rates or by adjusting cash flows.

2) A number of institutional services provide updated country risk ratings on a regular basis. This is an example of micro-risk information for MNEs using this data.

3) A country can react to the potential for blocked funds prior to making an investment, during operations, or by investing in the local country in assets than maintain their value.

4) Banks are very hesitant to engage in fronting loans because of the low probability of repayment and thus their risk exposure up to a 100% loss.

5) Many problems such as poverty, environmental concerns, and cyber attacks are beyond the capabilities of MNEs alone to correct and require government participation as well.

6) Business risk can be measured through sensitivity analysis but from only the project viewpoint.

Essay

1) What are blocked funds? List and explain two of the three methods the authors list in this chapter for dealing with blocked funds.

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions

18.1 Complexities of Budgeting for a Foreign Project

Multiple Choice

1) The traditional financial analysis applied to foreign or domestic projects, to determine the project’s value to the firm is called:
A) cost of capital analysis.
B) capital budgeting.
C) capital structure analysis.
D) agency theory.

2) Which of the following is NOT a basic step in the capital budgeting process?
A) Identify the initial capital invested.
B) Estimate the cash flows to be derived from the project over time.
C) Identify the appropriate interest rate at which to discount future cash flows.
D) All of the above are steps in the capital budgeting process.

3) Of the following capital budgeting decision criteria, which does NOT use discounted cash flows?
A) net present value
B) internal rate of return
C) accounting rate of return
D) All of these techniques typically use discounted cash flows.

4) Which of the following is NOT a reason why capital budgeting for a foreign project is more complex than for a domestic project?
A) Parent cash flows must be distinguished from project cash flows.
B) Parent firms must specifically recognize remittance of funds due to differing rules and regulations concerning remittance of cash flows, taxes, and local norms.
C) Differing rates of inflation exist between the foreign and domestic economies.
D) All of the above add complexity to the international capital budgeting process.

5) For purposes of international capital budgeting, which of the following statements is NOT true?
A) Managers must evaluate political risk because political events can drastically reduce the value or availability of expected cash flows.
B) Parent cash flows must be distinguished from project cash flows. Each of these two types of flows contributes to a different view of value.
C) An array of nonfinancial payments can generate cash flows from subsidiaries to the parent, including payment of license fees and payments for imports from the parent.
D) All of the above are true statements.

True/False

1) When engaged in international capital budgeting, the analyst must identify the initial amount of capital invested or put at risk.

2) In international capital budgeting, the appropriate discount rate for determining the present value of the
expected cash flows is always the firm’s domestic WACC.

3) For purposes of international capital budgeting, it is NOT important to distinguish between parent and total project cash flows.

4) For purposes of international capital budgeting, parent cash flows often depend on the form of financing. Thus, we cannot clearly separate cash flows from financing decisions, as we can in domestic capital budgeting.

18.2 Project Versus Parent Valuation

Multiple Choice

1) Project evaluation from the ________ viewpoint serves some useful purposes and/but should ________ the ________ viewpoint.
A) local; be subordinated to; parent’s
B) local; not be subordinated to; parent’s
C) parent’s; be subordinated to; local
D) none of the above

2) For financial reporting purposes, U.S. firms must consolidate the earnings of any subsidiary that is over ________ owned.
A) 20%
B) 40%
C) 50%
D) 75%

3) A foreign firm that is 20% to 49% owned by a parent is called a/an:
A) subsidiary.
B) affiliate.
C) partner.
D) rival.

4) Affiliate firms are consolidated on the parent’s financial statements on a ________ basis.
A) pro rated
B) 50%
C) 75%
D) 100%

True/False

1) There are no important differences between domestic and international capital budgeting methods.

2) It is important that firms adopt a common standard for the capital budgeting process for choosing among foreign and domestic projects.

3) The only proper way to estimate the NPV of a foreign project is to discount the appropriate cash flows first and then convert them to the domestic currency at the current spot rate.

4) When dealing with international capital budgeting projects, the value of the project is NOT sensitive to the firm’s cost of capital.

5) For purposes of international capital budgeting, evaluation of a project from the PARENT viewpoint serves some useful purposes, but it should be subordinated to evaluation from the LOCAL’s viewpoint.

6) Multinational firms should invest only if they can earn a risk-adjusted return greater than locally based competitors can earn on the same project.

Essay

1) The authors highlight a strong theoretical argument in favor of analyzing any foreign project from the viewpoint of the parent. Provide at least three reasons why the parent’s viewpoint is superior to the local viewpoint and give an example of when the local viewpoint fails to maximize the value of the firm.

2) Explain how political risk and exchange rate risk increase the uncertainty of international projects for the purpose of capital budgeting.

18.3 Illustrative Case: Cemex Enters Indonesia

Multiple Choice

1) Which of the following is NOT an example of political risk?
A) Expropriation of cash flows by a foreign government.
B) The U.S. government restricts trade with a foreign country where your firm has investments.
C) The foreign government nationalizes all foreign-owned assets.
D) All of the above are examples of political risk.

2) Real option analysis allows managers to analyze all of the following EXCEPT:
A) the option to defer.
B) the option to abandon.
C) the option to alter capacity.
D) All of the above may be analyzed using real option analysis.

3) Given a current spot rate of 8.10 Norwegian krone per U.S. dollar, expected inflation rates of 6% in Norway and 3% per annum in the U.S., use the formula for relative purchasing power parity to estimate the one-year spot rate of krone per dollar.
A) 7.87 krone per dollar
B) 8.10 krone per dollar
C) 8.34 krone per dollar
D) There is not enough information to answer this question.

4) When evaluating capital budgeting projects, which of the following would NOT necessarily be an indicator of an acceptable project?
A) an NPV > $0
B) an IRR > the project’s required rate of return
C) an IRR > $0
D) All of the above are correct indicators.

5) Given a current spot rate of 8.10 Norwegian krone per U.S. dollar, expected inflation rates of 3% in Norway and 6% per annum in the U.S., use the formula for relative purchasing power parity to estimate the one-year spot rate of krone per dollar.
A) 7.87 krone per dollar
B) 8.10 krone per dollar
C) 8.34 krone per dollar
D) There is not enough information to answer this question.

6) When determining a firm’s weighted average cost of capital (wacc) which of the following terms is NOT necessary?
A) the firm’s tax rate
B) the firm’s cost of debt
C) the firm’s cost of equity
D) All of the above are necessary.

7) When determining a firm’s weighted average cost of capital (WACC) which of the following terms is NOT necessary?
A) the firm’s weight of equity financing
B) the risk-free rate of return
C) the firm’s weight of debt financing
D) All of the above are necessary to determine a firm’s WACC.

Instruction 18.1:
Use the information to answer the following question(s).

The Velo Rapid Revolutions Inc., a company that produces bicycles, elliptical trainers, scooters and other wheeled non-motorized recreational equipment is considering an expansion of their product line to Europe. The expansion would require a purchase of equipment with a price of euro 1,200,000 and additional installation of euro 300,000 (assume that the installation costs cannot be expensed, but rather, must be depreciated over the life of the asset). Because this would be a new product, they will not be replacing existing equipment. The new product line is expected to increase revenues by euro 600,000 per year over current levels for the next 5 years, however; expenses will also increase by euro 200,000 per year. (Note: Assume the after-tax operating cash flows in years 1-5 are equal, and that the terminal value of the project in year 5 may change total after-tax cash flows for that year.) The equipment is multipurpose and the firm anticipates that they will sell it at the end of the five years for euro 500,000. The firm’s required rate of return is 12% and they are in the 40% tax bracket. Depreciation is straight-line to a value of euro 0 over the 5-year life of the equipment, and the initial investment (at year 0) also requires an increase in NWC of euro 100,000 (to be recovered at the sale of the equipment at the end of five years). The current spot rate is $0.95/euro , and the expected inflation rate in the U.S. is 4% per year and 3% per year in Europe.

8) Refer to Instruction 18.1. What is the initial investment for the Velo Rapid Revolutions project?
A) $1,500,000
B) €1,600,000
C) $1,600,000
D) €1,500,000

9) Refer to Instruction 18.1. What are the annual after-tax cash flows for the Velo Rapid Revolutions project?
A) €400,000
B) €240,000
C) €120,000
D) €360,000

10) Refer to Instruction 18.1. What is the NPV of the European expansion if Velo Rapid Revolutions first computes the NPV in euros and then converts that figure to dollars using the current spot rate?
A) $1,520,000
B) $1,684,210
C) -$75,310
D) -$71,544

11) Refer to Instruction 18.1. In euros, what is the NPV of the Velo Rapid Revolutions expansion?
A) €1,524,690
B) $1,611,317
C) -€75,310
D) -€111,317

12) Refer to Instruction 18.1. What is the IRR of the Velo Rapid Revolutions expansion?
A) 14.4%
B) 10.3%
C) 12.0%
D) 8.6%

13) If a firm undertakes a project with ordinary cash flows and estimates that the firm has a positive NPV, then the IRR will be:
A) less than the cost of capital.
B) greater than the cost of capital.
C) greater than the cost of the project.
D) cannot be determined from this information

14) When estimating a firm’s cost of equity capital using the CAPM, you need to estimate:
A) the risk-free rate of return.
B) the expected return on the market portfolio.
C) the firm’s beta.
D) all of the above

15) ________ is the risk that a foreign government will place restrictions such as limiting the amount of funds that can be remitted to the parent firm, or even expropriation of cash flows earned in that country.
A) Exchange risk
B) Foreign risk
C) Political risk
D) Unnecessary risk

16) Generally speaking, a firm wants to receive cash flows from a currency that is ________ relative to their own, and pay out in currencies that are ________ relative to their home currency.
A) appreciating; depreciating
B) depreciating; depreciating
C) appreciating; appreciating
D) depreciating; appreciating

17) When assessing the additional risk that can occur from investing abroad firms may choose to account for risk via:
A) adjusting the cash flows.
B) adjusting the discount rates.
C) adjusting both cash flows and discount rates.
D) adjusting all of the above.

True/False

1) When a multinational firm invests abroad, it is common to develop two capital budgets: one from the project viewpoint, and one from the parent viewpoint.

2) When estimating a capital budget, it is common to separate cash flows into: 1) the initial investment, 2) incremental cash flows over the life of the project, and 3) a terminal value.

3) Because international capital budgeting is so difficult, time consuming, expensive, and uncertain, firms generally forego any type of additional sensitivity analysis after completing a base-case scenario.

4) A criticism of adjusting the discount rate to account for political risk is that adjusting the discount rate for political risk penalizes early cash flows too heavily while not penalizing distant cash flows enough.

18.4 Project Financing

Multiple Choice

1) Which of the following is NOT a factor critical to the success of project financing?
A) separability of the project from its investors
B) long-lived and capital intensive singular projects
C) cash flow predictability from third part commitments
D) All of the above are critical factors for project financing.

2) Which of the following is NOT a characteristic of international long-term capital project financing?
A) The projects are large in scale.
B) The projects are long in life.
C) The projects are generally high in risk.
D) The projects may be all of the above.

3) Which of the following is NOT a reason given for international mergers and acquisitions?
A) gaining access to strategic proprietary assets
B) gaining market power and dominance
C) diversifying and spreading their risks wider
D) All of the above are commonly cited reasons for international mergers and acquisitions.

4) The process of acquiring an enterprise anywhere in the world has three common elements EXCEPT:
A) identification and valuation of the target.
B) execution of the acquisition offer and purchase—the tender.
C) management of the post-acquisition transition.
D) All of the above are common elements in acquiring an enterprise anywhere in the world.

True/False

1) Project financing is the arrangement of financing for very large individual long-term capital projects.

2) Currency risk is a concern for any international merger and acquisition activity. For instance, the initial bid, if denominated in a foreign currency, creates a contingent foreign currency exposure for the bidder.

3) Currency risk is a concern for any international merger and acquisition activity. For instance, once the bidder has successfully won the acquisition, the exposure evolves from a transaction exposure to a contingent exposure.

4) The drivers of international merger and acquisitions are only MACRO in scope.

5) As opposed to greenfield investment, a cross-border acquisition is typically quicker.

Chapter 19 Working Capital Management

19.1 Trident Brazil’s Operating Cycle

Multiple Choice

1) Working capital management involves the management of:
A) current and long-term assets.
B) current assets and current liabilities.
C) current liabilities and long-term assets.
D) current liabilities and long-term debt and equity.

2) The cash conversion cycle:
A) is a subset of the operating cycle.
B) occurs in the latter stages of the operating cycle.
C) is a subset of the accounts receivable period.
D) all of the above.

3) The proper order of events for the operating cycle is:
A) input serving period, accounts receivable period, inventory period, quotation period.
B) quotation period, accounts receivable period, inventory period, input servicing period.
C) quotation period, input servicing period, inventory period, accounts receivable period.
D) accounts receivable period, input servicing period, quotation period, inventory period.

4) TrinityApps Corporation (US) has bid a price on a project for a Korean firm, but the Korean firm has not yet placed an order. This portion of the operating cycle is best described as the:
A) quotation period.
B) input sourcing period.
C) cash conversion cycle.
D) accounts payable cycle.

5) The period in the cash cycle where the customer places the order, and the firm determines what materials for manufacture are NOT in inventory is called the ________ period.
A) quotation
B) input sourcing
C) accounts payable
D) accounts receivable

6) The accounts payable period of the operating cycle:
A) is equal to the inventory period.
B) may run concurrently but shorter than the inventory period.
C) may run concurrently but longer than the inventory period.
D) Any one of the above may be true.

True/False

1) Typically, the inventory period and the accounts payable period at least partially overlap in the firms operating cycle.

2) Typically, the inventory period and the accounts receivable period at least partially overlap in the firms operating cycle.

3) The operating cycle begins with the quotation period and ends with the accounts payable period.

19.2 Trident’s Repositioning Decisions

Multiple Choice

1) Of the following, which would NOT be a significant decision-making factor in a multinational firm’s repositioning decision-making?
A) the subsidiary’s tax environment (high or low)
B) the stability of the local currency
C) the ability to move capital in and out of the subsidiary’s country
D) All of the above are significant factors.

True/False

1) In a country with a relatively high tax rate, it make sense the the MNE to reposition cash flows TO that country.

2) The MNE would prefer to leave capital with a firm in a country with high growth prospects over the alternative of leaving capital with a firm in a country with low growth prospects (other factors equal).

19.3 Constraints on Repositioning Funds

Multiple Choice

1) Each of the following is listed by your authors as a constraint on repositioning funds by an MNE EXCEPT:
A) political constraints.
B) tax constraints.
C) transaction costs.
D) All of the above are listed by your authors.

True/False

1) Local liquidity needs sometimes impact a firm’s worldwide optimal cash position.

2) The constraints on repositioning of funds that occur when exchanging one currency for another are considered to be primarily political constraints.

3) Political constraints can block the transfer of funds either overtly or covertly. OVERT blockage occurs when dividends or other forms of fund remittances are severely limited, heavily taxed, or excessively delayed by the need for bureaucratic approval.

19.4 Conduits for Moving Funds by Unbundling Them

Multiple Choice

1) ________ allows a multinational firm to recover funds from subsidiaries without piquing host country sensitivities over large dividend drains.
A) Unbundling funds
B) Bundling funds
C) Coordinating funds
D) none of the above

2) Unbundling of funds by an MNE may be a useful practice for which of the following reasons?
A) An increase in the funds flow (charges) in any of the before-tax categories reduces the taxable profits of the foreign subsidiary if the host-country tax authorities acknowledge the charge as a legitimate expense.
B) An item-by-item matching of remittance to input, such as royalties for intellectual property, and fees for patents and advice, is equitable to the host country and foreign investor alike.
C) Unbundling facilitates allocation of overhead from a parent”s international division, so-called shared services, to each operating subsidiary in accordance with a predetermined formula.
D) All of the reasons listed above

True/False

1) If all investment inputs are unbundled, part of what might have been classified as residual profits may turn out to be tax-deductible expenses related to a specific purchased benefit.

2) The before-tax/after-tax distinction is quite significant to a parent company attempting to repatriate funds in the most tax-efficient method if it is attempting to manage its own foreign tax credit/deficits between foreign units.

19.5 International Dividend Remittances

Multiple Choice

1) In anticipation of a foreign exchange loss, an MNE may speed up the transfer of funds out of the company via dividends. When undertaking such an activity the MNE must be concerned with all of the following EXCEPT:
A) interest rate differences between the two countries.
B) the negative impact on host country relations.
C) defection on the part of executives in the home headquarters.
D) MNEs must be concerned with all of the above.

True/False

1) Political risk may motivate parent firms to require foreign subsidiaries to remit all locally generated funds above that required to internally finance growth in sales and planned capital expansions.

19.6 Net Working Capital

Multiple Choice

1) One possible definition of net working capital (NWC) provided by your authors is:
A) NWC = A/R + inventory – A/P.
B) NWC = cash + A/P – inventory.
C) NWC = A/P + A/R – short-term loans.
D) NWC = A/R + inventory – long-term debt.

2) Which of the following actions will result in an increase in NWC?
A) an increase in A/P that exceeds an increase in A/R
B) a reduction in inventory
C) a reduction in A/P plus a smaller reduction in A/R
D) an increase in A/P and a smaller reduction in inventory

3) Which of the following statements is true?
A) A/R provide part of the funding for inventory.
B) A/P provide part of the funding for A/R and inventory.
C) Inventory pays for A/R and A/P.
D) None of the above is true.

TABLE 19.1
Use the information to answer following question(s).

TrinityApps Corporation Balance Sheet December 31, 20xx

4) Refer to Table 19.1. The NWC for TrinityApps is:
A) $80,000
B) $680,000
C) $35,000
D) $45,000

5) Refer to Table 19.1. If TrinityApps increases inventory by $10,000 and A/P also by $10,000, the net change in NWC is:
A) $20,000
B) $10,000
C) $0
D) none of the above

6) Refer to Table 19.1. NWC currently makes up what percentage of total firm value for TrinityApps?
A) 6.6%
B) 5.1%
C) 11.8%
D) 9.2%

Instruction 19.1:
Use the information to answer the following question(s).

Sunny Manufacturing Systems Inc. is supplied with plastic chips for their plastic injection molding manufacturing process. Their supplier, Sun Chemical, Inc. offers financing terms of a 2% discount if the accounts payable are paid in 10 days or less with the full balance due in 45 days. Short-term financing available to Sunny Manufacturing is available at an annual rate of 9.6%. Sunny Manufacturing has just purchased $400,000 of plastic chips from Sun Chemical.

7) Refer to Instruction 19.1. What is the amount of money Sunny Manufacturing will save on accounts payable if they accept the discount?
A) $400,000
B) $8,000
C) $33,333
D) $20,000

8) Refer to Instruction 19.1. What is the effective annual interest cost of supplier financing offered by Sun Chemical?
A) 7.3%
B) 9.5%
C) 10.4%
D) 22.9%

9) Refer to Instruction 19.1. Should Sunny Manufacturing take the discount offered by Sun Chemical?
A) Yes, Sunny Manufacturing will get to use their raw materials 35 days earlier than if they waited to pay at the end of the 45 days.
B) No, Sunny Manufacturing will not have to pay any interest if they just pay in 45 days.
C) Yes, Sunny Manufacturing’s short term borrowing rate of 9.6% is less than Sun’s offered cost of carry of 22.9%.
D) No, it costs Sunny Manufacturing 22.9% to accept the discount and they are better off paying the full amount in 45 days.

10) Days working capital is equal to:
A) days payables + days receivables – days inventory.
B) days inventory + days receivables – days payables.
C) days payables + days inventory + days receivables.
D) none of the above

11) Amundsen of Norway receives raw materials from their corporate parent in the U.S. with payment terms of net 60 days. Most of their sales are to firms in Norway where normal payment terms are net 30 days. This causes a problem for the subsidiary with working capital management because:
A) accounts receivable are so much longer than accounts payable.
B) accounts payable are so much longer than accounts receivable.
C) accounts receivable and accounts payable are equal.
D) This doesn’t really cause a problem; in fact it is to the benefit of the Norwegian subsidiary.

True/False

1) In principle, the firm tries to minimize its NWC balance.

2) Other things equal, managers prefer a lower “days working capital” to a higher one.

3) The authors present empirical evidence that shows the days sales basis for working capital to be 30 days GREATER in the U.S. compared to a similar industry in Europe.

Essay

1) What is a free-trade zone? Identify three techniques and provide examples of how firms and countries can benefit from having free trade zones.

19.7 International Cash Management

Multiple Choice

1) Other things equal, a firm would rather have ________ in a depreciating currency, and ________ in an appreciating currency.
A) accounts receivable; accounts payable
B) accounts receivable; accounts receivable
C) accounts payable; accounts receivable
D) none of the above

2) Which of the following is NOT a precautionary motive for holding cash?
A) Anticipated funds to be remitted from several Middle East countries are in question due to unrest in the region.
B) The firm has several short-term obligations in unhedged foreign currency-denominated contracts.
C) The firm must pay ordinary wages in two days.
D) All are precautionary motives.

3) Increases to cash flows can be anticipated if which of the following occurs?
A) A receivables contract is denominated in an appreciating foreign currency.
B) Sales are less than anticipated.
C) Days in accounts receivable increase by 15 days.
D) none of the above

4) A centralized depository benefits the firm primarily by:
A) reducing the cost of repatriating funds.
B) positioning profits where taxes are lowest.
C) reducing the total amount of capital employed within the total firm.
D) earning a higher rate of return than in domestic banking deposits.

5) The Clearing House Interbank Payment System (CHIPS) is:
A) the largest publicly operated payments system in the world.
B) owned and operated by the world’s seven largest central banks.
C) a computerized network that connects banks globally.
D) none of the above

6) An organizational structure employed by an MNE to reduce its use of bank lending for the support of operations is:
A) a centralized depository.
B) a reinvoicing center.
C) a cost center.
D) a syndicated bank.

7) ________ is the process that cancels via offset all, or part, of the debt owed by one entity to another related entity.
A) Syndicated banking
B) Centralized depositing
C) Multilateral netting
D) Debt cancellation

True/False

1) In an inflationary economy, demand for credit usually exceeds supply.

2) For disbursement purposes, it is to the benefit of the firm to minimize float.

3) Regarding wire transfers, CHIPS actually clears transactions whereas SWIFT does not.

4) A significant problem with centralized cash depositories is that they are isolated from the rest of the firm and tend to be at an information disadvantage.

5) A reason for holding all precautionary balances in a central pool is that the total pool, if centralized, can be reduced in size without any loss in the level of protection.

6) A disadvantage of a centralized cash management system is that managers will not be able to get the lowest average rate available for the firm. Instead, it misses out on the really low borrowing rates.

Essay

1) Central depositories are used for international cash management. What is a central depository? Identify and provide examples of at least three advantages to MNEs of having a central depository.

19.8 Financing Working Capital

Multiple Choice

1) A precautionary cash balance:
A) is used to replace spoiled or damaged inventory.
B) is held to facilitate cash disbursements when receipts slow down.
C) is used for normal day-to-day operations.
D) is held for the benefit of a sister affiliate.

2) An in-house bank:
A) is a separate bank chartered to operate within a business firm.
B) is in fact a set of functions performed by the firm’s existing treasury department.
C) assesses the credit standing of the bank’s customers.
D) provides banking services for employees.

3) A foreign banking office that is separately incorporated in the host country is:
A) a correspondent bank.
B) a representative office.
C) a bank subsidiary.
D) an Edge Act corporation.

True/False

1) An Edge Act corporation is a subsidiary of a U.S. bank located outside of the U.S. and incorporated to engage in international banking and financing operations.

2) Because they are direct payments, dividends are among the most efficient way for foreign subsidiaries to remit funds back to the parent.

3) Even though dividends are cash payments, firms typically must consider both cash flow and net income when making dividend distribution decisions.

Chapter 20 International Trade Finance

20.1 The Trade Relationship

Multiple Choice

1) The exporter-importer relationship to a corporation of a foreign importer that has not previously conducted business with the firm would be an:
A) unaffiliated known.
B) affiliated party.
C) unaffiliated unknown.
D) any of the above

2) Which of the following relationships between importing and exporting parties would require the least detailed contract to conduct business?
A) affiliated party
B) unaffiliated unknown party
C) known unaffiliated party
D) domestic supplier

3) Polaris Corporation has made an agreement to ship goods to a foreign firm with whom they have not entered into a contract for three years. However, the firms have communicated regularly since the last sale three years ago. This is an example of an:
A) unaffiliated known party transaction.
B) unaffiliated unknown party transaction.
C) affiliated party transaction.
D) none of the above

True/False

1) Today, international trade is dominated by transactions between unaffiliated parties (known or unknown).

2) Because most international transactions are between affiliated parties, international transaction contracts are less complex, but the management of the total value of the MNE is more complex.

3) An advantage of trading with an affiliated party for an MNE, compared to an unaffiliated party, could be reduced contracting costs and less to even no need to protect against nonpayment.

20.2 The Trade Dilemma

Multiple Choice

1) Which of the following is NOT a financial instrument that may be included in an international trade transaction?
A) Letter of Credit
B) Sight Draft
C) Order bill of lading
D) Federal funds transaction

True/False

1) The fundamental dilemma of foreign trade is being unwilling to trust a stranger in a foreign land.

20.3 Benefits of the System

Multiple Choice

1) The combination of a letter of credit, a sight draft, and an order bill of lading protect both parties in international transactions from which of the following?
A) the risk of noncompletion
B) the risk of foreign exchange risk (when combined with a various hedging techniques)
C) the risk that financing will not be available due to foreign exchange risk
D) All of these risks are reduced when using these trade implements.

True/False

1) If a foreign exchange transaction calls for payment in the importer’s currency, the exporter has the foreign exchange risk.

2) If a foreign exchange transaction calls for payment in the exporter’s currency, the importer has the foreign exchange risk.

3) In the case of international trade, the risk of nonpayment is essentially eliminated with the use of a letter of credit issued through a trustworthy bank.

20.4 Key Documents

Multiple Choice

1) Which of the following is NOT true regarding a letter of credit?
A) The importer and exporter agree on a transaction.
B) The importer applies to its local bank for the issuance of a letter of credit.
C) The exporter applies to its local bank for the issuance of a letter of credit.
D) The importer’s bank cuts a sales contract based on its assessment of the creditworthiness of the importer.

2) A/An ________ letter of credit is intended to serve as a means of arranging payment, but not as a guarantee of payment.
A) irrevocable
B) revocable
C) confirmed
D) unconfirmed

3) A/An ________ letter of credit is an obligation only of the issuing bank whereas other banks honor a/an ________ letter of credit.
A) irrevocable; unconfirmed
B) revocable; confirmed
C) confirmed; irrevocable
D) unconfirmed; confirmed

4) A letter of credit that is confirmed in the ________ country has the additional advantage of eliminating the problem of ________.
A) exporter’s; portfolio risk
B) importer’s; blocked foreign exchange
C) exporter’s; blocked foreign exchange
D) none of the above

5) The draft is the instrument normally used in international commerce to:
A) transfer product.
B) prove ownership.
C) transfer title.
D) initiate the sale.

6) The ________ is the instrument normally used to actually effect payment in international commerce.
A) banker’s acceptance
B) bill of exchange
C) bill of lading
D) letter of credit

7) The person or company initiating the draft or bill of exchange is known as the:
A) maker.
B) drawer.
C) originator.
D) any of the above

8) The person or company to whom the draft or bill of exchange is addressed is the:
A) drawee.
B) drawer.
C) maker.
D) originator.

9) Drafts that have been accepted by banks become:
A) clean drafts.
B) nonmarketable.
C) banker’s acceptances.
D) none of the above

10) Which of the following purposes is NOT served by the bill of lading?
A) It acts as a receipt.
B) It acts as a contract.
C) It acts as a document of title.
D) It acts as all of the above.

11) The ________ is issued to the exporter by a common carrier transporting the merchandise.
A) bill of lading
B) draft
C) banker’s acceptance
D) line of credit

12) A straight bill of lading is most likely to be used under which of the following circumstances?
A) when the merchandise has not been paid for in advance
B) when the transaction is being financed by a bank
C) when the shipment is to an affiliate
D) none of the above

13) To become a negotiable instrument, a draft must conform to the following requirements EXCEPT:
A) it must be in writing and signed by the maker or drawer.
B) it must be payable to order or to bearer.
C) it must be written in English.
D) it must be payable on demand or at a fixed or determinable future date.

True/False

1) A letter of credit is an agreement by the bank to pay against documents rather than the actual merchandise.

2) The primary advantage of a letter of credit is that it reduces risk.

3) The major advantage of a letter of credit to the exporter is that the exporter does not receive any funds until the documents have arrived at a local port or airfield.

4) To constitute a true letter of credit transaction, the issuing bank must receive a fee or other valid business consideration for issuing the L/C.

5) To constitute a true letter of credit transaction, the bank’s L/C must contain a specified expiration date or a definite maturity.

6) To constitute a true letter of credit transaction, the bank’s commitment must be open-ended and cannot have a stated maximum amount of money.

7) A revocable L/C is intended to serve as a means of arranging payment but not as a guarantee of payment.

8) A sight draft is payable on presentation to the drawee; a time draft allows a delay in payment.

9) A draft is sometimes called a revocable letter of credit.

10) A time draft is payable on presentation to the drawee; the drawee must pay at once or dishonor the draft. A sight draft, allows a delay in payment.

11) The bill of lading is issued to the exporter by a common carrier transporting the merchandise. It serves three purposes: a receipt, a contract, and a document of title.

Essay

1) Explain what a letter of credit (L/C) is, who the principle parties are, what the principle advantage is, and how the L/C facilitates international trade.

20.5 Example: Documentation in a Typical Trade Transaction

Multiple Choice

1) In a typical international trade transaction, the order of activity would be which of the following?
A) The foreign buyer places an order; The domestic manufacturer ships to the buyer; The manufacturer’s bank presents a draft and documents to the buyer’s bank for acceptance; The buyer’s bank submits payment to the manufacturer’s bank.
B) The domestic manufacturer ships to the buyer; The buyer’s bank submits payment to the manufacturer’s bank; The foreign buyer places an order; The domestic manufacturer ships to the buyer; The manufacturer’s bank presents a draft and documents to the buyer’s bank for acceptance.
C) The foreign buyer places an order; The manufacturer’s bank presents a draft and documents to the buyer’s bank for acceptance; The domestic manufacturer ships to the buyer; The buyer’s bank submits payment to the manufacturer’s bank.
D) The domestic manufacturer ships to the buyer; The manufacturer’s bank presents a draft and documents to the buyer’s bank for acceptance; The foreign buyer places an order; The buyer’s bank submits payment to the manufacturer’s bank.

True/False

1) Because of the risks involved in international trade, most transactions follow conventional methods and rarely require flexibility or creativity on the part of management.

Comment: Few international transactions are typical and often require flexibility or creativity on the part of management.

20.6 Government Programs to Help Finance Exports

Multiple Choice

1) The Export-Import Bank is an independent agency of the U.S. government established in 1934 to:
A) ship money abroad.
B) import agricultural products during the recession.
C) facilitate and stimulate foreign trade of the United States.
D) none of the above

2) In the United States, the Foreign Credit Insurance Corporation:
A) is a subsidiary of the Export-Import Bank.
B) provides letters of credit for U.S. importers.
C) provides letters of credit for U.S. exporters.
D) provides policies that protect U.S. exporters against default by foreign importers.

Instruction 20.1:
Use the information to answer the following question(s).

Cypress Systems Inc., of Florida, agrees to sell specialized hydroponic growing equipment to Landcaster’s of Australia. Because the two companies have never done business with each other, Cypress requires a banker’s acceptance as payment for the $1,000,000 order. The banker’s acceptance carries a 1.4% commission per annum and payment is to be received in 6 months. If Cypress Inc. chooses to discount or sell the bankers acceptance to its bank, the discount rate is 1.00% per annum.

3) Refer to Instruction 20.1. What is the size of the discount (not including the commission fee) Cypress must take for receiving the proceeds of the sale today rather than waiting for six months?
A) $7,000
B) $5,000
C) $12,000
D) $14.000

4) Refer to Instruction 20.1. What is the size of the commission Cypress will pay the bank for the banker’s acceptance?
A) $7,000
B) $5,000
C) $12,000
D) $14,000

5) Refer to Instruction 20.1. What is the total Cypress can expect to receive if the firm takes payment today?
A) $993,000
B) $995,000
C) $988,000
D) $996,000

6) Refer to Instruction 20.1. ________ is an unsecured promissory note.
A) A banker’s acceptance
B) An overdraft
C) A securitized loan
D) Commercial paper

7) Rogue Spices Inc. has a Canadian receivables contract for $200,000 due in 270 days. The firm has been approached by a factoring firm that offers to purchase the receivables at a 12% per annum discount plus a 1% charge for a nonrecourse clause. What is the annualized percentage all-in-cost of this factoring alternative?
A) 14.82%
B) 13.00%
C) 12.00%
D) 9.09%

True/False

1) The Foreign Credit Insurance Association is a branch of the U.S. federal government.

2) The Export-Import Bank (also called Eximbank) is an independent agency of the U.S. government, established in 1934 to stimulate and facilitate the foreign trade of the United States.

3) Essentially, the Eximbank lends dollars to borrowers inside the United States for the purchase of U.S. goods and services.

4) Banker’s acceptances can be used to finance only international trade receivables but not domestic trade receivables.

Essay

1) What is a banker’s acceptance? How are they initiated? Why are they desirable for the exporter?

20.7 Forfaiting: Medium- and Long-Term Financing

Multiple Choice

1) ________ is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit.
A) Forfeiting
B) Marketable Bank Shares
C) Forfaiting
D) Banker’s Acceptances

True/False

1) In effect, the forfaiter functions both as a money market firm and a specialist in packaging financial deals involving country risk.

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Week 5 DQ

ACC 206, ACC 303, ACC 304, ACC 350, ACC 401, ACC 410, ACC 555, ACC 556, ACC 557, ACC 560, ACC 562, ACC 563, ACC 564, ACC 565, ACC 571, ACC 576, BUS 230, BUS 309, BUS 310, BUS 322, BUS 325, BUS 335, BUS 365, BUS 402, BUS 430, BUS 508, BUS 515, BUS 517, BUS 518, BUS 519, BUS 521,BUS 536, CIS 210, CIS 499, CIS 501,CIS 505,CIS 513, CIS 518, CIS 519, CIS 524, CIS 562, ECO 302, ECO 305, ECO 405, ECO 410,ECO 450, ECO 550, FIN 317, FIN 320, FIN 350, FIN 534, FIN 535, FIN 540, HRM 500, HRM 510, HRM 522, HSA 590, LEG 320, LEG 500, MGT 510, MKT 475, MKT 500, MKT 515, PAD 500,PAD 530,

Week 5 Midterm Exam, Quiz, Assignments, Discussion Questions, Homework Problems,

Auditing and Assurance Services 14th Edition By Arens, Beasley and Elder – Test Bank

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

Learning Objective 1-1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 1-3

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

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

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

Learning Objective 1-4

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

Learning Objective 1-5

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

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

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

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

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

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

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

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

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

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

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

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

11) What are the five categories of attestation services?

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

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

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

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

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

Learning Objective 1-6

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

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

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

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

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

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

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

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

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

Learning Objective 1-7

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

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

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

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

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

Learning Objective 1-8

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

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

Learning Objective 2-1

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 2-2

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

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

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

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

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

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

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

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

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

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

Learning Objective 2-3

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

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

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

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

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

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

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

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

3) What are the major functions of the AICPA?

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

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

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

Learning Objective 2-5

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 2-6

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 2-7

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-1

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

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

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

B)
Company Controller Shareholders Board of Directors
No No Yes

C)
Company Controller Shareholders Board of Directors
Yes Yes No

D)
Company Controller Shareholders Board of Directors
Yes No No

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

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

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

B)
GAAS GAAP
Intro only Scope and Opinion

C)
GAAS GAAP
Intro and Scope Opinion only

D)
GAAS GAAP
Intro only All paragraphs

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

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

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

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

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

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

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

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

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

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

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

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

Garrett and Brown, CPAs

March, 2013

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

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

Auditor’s Report

To the president and management of EPM, Inc.

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

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

Harrington and Perry, LLP
December 31, 2012

Other information:

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

Required:

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-2

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

Learning Objective 3-3

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

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

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

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

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

Learning Objective 3-4

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-5

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

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

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

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

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

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

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

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

B)
Disclaimer Qualified Adverse
No Yes No

C)
Disclaimer Qualified Adverse
Yes No Yes

D)
Disclaimer Qualified Adverse
No Yes Yes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-6

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

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

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

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

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

8) Discuss how materiality affects audit reporting decisions.

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

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

Learning Objective 3-7

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

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

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

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

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

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

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

B)
Introductory Scope Opinion
Yes Yes No

C)
Introductory Scope Opinion
No Yes No

D)
Introductory Scope Opinion
No Yes Yes

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

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

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

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

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

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

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

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

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

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

B)
Introductory Scope Opinion Explanatory
Yes No Yes Yes

C)
Introductory Scope Opinion Explanatory
Yes No Yes No

D)
Introductory Scope Opinion Explanatory
No No Yes No

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

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

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

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

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

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

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

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

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

Independent Auditor’s Report

To the shareholders of Wallace Corporation

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

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

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

Required:

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

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

Independent Auditor’s Report

To the shareholders of Fast Times Corporation

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

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

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

Required:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Independent Auditor’s Report

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

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

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

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

Smith & Jones, CPAs
November 4, 2012

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

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

Smith’s Review Notes

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

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

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

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

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

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

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

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

Situation Opinion
Type Intro
Scope
Opinion
Exp1

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-8

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

B)
Introductory Scope Opinion Explanatory
No Yes Yes Yes

C)
Introductory Scope Opinion Explanatory
No No Yes Yes

D)
Introductory Scope Opinion Explanatory
No No Yes No

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 3-9

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

Learning Objective 4-1

1) There are no questions for this Learning Objective.

Learning Objective 4-2

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

Learning Objective 4-3

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

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

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

Learning Objective 4-4

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

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

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

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

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

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

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

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

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

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

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

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

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

B)
Employees Shareholders
Yes Yes

C)
Employees Shareholders
Yes Yes

D)
Employees Shareholders
Yes Yes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 4-5

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Violation? Yes No
Explanation:

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

Violation? Yes No
Explanation:

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

Violation? Yes No
Explanation:

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

Violation? Yes No
Explanation:

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

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

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

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

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

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

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

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

Learning Objective 4-6

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

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

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

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

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

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

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

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

Rule: ________ Violation? Yes No
Explanation:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 4-7

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 4-8

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

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

Learning Objective 5-1

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

Learning Objective 5-2

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

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

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

Learning Objective 5-3

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

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

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

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

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

B)
Punitive damages Compensatory damages
No No

C)
Punitive damages Compensatory damages
Yes No

D)
Punitive damages Compensatory damages
No Yes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 5-4

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 5-5

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

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

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

B)
Actual and potential stockholders Employees of client
No No

C)
Actual and potential stockholders Employees of client
Yes No

D)
Actual and potential stockholders Employees of client
No Yes

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

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

B)
A primary beneficiary A known third party
No No

C)
A primary beneficiary A known third party
Yes No

D)
A primary beneficiary A known third party
No Yes

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 5-6

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 5-7

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

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

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

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

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

Learning Objective 5-8

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 6-1

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

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

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

Learning Objective 6-2

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

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

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

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

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

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

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

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

Learning Objective 6-3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 6-4

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 6-7

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 6-8

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 6-10

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

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

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

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

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

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

6) List the four phases of a Financial Statement Audit

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

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

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

________ 1. An intentional misstatement of the financial statements.

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

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

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

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

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

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

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

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

Learning Objective 7-1

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

Learning Objective 7-2

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

B)
Sample size Timing of audit procedures
No No

C)
Sample size Timing of audit procedures
Yes No

D)
Sample size Timing of audit procedures
No Yes

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

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

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

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

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

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

Learning Objective 7-3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Learning Objective 7-4

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

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

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

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

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

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

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

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

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

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

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

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

B)
Test of Controls Planning Completion
No Yes Yes

C)
Test of Controls Planning Completion
Yes No No

D)
Test of Controls Planning Completion
No No No

Answer
Terms: Analytical procedures use during phases of the audit
Diff: Moderate
Objective: LO 7-4
AACSB: Analytic skills

11) Auditors may decide to replace tests of details with analytical procedures when possible because the:
A) analytical procedures are more reliable.
B) analytical procedures are considerably less expensive.
C) analytical procedures are more persuasive.
D) tests of details are more difficult to interpret.
Answer
Terms: Tests of details of balances; Substantive analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

12) When making decisions about evidence for a given audit, the auditor’s goal is to obtain a sufficient amount of timely, reliable evidence that is relevant to the information being verified. In addition, the goal of audit efficiency is to gather and evaluate the information:
A) no matter the cost involved in obtaining such evidence.
B) even if cost is irrelevant to the auditor, because they bill the client for costs incurred.
C) at the lowest possible total cost.
D) at the cost suggested in the engagement letter.
Answer
Terms: Goal of audit efficiency
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
13) “Physical examination” is the inspection or count by the auditor of items such as:
A) cash, inventory, and payroll timecards.
B) cash, inventory, canceled checks, and sales documents.
C) cash, inventory, canceled checks, and tangible fixed assets.
D) cash, inventory, securities, notes receivable, and tangible fixed assets.
Answer
Terms: Physical examination
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

14) Which of the following statements is most correct regarding the primary purpose of audit procedures?
A) to detect all errors or fraudulent activities as well as illegal activities
B) to comply with auditing standards promulgated by the PCAOB for publicly held clients
C) to gather corroborative audit evidence about management’s assertions regarding the client’s financial statements
D) to determine the amount of errors in the balance sheet accounts in order to adjust the accounts to actual
Answer
Terms: Primary purpose of audit procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

15) Given the audit procedures below, which one provides the most reliable evidence?
A) Confirmations
B) Recalculation
C) Reperformance
D) Observations
Answer
Terms: Audit procedure that provides most reliable evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

16) Confirmations would almost always be used, assuming all the accounts below are material, for:
A) individual transactions between organizations, such as sales transactions.
B) bank balances and accounts receivable.
C) fixed asset additions.
D) payroll expenses.
Answer
Terms: Confirmations
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
17) To be considered reliable evidence, confirmations must be controlled by:
A) a client employee responsible for accounts receivable.
B) a financial statement auditor.
C) a client’s internal audit department.
D) a client’s controller or CFO.
Answer
Terms: Confirmations controlled to be considered reliable evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

18) Indicate whether confirmation of accounts receivable and accounts payable, provided they each are significant accounts, is required or optional:
A)
Accounts Receivable Accounts Payable
Required Required

B)
Accounts Receivable Accounts Payable
Required Optional

C)
Accounts Receivable Accounts Payable
Optional Required

D)
Accounts Receivable Accounts Payable
Optional Optional

Answer
Terms: Confirmation of accounts receivable and accounts payable
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

19) The Auditing Standards Board has concluded that analytical procedures are so important that they are required during:
A) planning and test of control phases.
B) planning and completion phases.
C) test of control and completion phases.
D) planning, test of control, and completion phases.
Answer
Terms: Analytical procedures required
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
20) A benefit obtained from comparing the client’s data with industry averages is that it provides a(n):
A) benchmark to compare the company against industry averages.
B) indication where errors exist in the statements.
C) benchmark to be used in evaluating a client’s budgets.
D) comparison of “what is” with “what should be.”
Answer
Terms: Comparing client data with industry averages
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

21) The primary purpose of performing analytical procedures in the planning phase of an audit is to:
A) help the auditor obtain an understanding of the client’s industry and business.
B) assess the going concern assumption.
C) indicate possible misstatements.
D) reduce detailed tests.
Answer
Terms: Primary purpose of analytical procedures in planning phase of audit
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

22) Which of the following is not a correct combination of terms and related type of audit evidence?
A) Inquire  inquiries of client
B) Count  physical examination
C) Recompute  documentation
D) Read  documentation
Answer
Terms: Combination of terms and related audit evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

23) Which of the following is not one of the major types of analytical procedures?
A) compare client with industry averages
B) compare client with prior year
C) compare client with budget
D) compare client with SEC averages
Answer
Terms: Major type of analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
24) An important benefit of industry comparisons is as:
A) an aid to understanding the client’s business.
B) an indicator of errors.
C) an indicator of fraud.
D) a least-cost indicator for audit procedures.
Answer
Terms: Benefit of industry comparisons
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

25) The auditor is concerned that a client is failing to bill customers for shipments. An audit procedure that would gather relevant evidence would be to:
A) select a sample of duplicate sales invoices and trace each to related shipping documents.
B) trace a sample of shipping documents to related duplicate sales invoices.
C) trace a sample of Sales Journal entries to the Accounts Receivable subsidiary ledger.
D) compare the total of the Schedule of Accounts Receivable with the balance of the Accounts Receivable account in the general ledger.
Answer
Terms: Audit procedure to gather relevant evidence that client fails to bill
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

26) In performing your audit for a privately-held firm your inquiries have yielded that one of the company’s owner’s primary motivations is to pay the least amount of income tax that is possible. Based on this observation which audit objective for ending inventory would the auditor be most concerned about ascertaining?
A) Completeness
B) Accuracy
C) Rights and obligations
D) Existence
Answer
Terms: Audit objective for ending inventory
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

27) Which of the following statements is not correct?
A) Analytical procedures are used to isolate accounts or transactions that should be investigated more extensively.
B) For certain immaterial accounts, analytical procedures may be the only evidence needed.
C) In some instances, other types of evidence may be reduced when analytical procedures indicate that an account balance appears reasonable.
D) Analytical procedures use supporting documentation to determine which account balances need additional detailed procedures.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

28) You are auditing the company’s purchasing process for goods and services. You are primarily concerned with the company not recording all purchase transactions. Which audit procedure below would be the most effective audit procedure in this case?
A) Vouching from the accounts payable account to the vendor invoices.
B) Tracing vendor invoices to recorded amounts in the accounts payable account.
C) Confirmation accounts payable recorded amounts.
D) Reconciling the accounts payable subsidiary ledger to the accounts payable account.
Answer
Terms: Audit procedure for recording all purchase transactions
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

29) Which of the following discoveries through the use of analytical procedures would most likely indicate a relatively high risk of financial failure?
A) A decline in gross margin percentages.
B) An increase in the balance in fixed assets.
C) An increase in the ratio of allowance for uncollectible accounts to gross accounts receivable, while at the same time accounts receivable turnover also decreased.
D) A higher than normal ratio of long-term debt to net worth as well as a lower than average ratio of profits to total assets.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 7-4
AACSB: Analytic skills

30) Which of the following statements is correct regarding the costs involved in obtaining evidence?
A)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
Yes Yes

B)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
No No

C)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
Yes No

D)
Physical examination is usually the
least expensive type of audit
evidence Cost of obtaining evidence may be a factor in deciding whether to
obtain that evidence
No Yes

Answer
Terms: Costs in obtaining evidence
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

31) An analytical procedure used to test the reasonableness of an account balance occurs when the auditor calculates the expected balance and compares it with the actual balance. The auditor’s expected account balance may be determined by:
A) using industry standards.
B) using Dun and Bradstreet reports.
C) relating it to another account that involves financial statement articulation.
D) inquiry of the client.
Answer
Terms: Analytical procedure used to test reasonableness of an account balance
Diff: Challenging
Objective: LO 7-4
AACSB: Reflective thinking skills

32) One purpose of performing analytical procedures in the planning phase of an audit is to assess the client’s financial condition. Explain how the assessment of a client’s financial condition can affect the auditor’s decisions concerning evidence accumulation in later phases of the audit.

33) There are four important purposes of analytical procedures. Identify three of these four purposes and, for each purpose, give a specific example of an analytical procedure that an auditor might perform.

34) Define the following terms commonly used in audit procedures:
1. Examine
2. Scan
3. Compute
4. Foot
5. Compare
6. Count
7. Vouch

35) Below are 12 audit procedures. Classify each procedure according to the following types of audit evidence: (1) physical examination, (2) confirmation, (3) documentation, (4) observation, (5) inquiry of the client, (6) reperformance, and (7) analytical procedure.

Type of Evidence Audit Procedures
1. Watch client employees count inventory to determine whether company procedures are being followed.
2. Count inventory items and record the amount in the audit files.
3. Trace postings from the sales journal to the general ledger accounts.
4. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year.
5. Obtain information about the client’s internal controls by asking questions of client personnel.
6. Trace column totals from the cash disbursements journal to the general ledger.
7. Examine a piece of equipment to make sure a recent purchase of equipment was actually received and is in operation.
8. Review the total of repairs and maintenance for each month to determine whether any month’s total was unusually large.
9. Compare vendor names and amounts on purchase invoices with entries in the purchases journal.
10. Foot entries in the sales journal to determine whether they were correctly totaled by the client.
11. Make a surprise count of petty cash to verify that the amount of the petty cash fund is intact.
12. Obtain a written statement from the client’s bank stating the client’s year-end balance on deposit.

36) Match nine of the terms (a-k) with the definitions provided below (1-9):

a. Foot
b. Compute
c. Scan
d. Inquire
e. Count
f. Trace
g. Reperform
h. Read
i. Examine
j. Observe
k. Compare

________ 1. A calculation done by the auditor independent of the client.

________ 2. Addition of a column of numbers to determine if the total is the same as the client’s.

________ 3. A comparison of information in two different locations.

________ 4. A use of the senses to assess certain activities.

________ 5. Following details of transactions from original documents to journals.

________ 6. A less detailed examination of a document or record to determine if there is something unusual warranting further investigation.

________ 7. Obtaining information from the client in response to specific questions.

________ 8. A determination of assets on hand at a given time.

________ 9. An examination of written information to determine facts pertinent to the audit.

37) Match five of the terms (a-h) with the definitions provided below (1-5):

a. Audit documentation
b. Audit procedures
c. Audit objectives
d. Analytical procedures
e. Budgets
f. Reliability of evidence
g. Sufficiency of evidence
h. Persuasiveness of evidence

________ 1. Use of comparisons and relationships to assess the reasonableness of account balances.

________ 2. Detailed instructions for the collection of a type of audit evidence.

________ 3. The degree to which evidence can be considered believable or trustworthy.

________ 4. Contains all the information that the auditor considers necessary to conduct an adequate audit and to provide support for the audit report.

________ 5. This is determined by the amount of evidence obtained.

38) Confirmations are among the most expensive type of evidence to obtain.
A) True
B) False
Answer
Terms: Confirmations; Cost of evidence
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

39) Whenever practical and reasonable, the confirmation of accounts receivable is required of CPAs.
A) True
B) False
Answer
Terms: Confirmations of accounts receivable required of CPAs
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

40) Inquiries of clients and reperformance normally have a low cost associated with them.
A) True
B) False
Answer
Terms: Inquiries of clients and reperformance have low cost
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

41) When analytical procedures reveal unusual fluctuations in an account balance, the auditor will probably perform fewer tests of details for that account and increase the tests of controls related to the account.
A) True
B) False
Answer
Terms: Analytical procedures reveal unusual fluctuations
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills

42) The type of audit evidence known as inquiry requires the auditor to obtain oral information from the client in response to questions.
A) True
B) False
Answer
Terms: Audit evidence; Inquiry
Diff: Easy
Objective: LO 7-4
AACSB: Reflective thinking skills
43) Auditor judgment is the primary determinant in determining the amount of evidence gathered.
A) True
B) False
Answer
Terms: Auditor judgment; Evidence
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

44) Analytical procedures must be used in the planning and completion phases of the audit.
A) True
B) False
Answer
Terms: Analytical procedures used in planning and completion phases of audit
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

45) Confirmations are ordinarily used to verify account balances, but may be used to verify transactions.
A) True
B) False
Answer
Terms: Confirmations to verify balances and transactions
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

46) Accounts receivable confirmations must be controlled by the client from the time they are prepared until the time they are returned to the auditor.
A) True
B) False
Answer
Terms: Confirmations control
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

47) Cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size.
A) True
B) False
Answer
Terms: Cost of audit procedures; Sample size
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills
48) Analytical procedures can be used to provide reliable substantive evidence for all balance-related audit objectives.
A) True
B) False
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

49) One advantage of using statistical techniques when performing analytical procedures is that they eliminate the need for auditor judgment.
A) True
B) False
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 7-4
AACSB: Reflective thinking skills

Learning Objective 7-5

1) Which of the following best describes one of the primary objectives of audit documentation?
A) Defend against claims of a deficient audit.
B) Provide a basis for reviewing the work of subordinates.
C) Provide reasonable assurance that the audit was conducted in accordance with auditing standards.
D) Provide additional support of recorded amounts to the client.
Answer
Terms: Primary objective of audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

2) The permanent files included as part of audit documentation do not normally include:
A) a copy of the current and prior years’ audit programs.
B) copies of articles of incorporation, bylaws and contracts.
C) information related to the understanding of internal control.
D) results of analytical procedures from prior years.
Answer
Terms: Permanent files as audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills
3) The auditor’s results of evidence gathering procedures are contained in audit documentation for the audit. When preparing the requisite audit, documentation should be cognizant of:
A) Documents are kept by the client for easy reference for their accounting staff.
B) Audit documents should be considered as a substitute for the clients accounting records.
C) Audit documents are designed to facilitate the review and supervision of the work performed by the audit team by a reviewing partner.
D) Audit documents are the sole source of evidence that an auditor uses in forming an opinion about the client’s financial statements.
Answer
Terms: Audit documentation for audit
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

4) Audit documentation should provide support for:
A)
The audit report The financial statements
Yes Yes

B)
The audit report The financial statements
No No

C)
The audit report The financial statements
Yes No

D)
The audit report The financial statements
No Yes

Answer
Terms: Audit documentation should provide support
Diff: Challenging
Objective: LO 7-5
AACSB: Reflective thinking skills

5) Audit documentation is the joint property of the auditor and the audit client.
A) True
B) False
Answer
Terms: Audit documentation
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

6) Ordinarily, audit documentation can be provided to someone else only with the express permission of the client.
A) True
B) False
Answer
Terms: Audit documentation provided with permission of client
Diff: Moderate
Objective: LO 7-5
AACSB: Reflective thinking skills

Learning Objective 7-6

1) What client information is needed by auditors in creating lead schedules?
A) Interim statements prepared by the client for the company’s 3rd quarter financial results.
B) General ledger information, including unadjusted ending balances and beginning balances for accounts.
C) A schedule of adjusting entries made by the client for all balance sheet accounts.
D) Detailed transaction information that may explain the changes in balance sheet accounts for the current year under audit.
Answer
Terms: Client information needed for auditor to create lead schedules
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills

2) Audit documentation should possess certain characteristics. Which of the following is true regarding those characteristics?
A)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
Yes Yes

B)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
No No

C)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
Yes No

D)
Audit documentation should be indexed and cross-referenced Audit documentation should be organized to benefit the client’s staff
No Yes

Answer
Terms: Audit documentation characteristics
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills

3) The permanent audit file would usually include the following:
A) client’s working trial balance
B) summary of the risk assessment procedures performed
C) organizational chart of the company’s employees
D) summary of the auditors test of controls for the current years audit
Answer
Terms: Permanent file
Diff: Challenging
Objective: LO 7-6
AACSB: Reflective thinking skills
4) When determining sufficient and appropriate audit evidence in order to form an opinion on the client’s financial statements the auditor compiles audit documentation to support the opinion. The largest portion of audit documentation will include detailed supporting schedules prepared by the client or the auditor in support of specific accounts on the financial statements. The major types of supporting schedules include analysis schedules and tests of reasonableness. Discuss those two schedules and give an example for each schedule.

5) The basis for preparing financial statements for companies is the general ledger. As soon as possible the auditor obtains the general ledger accounts of the client and prepares a working trial balance. Discuss the audit documentation in the current file that relates to the working trial balance. Include a description of lead and support schedules in your answer.

Auditing and Assurance Services, 14e (Arens)
Chapter 8 Audit Planning and Analytical Procedures

Learning Objective 8-1

1) A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued is the:
A) inherent risk.
B) acceptable audit risk.
C) statistical risk.
D) financial risk.
Answer
Terms: Measure of how willing auditor is to accept that the financial statements may be materially misstated after audit is completed
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

2) A measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of the client’s internal control is called:
A) control risk.
B) acceptable audit risk.
C) statistical risk.
D) inherent risk.
Answer
Terms: A measure of auditor’s assessment of likelihood that there are material misstatements in an account before considering internal control
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

3) When inherent risk is high, there will need to be:
A)
A lower assessment of audit risk More evidence accumulated by the auditor
Yes Yes

B)
A lower assessment of audit risk More evidence accumulated by the auditor
No No

C)
A lower assessment of audit risk More evidence accumulated by the auditor
Yes No

D)
A lower assessment of audit risk More evidence accumulated by the auditor
No Yes

Answer
Terms: Inherent risk is high
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills
4) In what order should the following steps occur?
A. assess client business risk
B. understand the client’s business and industry
C. perform preliminary analytical procedures
D. assess acceptable audit risk
A) D, B, C, A
B) B, A, D, C
C) B, D, A, C
D) D, C, B, A
Answer
Terms: Steps in planning an audit
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills

5) The auditor uses knowledge gained from the understanding of the client’s business and industry to assess:
A) client business risk.
B) control risk.
C) inherent risk.
D) audit risk.
Answer
Terms: First standard of fieldwork; Proper planning
Diff: Challenging
Objective: LO 8-1
AACSB: Analytic skills
6) There are three main reasons why an auditor should properly plan audit engagements. Discuss each of these reasons.

7) When an auditor decides there is higher inherent risk for an account, one potential effect is that more audit evidence will be required for that account.
A) True
B) False
Answer
Terms: Inherent risk
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills
8) As acceptable audit risk is decreased, the likely cost of conducting an audit increases.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Easy
Objective: LO 8-1
AACSB: Reflective thinking skills

9) Acceptable audit risk is a measure of the auditor’s willingness to accept that the financial statements do not contain material misstatements after the audit is completed and a qualified audit report has been issued.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills

10) Two major factors that affect acceptable audit risk are the likely users of the financial statements and the likelihood of issuing an unqualified audit opinion.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 8-1
AACSB: Reflective thinking skills
Learning Objective 8-2

1) One of the purposes of an engagement letter is to avoid misunderstandings with the client. This is important for:
A)
Good client relations Facilitating high-quality work at a reasonable cost
Yes Yes

B)
Good client relations Facilitating high-quality work at a reasonable cost
No No

C)
Good client relations Facilitating high-quality work at a reasonable cost
Yes No

D)
Good client relations Facilitating high-quality work at a reasonable cost
No Yes

Answer
Terms: Engagement letter
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

2) The auditor is likely to accumulate more evidence when the audit is for a company:
A)
Which has large amounts of debt Which is to be sold in the near future
Yes Yes

B)
Which has large amounts of debt Which is to be sold in the near future
No No

C)
Which has large amounts of debt Which is to be sold in the near future
Yes No

D)
Which has large amounts of debt Which is to be sold in the near future
No Yes

Answer
Terms: Auditors accumulate more evidence when audit is for company
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills
3) Initial audit planning involves four matters. Which of the following is not one of these?
A) Develop an overall audit strategy.
B) Request that bank balances be confirmed.
C) Schedule engagement staff and audit specialists.
D) Identify the client’s reason for the audit.
Answer
Terms: Initial audit planning
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

4) Rodgers CPA has requested permission to communicate with predecessor auditor in order to review certain workpapers for high risk accounts for a new audit client. The new audit clients refusal to allow this communication to occur would impact Rodgers decision concerning:
A) the auditor’s ability to design audit tests.
B) possible scope exception due to lack of access.
C) integrity of management concerning possible accounting misstatements.
D) violation of the GAAP rules concerning consistency and comparability of financial information.
Answer
Terms: New audit clients refusal to allow communication between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

5) A successor auditor may perform which of the following for a new audit client?
A)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
Yes Yes

B)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
No No

C)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
Yes No

D)
Speak to local attorneys, banks and other businesses regarding the company’s reputation Speak to the predecessor auditors about disagreements they had with management
No Yes

Answer
Terms: Successor auditor may perform communication for new audit client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
6) Which of the following is not correct regarding an auditor’s decision that a lower acceptable audit risk is appropriate?
A) More evidence is accumulated.
B) Less evidence is accumulated.
C) Special care is required in assigning experienced staff.
D) Review of audit documentation is performed by personnel not assigned to the engagement.
Answer
Terms: Lower acceptable audit risk
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

7) A written understanding detailing what the auditors will do in determining if the financial statements are fair representations of the company’s financial statements and what the auditor expects from the client in performing an audit will normally be expressed in the:
A) management letter requested by the auditor.
B) engagement letter.
C) Audit Plan.
D) Audit Strategy for the client.
Answer
Terms: Written understanding detailing what auditor will do and what auditor expects from client in performing audit
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

8) If an auditor is requested to perform nonaudit services for a public company audit client, who is responsible for agreeing to those services with the audit firm?
A) the client’s management
B) the client’s chief executive officer
C) the client’s chief financial officer
D) the client’s audit committee
Answer
Terms: Responsibility for agreeing nonaudit services for a public company audit client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
Topic: SOX

9) Which of the following statements is true regarding communications between predecessor and successor auditors?
A) The burden of initiating the communication rests with the predecessor.
B) The predecessor’s response can be limited to stating that no information will be provided.
C) The predecessor should communicate with the successor only if the client is public.
D) There must be communication between the predecessor and successor if the successor is to accept the engagement.
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
10) The purpose of an engagement letter is to:
A) document the CPA firm’s responsibility to external users of the audited financial statements.
B) document the terms of the engagement.
C) notify the audit staff of an upcoming engagement so that personnel scheduling can be facilitated.
D) emphasize management’s responsibility for approving the audit program.
Answer
Terms: Purpose of engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
11) Written communication that the auditor will provide reasonable assurance for the detection of fraud is found in:
A) engagement letter.
B) representation letter.
C) responsibility letter.
D) client letter.
Answer
Terms: Written communication that auditor will provide reasonable assurance
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

12) Which of the following normally signs the engagement letter for an audit of a private company?
A) Management.
B) Board of directors representative
C) Audit committee representative
D) Corporate treasurer
Answer
Terms: Normally signs engagement letter for audit of private company
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

13) The first standard of field work, which states that the work is to be adequately planned and that assistants, if any, are to be properly supervised, recognizes that:
A) early appointment of the auditor is advantageous to the auditor and the client.
B) acceptance of an audit engagement after the close of the client’s fiscal year is generally not permissible.
C) appointment of the auditor subsequent to the physical count of inventories requires a disclaimer of opinion.
D) performance of substantial parts of the examination is necessary at interim dates.
Answer
Terms: Standard of field work; Audit planning
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
14) An engagement letter sent to a publicly held audit client usually would not include a:
A) reference to the auditor’s responsibility for the detection of errors or irregularities.
B) estimation of the time to be spent on the audit work by audit staff and management.
C) statement that management advisory services would be made available upon request.
D) reference to management’s responsibility for the financial statements.
Answer
Terms: Engagement letter sent to publicly held client
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

15) Jennings and Company has repositioned the firm’s business strategy from the basis of competing on costs to competing on product differentiation. All the following will increase, except:
A) Audit risk.
B) Business Risk.
C) Financial risk.
D) Risk of Material Misstatements.
Answer
Terms: Client repositioned firm’s business strategy
Diff: Moderate
Objective: LO 8-2
AACSB: Analytic skills

16) The purpose of the requirement in having communication between the predecessor and successor auditors is to:
A) allow the predecessor to disclose information which would otherwise be confidential.
B) help the successor auditor to evaluate whether to accept the engagement.
C) help the client by facilitating the change of auditors.
D) ensure the predecessor collects all unpaid fees prior to a change in auditor.
Answer
Terms: Purpose of having communication between predecessor and successor audit
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

17) The predecessor auditor is required to respond to the request of the successor auditor for information, but the response can be limited to stating that no information will be provided when:
A) the predecessor auditor has poor relations with the successor auditor.
B) the client is dissatisfied with the predecessor’s work.
C) there are actual or potential legal problems between the client and the predecessor.
D) the predecessor believes that the client lacks integrity.
Answer
Terms: Predecessor auditor respond to request of successor auditor for information
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills
18) Which of the following best expresses the requirement to establish with the client an understanding of the responsibilities the auditor and company is taking for the audit engagement?
A) Management asserts there are no material misstatements in the financials.
B) Auditors assert that the primary audit goal is audit efficiency.
C) Auditors assert that their primary responsibility is to plan and perform the audit in order to provide reasonable assurance as to the detection of material misstatement due to error or fraud.
D) Management’s assertion that they will provide the auditor with a risk assessment as to material misstatements due to errors or fraud in the company’s financial statements.
Answer
Terms: Understand responsibilities of the auditor and company for the audit
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

19) Early appointment of the independent auditor will enable:
A) a more thorough examination to be performed.
B) a proper study and evaluation of internal control to be performed.
C) sufficient competent evidential matter to be obtained.
D) a more efficient examination to be planned.
Answer
Terms: Early appointment of auditor
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

20) An auditor who accepts an audit engagement and does not possess the industry expertise of the business entity should:
A) engage financial experts familiar with the nature of the business entity.
B) obtain a knowledge of matters that relate to the nature of the entity’s business.
C) refer a substantial portion of the audit to another CPA who will act as the principal auditor.
D) first inform management that an unqualified opinion cannot be issued.
Answer
Terms: Auditor accepts audit engagement and does not possess industry expertise
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills
21) Which is usually included in an engagement letter?
A)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
Yes Yes

B)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
No No

C)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
Yes No

D)
Estimate of hours required to
complete audit Dollar estimate of fees to be billed to
the client
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills
22) Which is usually included in an engagement letter?
A)
A reference to GAAP A reference to GAAS
Yes Yes

B)
A reference to GAAP A reference to GAAS
No No

C)
A reference to GAAP A reference to GAAS
Yes No

D)
A reference to GAAP A reference to GAAS
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

23) Which is usually included in an engagement letter?
A)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
Yes Yes

B)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
No No

C)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
Yes No

D)
The financial statements are
the responsibility of the
company’s management Ratios to be used by the auditor in the planning phase
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

24) When may the auditor refer to a specialist in the audit report?
A)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
Yes Yes

B)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
No No

C)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
Yes No

D)
Only if the specialist’s report
results in a modification of the audit
opinion Only if the specialist assisted in the audit of an account material to the financial statements
No Yes

Answer
Terms: Auditors refer to specialist in audit report
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

25) Which is usually included in the engagement letter?
A)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
Yes Yes

B)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
No No

C)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
Yes No

D)
The projected type of opinion on the financials statement to be audited Name(s) of the client personnel responsible for supplying the auditor with information
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

26) Which is usually included in the engagement letter?
A)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
Yes Yes

B)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
No No

C)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
Yes No

D)
List of audit procedures to be used
in inventory observation The auditors’ assessment of Audit Risk
No Yes

Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

27) Discuss the factors an auditor should consider before accepting a company as an audit client.

28) Discuss the primary purpose of an audit engagement letter. Is an engagement letter required?

29) Discuss the essential activities involved in the initial planning of an audit.

30) Discuss the required communications between predecessor and successor auditors.

31) Discuss several reasons why an auditor may not wish to continue a relationship with an existing audit client.

32) Discuss four of the matters that should be specified in an engagement letter.

33) Before accepting a new client, most CPA firms investigate the company to determine its acceptability. However, AICPA confidentiality requirements prohibit CPA firms from contacting certain parties–namely the company’s attorneys and bankers–during this investigation.
A) True
B) False
Answer
Terms: Acceptance of new client
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

34) For prospective clients that have previously been audited by another CPA firm, the predecessor auditor is required to communicate with the successor auditor.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

35) When a successor auditor contacts a company’s previous auditor, the predecessor auditor is required to respond fully and without limit to the request for information.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

36) A predecessor auditor who has been contacted by a successor auditor for information about the client does not have to obtain permission from the former client before providing any confidential information to the successor auditor because the confidentiality requirement does not extend to former clients.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

37) An auditor must evaluate a specialist’s professional qualifications and understand the objectives of the specialist’s work.
A) True
B) False
Answer
Terms: Auditor evaluate specialist’s work
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills

38) To evaluate a specialist’s work the auditor must himself/herself be considered a specialist.
A) True
B) False
Answer
Terms: Auditor evaluated specialist’s work
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

39) An engagement letter establishes a clear understanding of the terms of the engagement between the client and the auditor, but it is optional for private companies.
A) True
B) False
Answer
Terms: Engagement letter
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

40) Because of the requirements of Rule 201 of the AICPA’s Code of Professional Conduct which state that auditors should “undertake only those professional services that the member or the member’s firm can reasonably expect to be completed with professional competence,” auditors are not normally permitted to consult with, or rely on the work of, outside specialists during an audit engagement.
A) True
B) False
Answer
Terms: Use of outside specialists during audit engagement
Diff: Easy
Objective: LO 8-2
AACSB: Reflective thinking skills
41) If a prospective client has been audited in the past, the successor auditor will typically rely solely on the representations about the client by the predecessor auditor.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

42) A major consideration in assigning staff to an audit engagement is the experience levels required for the work, while a less important consideration is maintaining staff continuity on the engagement.
A) True
B) False
Answer
Terms: Consideration in assigning staff to audit engagement
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

43) When a successor auditor requests information from a company’s previous auditor, and there are legal problems or disputes between the client and the predecessor auditor, the predecessor auditor’s response to the new auditor may be limited to stating that no information will be provided.
A) True
B) False
Answer
Terms: Communications between predecessor and successor auditors
Diff: Moderate
Objective: LO 8-2
AACSB: Reflective thinking skills

44) An engagement letter can affect the CPA firm’s legal responsibilities to the client, but does not affect responsibility to external users of audited financial statements.
A) True
B) False
Answer
Terms: Engagement letter
Diff: Challenging
Objective: LO 8-2
AACSB: Reflective thinking skills

Learning Objective 8-3

1) In making client acceptance decisions the audit firm will consider:
A) inherent and control risk of the client.
B) audit risk to the CPA Firm.
C) the client’s business risk and the CPA Firm’s engagement risk.
D) CPA Firm’s potential ongoing revenue from the audit client.
Answer
Terms: Client acceptance decisions
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

2) Most auditors assess inherent risk as high for related parties and related-party transactions because:
A) of the unique classification of related-party transactions required on the balance sheet.
B) of the lack of independence between the parties.
C) of the unique classification of related-party transactions required on the income statement.
D) it is required by generally accepted accounting principles.
Answer
Terms: Inherent risk assessed high for relate parties and transactions
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

3) The audit team gathers information about a new client’s business and industry in order to obtain:
A) an understanding of the clients internal control system for financial reporting.
B) an understanding of how economic events and transactions have an effect on the company’s financial statements.
C) information about engagement risk.
D) information regarding whether the company is engaging in financial statement fraud.
Answer
Terms: Information about new client’s business and industry
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

4) The auditor determines that Mathews Company occupies the 3rd floor of an office tower for which it pays no rent. The most likely explanation is:
A) they got lucky the landlord hasn’t noticed the lack of payments.
B) landlord has weak internal controls over billings.
C) related party transaction in which a major shareholder owns the office tower.
D) Matthews Company is engaging in fraudulent activities.
Answer
Terms: Auditor determines client occupies office for which it pays no rent
Diff: Moderate
Objective: LO 8-3
AACSB: Analytic skills

5) An official record of meetings of the board of directors and stockholders is included in the corporate:
A) bylaws.
B) charter.
C) minutes.
D) license.
Answer
Terms: Official record of meetings of board of directors and stockholders
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

6) Related party transactions may be indicated when another company:
A) Subsidizes certain operating expenses of the company
B) Purchases its securities at their fair value
C) Loans to company at market rates
D) Has had a distributor relationship with the company for 10 years
Answer
Terms: Related party transactions
Diff: Moderate
Objective: LO 8-3
AACSB: Analytic skills

7) Which one of the following is not an inherent risk factor in the financial statements?
A) The company made 3 acquistions during the year in different lines of business.
B) The company’s industry is experiencing downward pricing pressure for its goods and services.
C) The company’s inventory, because of multiple locations, is difficult to count.
D) The company has hired 3 different chief accounting officers for the year.
Answer
Terms: Inherent risk factor
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

8) An auditor should examine minutes of the board of directors’ meetings:
A) through the date of the financial statements.
B) through the date of the audit report.
C) only at the beginning of the audit.
D) on a test basis.
Answer
Terms: Minutes of the board of directors’ meetings
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

9) Which of the following would not likely be classified as a related-party transaction?
A) an advance of one week’s salary to an employee
B) sales of merchandise between affiliated companies
C) loans or credit sales to the principal owner of the client company
D) exchanges of equipment between two companies owned by the same person
Answer
Terms: Related-party transaction
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

10) Which of the following best describes the coporate minutes of an entity?
A) official record of the meetings of the board of directors and the stockholders
B) unofficial record of the meeting of the board of directors
C) official record of management meeting with investors and creditors of the company
D) unofficial record of the board of directors meetings
Answer
Terms: Corporate minutes
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

11) An auditor searching for related party transactions should obtain an understanding of each subsidiary’s relationship to the total entity because:
A) the business structure may be deliberately designed to obscure related party transactions.
B) this may reveal whether transactions would have taken place if the parties had been unrelated.
C) transactions may have been consummated on terms equivalent to arm’s-length transactions.
D) this may permit the audit of intercompany account balances to be performed as of concurrent dates.
Answer
Terms: Related party transactions; subsidiary relationships to total entity
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

12) Define the term “related party” and discuss why an auditor should identify the client’s related parties early in the audit.
Answer related party is an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. Auditors need to be aware of who the client’s related parties are early in the audit to enable the auditor to identify related-party transactions, especially those that have not been disclosed.
Terms: Related party
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

13) What documents do auditors routinely obtain to aid in their understanding of a client’s governance system? Briefly discuss each of these documents.
Answeruditors commonly obtain organizational structure, code of ethics, and the minutes of meetings of the board of directors and shareholders. Companies frequently communicate the entity’s values and ethical standards through policy statements and codes of conduct. The corporate minutes are the official record of the meetings of the board of directors and stockholders. They include summaries of the most important topics discussed and decisions made at the board meetings.
Terms: Documents for client’s governance system
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

14) What are three factors that have increased the importance of obtaining an understanding of a client’s business and industry? How can an auditor obtain this understanding?

15) There are three primary reasons for obtaining a thorough understanding of the client’s industry and external environment. What are these reasons?

16) Auditors should obtain copies of the client’s code of ethics and minutes of the meetings of the board of directors to aid in their understanding of the company’s management and governance structure.
A) True
B) False
Answer
Terms: Code of ethics and board of directors’ meeting minutes; Understanding of company management and governance structure
Diff: Easy
Objective: LO 8-3
AACSB: Reflective thinking skills

17) Inherent risks typically vary across industries.
A) True
B) False
Answer
Terms: Inherent risk
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

18) Transactions with related parties must be disclosed in the financial statements if they are deemed to be material.
A) True
B) False
Answer
Terms: Related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

19) All known related parties must be identified and included in the auditor’s permanent files related to the client.
A) True
B) False
Answer
Terms: Related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

20) Generally, auditors assess inherent risk as moderate for related party transactions because they expect clients to be aware of their scrutiny of such transactions.
A) True
B) False
Answer
Terms: Inherent risk for related parties
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

21) The cr code of ethics typically establishes the company’s fiscal year and frequency of stockholder meetings.
A) True
B) False
Answer
Terms: Code of ethics
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

22) Ordinarily, the auditor should review corporate minutes during the later stages of an audit.
A) True
B) False
Answer
Terms: Corporate minutes
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

23) Material transactions between the client and the client’s related parties must be disclosed in the auditor’s report.
A) True
B) False
Answer
Terms: Material related party transactions
Diff: Moderate
Objective: LO 8-3
AACSB: Reflective thinking skills

24) Two categories of audit-relevant information found in corporate code of ethics are authorizations and discussions of matters affecting inherent risk.
A) True
B) False
Answer
Terms: Code of ethics
Diff: Challenging
Objective: LO 8-3
AACSB: Reflective thinking skills

Learning Objective 8-4

1) An auditor has accessed client business risk and the risk to material misstatements to the clients financial statements. These are done in order to:
A) apply the audit risk model in determining the appropriate audit procedures to perform.
B) determine the reliance on the company’s internal control systems for financial reporting.
C) determine the test of balances to be performed by the audit team.
D) assure the CPA firm that they can perform the audit effectively and efficiently,
Answer
Terms: Business risk and risk of material misstatements
Diff: Moderate
Objective: LO 8-4
AACSB: Reflective thinking skills

2) Which of the following statements is most correct concerning audit risk?
A) Audit risk can be quantified with a reasonable degree of certainty.
B) Audit risk cannot be quantified with certainty.
C) Audit risk is the same for all audit client in the same industry.
D) Audit risk can be eliminated by having the correct audit procedures.
Answer
Terms: Audit risk
Diff: Moderate
Objective: LO 8-4
AACSB: Reflective thinking skills

3) Define business risk. List several factors that may impact the auditor’s assessment of business risk.
Answerusiness risk is the risk that a company will fail to achieve its objectives.
Factors that may impact business risk include:
• General economic conditions,
• Extent of competition within an industry,
• Changing regulatory requirements,
• Competence of management,
• Ability to maintain sufficient cash flows and secure financing, and
• Successful implementation of business strategies.
Terms: Business risk and factors that impact auditor’s assessment
Diff: Challenging
Objective: LO 8-4
AACSB: Reflective thinking skills

Learning Objective 8-5

1) Auditors routinely conduct analytical procedures in the planning, testing, and completion phases of the audit. Identify the primary and secondary purposes of performing analytical procedures in each phase of the audit.

Learning Objective 8-6

1) During audit planning, the auditor uses analytical procedures primarily to:
A) identify weaknesses in internal control.
B) determine if the company’s financial statements appear reasonable and are free of material misstatement.
C) determine the correspondence of the company’s financial statements to the valuation and accuracy audit objectives.
D) understand the client’s business and industry and to indicate possible misstatements.
Answer
Terms: Audit planning phase and primary purpose of analytical procedures
Diff: Moderate
Objective: LO 8-6
AACSB: Reflective thinking skills

2) Which of the following is most correct with respect to the use of analytical procedures?
A) Analytical procedures may be used in evaluating balances in the testing phase as long as the auditor also uses them in assessing the going concern assumption.
B) Analytical procedures must be used throughout the audit.
C) Analytical procedures used in the testing phase of the audit are primarily used to direct an auditor’s attention so that the auditor’s understanding of the business is improved.
D) Analytical procedures are performed by studying plausible relationships between financial and nonfinancial data.
Answer
Terms: Use of analytical procedures
Diff: Challenging
Objective: LO 8-6
AACSB: Reflective thinking skills

3) Which of the following statements is not correct?
A) Analytical procedures used in the planning phase of the audit are primarily directed at understanding the client’s business and directing the auditor’s attention to areas that may contain possible misstatements.
B) Analytical procedures used in the completion phase are primarily aimed at assessing going concern and secondarily aimed at directing the auditor’s attention to areas that may contain possible misstatements.
C) Analytical procedures must be used in the planning and completion phases of the audit, and are optional in the testing phase.
D) Analytical procedures used in the completion phase are primarily aimed at directing the auditor’s attention to areas that may contain possible misstatements and secondarily aimed at assessing going concern.
Answer
Terms: Analytical procedures
Diff: Challenging
Objective: LO 8-6
AACSB: Reflective thinking skills

4) Discuss the four primary purposes of analytical procedures performed during the planning phase of an audit.

5) One purpose of performing preliminary analytical procedures in the planning phase of an audit is to help the auditor make a preliminary assessment of control risk.
A) True
B) False
Answer
Terms: Preliminary analytical procedures
Diff: Moderate
Objective: LO 8-6
AACSB: Reflective thinking skills

Learning Objective 8-7

1) Which of the following best describes the first standard of field work?
A) The auditor must adequately plan the work and properly supervise any assistants.
B) The auditor must have adequate technical training and proficiency to perform the audit.
C) The auditor must maintain independence in mental attitude in all matters relating to the audit.
D) The auditor must exercise due professional care in the performance of the audit and the preparation of the report.
Answer
Terms: Risk of material misstatement with accounting estimates
Diff: Easy
Objective: LO 8-7
AACSB: Reflective thinking skills

2) Which of the following would not be classified as an analytical procedure?
A) Benchmarking the company’s profitability ratios against others in the industry.
B) Variance analysis of actual versus budgeted amounts for production.
C) Reperforming the client’s depreciation expense using the client’s accounting policies for capital expenditures made during the year.
D) Reconciling fixed asset dispositions with the fixed asset ledger .
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 8-7
AACSB: Reflective thinking skills

3) Which of the following statements is not correct with respect to analytical procedures?
A) Auditing standards emphasize the need for auditors to develop and use expectations.
B) Analytical procedures must be performed throughout the audit.
C) Analytical procedures may be performed at any time during the audit.
D) Analytical procedures use comparisons and relationships to assess whether account balances appear reasonable.
Answer
Terms: Analytical procedures
Diff: Moderate
Objective: LO 8-7
AACSB: Reflective thinking skills

4) When performing planning analytical procedures for a client the auditor detected that the gross profit percentage had declined by 50% from the previous year to the year currently under audit. The auditor should:
A) investgate the possibility the client may have made an error in their cost of goods sold computation.
B) assist management in developing greater cost efficiencies in their product line.
C) prepare a going concern opinion for the client.
D) advise the client to have extensive disclosure to alleviate investor concerns.
Answer
Terms: Analytical procedures in planning phase
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills
5) When are auditors likely to encounter judgment problems in the use of analytical procedures?
A) Whenever the auditor places reliance on management’s explanations for unusual fluctuations in account balances without first developing independent expectations.
B) Whenever the auditor allows unaudited balances to unduly influence his/her expectations of current balances.
C) Whenever the auditor fails to consider the pattern reflected by several unusual fluctuations when trying to explain what caused them.
D) The auditor is likely to encounter judgment problems in each of the above instances.
Answer
Terms: Judgment problems in use of analytical procedures
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills

6) The major concern when using nonfinancial data in analytical procedures is the:
A) accuracy of the nonfinancial data.
B) source of the nonfinancial data.
C) type of nonfinancial data.
D) presence of multiple sources of nonfinancial data.
Answer
Terms: Concern when using nonfinancial data in analytical procedures
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills

7) Whenever an auditor compares client data to client-prepared budgets, there are two special concerns. Indicate if the two items below are concerns.
A)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
A concern A concern

B)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
Not a concern Not a concern

C)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
A concern Not a concern

D)
Assessing whether the budgets were realistic plans Client data may have been altered to conform to the budget
Not a concern A concern

Answer
Terms: Comparison of client data to client-prepared budgets
Diff: Challenging
Objective: LO 8-7
AACSB: Reflective thinking skills
Learning Objective 8-8

1) Which is a liquidity activity ratio?
A) Profit margin
B) Inventory turnover
C) Return on assets
D) Times interest earned
Answer
Terms: Liquidity ratio
Diff: Moderate
Objective: LO 8-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 9 Materiality and Risk

Learning Objective 9-1

1) If it is probable that the judgment of a reasonable person will be changed or influenced by the omission or misstatement of information, then that information is, by definition of FASB Statement No. 2:
A) material.
B) insignificant.
C) significant.
D) relevant.
Answer
Terms: FASB Statement No. 2; Probable judgment of a reasonable person
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

2) The scope paragraph of the standard unqualified auditor’s report states that “… the standards require that we plan and perform the audit to obtain ________ assurance about whether the financial statements are free of material misstatement”. What type of assurance is given?
A) immediate
B) limited
C) reasonable
D) absolute
Answer
Terms: Type of assurance provided
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

3) Auditors are responsible for determining whether financial statements are materially misstated, so upon discovering a material misstatement they must bring it to the attention of:
A) regulators.
B) the audit firm’s managing partner.
C) the client shareholders.
D) the client’s management.
Answer
Terms: Discovery of a material misstatement must bring it to the attention
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills

4) The FASB definition of materiality focuses on potential users of financial statements.
A) True
B) False
Answer
Terms: Materiality focuses on potential users
Diff: Easy
Objective: LO 9-1
AACSB: Reflective thinking skills
Learning Objective 9-2

1) Audit standards require the auditor to consider materiality early in the audit. Which statement(s) regarding preliminary materiality are true?
I. Preliminary materiality may change during the engagement.
II. Preliminary materiality is the maximum amount the auditor by which the auditor believes the financials could be misstated and still not affect the decisions of reasonable users.
A) I only
B) II only
C) both I and II
D) neither are true
Answer
Terms: Preliminary materiality assessment
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

2) Why do auditors establish a preliminary judgment about materiality?
A) To determine the appropriate level of staff to assign to the audit.
B) So that the client can know what records to make available to the auditor.
C) To plan the appropriate audit evidence to accumulate and develop an overall audit strategy.
D) To finalize the control risk assessment.
Answer
Terms: Purpose to establish preliminary judgment about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

3) If an auditor establishes a relatively high level for materiality, then the auditor will:
A) accumulate more evidence than if a lower level had been set.
B) accumulate less evidence than if a lower level had been set.
C) accumulate approximately the same evidence as would be the case were materiality lower.
D) accumulate an undetermined amount of evidence.
Answer
Terms: High level for materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

4) The preliminary judgment about materiality and the amount of audit evidence accumulated are ________ related.
A) directly
B) indirectly
C) not
D) inversely
Answer
Terms: Preliminary judgment about materiality and amount of evidence accumulated
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
5) Which of the following is the primary basis used to decide materiality for a for-profit entity?
A) net sales
B) net assets
C) net income before tax
D) all of the above
Answer
Terms: Primary basis to decide materiality for a for-profit entity
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

6) Auditing standards ________ that the basis used to determine the preliminary judgment about materiality be documented in the audit files.
A) permit
B) do not allow
C) require
D) strongly encourage
Answer
Terms: Auditing standards; Preliminary judgment about materiality documented
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

7) Amounts involving fraud are usually considered ________ important than unintentional errors of equal dollar amounts.
A) less
B) no less
C) no more
D) more
Answer
Terms: Amounts involving fraud
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

8) Qualitative factors can affect an auditor’s assessment of materiality. Which of the following qualitative factors could influence the assessment of materiality?
I. Misstatements that are otherwise immaterial may be material if they affect earnings trends.
II. Minor misstatements resulting from the consequences of contractual obligations.
A) I only
B) II only
C) I and II
D) neither I nor II
Answer
Terms: Qualitative factors can affect auditor’s assessment of materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
9) The five steps in applying materiality are listed below in random order.
1. Estimate the combined misstatement.
2. Estimate the total misstatement in the segment.
3. Set preliminary judgment about materiality.
4. Allocate preliminary judgment about materiality to segments.
5. Compare combined estimate with preliminary judgment about materiality.
The first three steps in correct sequence would be:
A) 1, 2, 5
B) 3, 4, 2
C) 2, 1, 5
D) 3, 2, 4
Answer
Terms: Five steps in applying materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

10) Which of the following statements is not correct?
A) Materiality is a relative rather than an absolute concept.
B) The most important base used as the criterion for deciding materiality is total assets.
C) Qualitative factors as well as quantitative factors affect materiality.
D) Given equal dollar amounts, frauds are usually considered more important than errors.
Answer
Terms: Materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

11) Certain types of misstatements are likely to be more important than other types to users, even if the dollar amounts are the same. Which of the following demonstrates this?
A)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
Yes Yes

B)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
No No

C)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
Yes No

D)
Amounts involving frauds are considered more important than
errors of equal amount Misstatements that are otherwise immaterial may be material if they affect a trend in earnings
No Yes

Answer
Terms: Certain types of misstatements are likely more important than other types
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

12) When setting a preliminary judgment about materiality:
A) more evidence is required for a low dollar amount than for a high dollar amount.
B) less evidence is required for a low dollar amount than for a high dollar amount.
C) the same amount of evidence is required for either low or high dollar amounts.
D) there is no relationship between it and the dollar amount of evidence needed.
Answer
Terms: Setting preliminary judgment about materiality
Diff: Challenging
Objective: LO 9-2
AACSB: Reflective thinking skills

13) Lewis Corporation has a few large accounts receivable that total one million dollars whereas
Clark Corporation has many small accounts receivable that total one million dollars. Misstatement in any one account is more significant for Lewis corporation because of the concept of:
A) Materiality.
B) Audit risk.
C) Reasonable assurance.
D) Comparative analysis.
Answer
Terms: Misstatements
Diff: Challenging
Objective: LO 9-2
AACSB: Reflective thinking skills
14) Material misstatement is the magnitude of misstatement that makes a reasonable person either change their mind or be influenced by the misstatement. Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor’s preliminary judgment about materiality.

15) Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor’s materiality judgment, and give an example of each.

16) The auditor’s preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users.
A) True
B) False
Answer
Terms: Preliminary judgments about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills
17) Preliminary judgments about materiality are often changed during the course of the engagement.
A) True
B) False
Answer
Terms: Preliminary judgments about materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

18) Net assets are the most often used base for deciding materiality.
A) True
B) False
Answer
Terms: Base for deciding materiality
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

19) The lower the dollar amount of the preliminary judgment the more audit evidence is required.
A) True
B) False
Answer
Terms: Amount of preliminary judgment and audit evidence required
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

20) Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment.
A) True
B) False
Answer
Terms: Qualitative factors affecting preliminary materiality judgment; Fraud
Diff: Easy
Objective: LO 9-2
AACSB: Reflective thinking skills

21) Auditors have difficulty applying the concept of materiality in practice because they often do not know who the users of the financial statements are or what decisions will be made.
A) True
B) False
Answer
Terms: Difficulty in applying concept of materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills
22) Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establish a preliminary materiality level, thus eliminating the need for subjective auditor judgment in this task.
A) True
B) False
Answer
Terms: Statements on Auditing Standards; Objective guidance on establishing preliminary materiality level
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

23) If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease.
A) True
B) False
Answer
Terms: Preliminary judgment of materiality and audit evidence
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

24) Net income before tax is the normal base used to determine materiality in a non-for-profit company.
A) True
B) False
Answer
Terms: Base used to determine materiality
Diff: Moderate
Objective: LO 9-2
AACSB: Reflective thinking skills

Learning Objective 9-3

1) When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance is referred to as:
A) the materiality range.
B) the error range.
C) tolerable materiality.
D) tolerable misstatement.
Answer
Terms: Allocate preliminary judgment about materiality to account balances
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills
2) Auditors generally allocate the preliminary judgment about materiality to the:
A) balance sheet only.
B) income statement only.
C) income statement and balance sheet.
D) statement of cash flows.
Answer
Terms: Preliminary materiality allocation
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills

3) Which of the following is an incorrect statement regarding the allocation of the preliminary judgment about materiality to balance sheet accounts?
A) Auditors expect certain accounts to have more misstatements than others.
B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence.
C) Auditors expect to identify overstatements as well as understatements in the accounts.
D) Relative audit costs affect the allocation.
Answer
Terms: Allocation of preliminary judgment about materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

4) Which of the following statements is true concerning the allocation of preliminary materiality?
A) It is necessary to allocate preliminary materiality to financial statements as a whole rather than by segments.
B) Preliminary materiality should be allocated to income statement accounts only.
C) It is required by the SEC.
D) When preliminary materiality is allocated to segments it is termed tolerable misstatement.
Answer
Terms: Allocation of preliminary materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

5) Which of the following statements is false?
A) Either an overstatement of an asset account or an understatement of a liability account would have the same effect on the income statement.
B) A misclassification in the balance sheet will have no effect on operating income.
C) Either an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
D) Either an understatement of an asset account or an overstatement of a liability account would have the same effect on the income statement.
Answer
Terms: Effects of misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
6) Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts?
A)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes No Yes

B)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes Yes No

C)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
Yes Yes Yes

D)
Certain accounts contain
more misstatements
than others Only overstatements
need be considered Audit costs can
affect allocation
No Yes No

Answer
Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

7) When tolerable misstatement is exceeded by ________ the auditor should request the client to adjust their account balance.
I. Known misstatements
II. Projected misstatement
A) I only
B) II only
C) I and II
D) None of the above
Answer
Terms: Tolerable misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
8) When allocating materiality, most practitioners choose to allocate to:
A) the income statement accounts because they are more important.
B) the balance sheet accounts because there are fewer.
C) both balance sheet and income statement accounts because there could be errors on either.
D) all of the financial statements because it is required by GAAS.
Answer
Terms: Allocating materiality
Diff: Challenging
Objective: LO 9-3
AACSB: Reflective thinking skills

9) Tolerable misstatement as set by the auditor:
A) decreases acceptable audit risk.
B) increases inherent risk and control risk.
C) affects planned detection risk.
D) does not affect any of the four risks.
Answer
Terms: Tolerable misstatements
Diff: Challenging
Objective: LO 9-3
AACSB: Reflective thinking skills

10) Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts.
Answerllocating the preliminary judgment about materiality to individual accounts (segments) is necessary because evidence is accumulated for accounts (segments) rather than for the financial statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement amount for each account, which helps the auditor decide the appropriate audit evidence to accumulate for each account. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because most income statement misstatements have an equal effect on the balance sheet due to the nature of double-entry accounting. Because there are fewer balance sheet accounts than income statement accounts in most audits, and because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts.
Terms: Allocation of the preliminary judgment about materiality
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills
11) Auditor’s allocate the preliminary judgment about materiality to financial statement segments rather than by financial statements as a whole. What is the term for the auditor’s allocation of preliminary misstatement to account balances? What are three difficulties auditor’s face when allocating materiality to balance sheet accounts?

12) Most practitioners allocate the preliminary judgment about materiality to balance sheet accounts.
A) True
B) False
Answer
Terms: Allocate preliminary judgment about materiality to balance sheet accounts
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

13) The primary purpose of allocating the preliminary judgment about materiality to financial statement accounts is to help the auditor decide the appropriate evidence to accumulate.
A) True
B) False
Answer
Terms: Primary purpose of allocating the preliminary judgment about materiality
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills

14) Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts.
A) True
B) False
Answer
Terms: Allocating materiality; Consideration of overstatements and understatements
Diff: Easy
Objective: LO 9-3
AACSB: Reflective thinking skills
15) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would need to obtain more audit evidence for that account than if $100,000 had been assigned.
A) True
B) False
Answer
Terms: Tolerable misstatements and audit evidence
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

16) To maximize audit efficiency, the auditor should allocate less tolerable misstatement to accounts that can be verified by using low-cost audit procedures, such as analytical procedures, than to accounts that are more costly to audit.
A) True
B) False
Answer
Terms: Maximize audit efficiency, allocate less tolerable misstatements
Diff: Moderate
Objective: LO 9-3
AACSB: Reflective thinking skills

Learning Objective 9-4

1) Auditors are ________ to document the known and likely misstatements in the financial statements under audit.
A) permitted
B) required
C) not allowed
D) strongly encouraged
Answer
Terms: Known and likely misstatements in the financial statements
Diff: Easy
Objective: LO 9-4
AACSB: Reflective thinking skills

2) ________ misstatements are those where the auditor can determine the amount of the misstatement in the account.
A) Potential
B) Likely
C) Known
D) Projected
Answer
Terms: Misstatements where auditor can determine the amount
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

3) Likely misstatements can result from:
A)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
No Yes Yes

B)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
Yes Yes No

C)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
No No Yes

D)
Computation of the
sampling error for the
cash account Differences between management’s and an auditor’s judgment about account balances Projections of
misstatements based on
an auditor’s tests of a
sample from a
population
Yes No No

Answer
Terms: Likely misstatements result from
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

4) When expressing an unqualified opinion, the auditor who evaluates the audit findings should be satisfied that the:
A) amount of known misstatement is documented in the management representation letter.
B) estimate of the total known and likely misstatements is less than a material amount.
C) estimate of the total likely misstatement includes sample error.
D) amount of known misstatement is acknowledged and recorded by the client.
Answer
Terms: Evaluating audit findings and materiality
Diff: Challenging
Objective: LO 9-4
AACSB: Reflective thinking skills
5) Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur.

6) Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, tolerable misstatement, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged.

1. An increase in acceptable audit risk.________.
2. An increase in inherent risk. ________.
3. A decrease in control risk. ________.
4. An increase in planned detection risk. ________.
5. An increase in tolerable misstatement. ________.

7) The preliminary judgment on materiality is compared to an estimated total misstatements to determine if an account balance is materially misstated.
A) True
B) False
Answer
Terms: Preliminary judgment on materiality; Estimated total misstatments
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

8) Total estimated misstatements include known misstatements and projected misstatements plus a sampling error.
A) True
B) False
Answer
Terms: Total estimated misstatements and sampling error
Diff: Moderate
Objective: LO 9-4
AACSB: Reflective thinking skills

Learning Objective 9-5

1) An auditor who audits a business cycle that has low inherent risk should:
A) increase the amount of audit evidence gathered.
B) assign more experienced staff to that area.
C) increase the tolerable misstatement for the area.
D) expand planning procedures.
Answer
Terms: Low inherent risk
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills

2) Which of the following audit risk components may be assessesed in non-quantitative terms?
A)
Control Risk Inherent Risk Detection Risk
Yes Yes Yes

B)
Control Risk Inherent Risk Detection Risk
Yes Yes No

C)
Control Risk Inherent Risk Detection Risk
No No Yes

D)
Control Risk Inherent Risk Detection Risk
No No No

Answer
Terms: Audit risk components assessed in non-quantitative terms
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills
3) Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would:
A) increase materiality levels.
B) decrease detection risk.
C) decrease substantive testing.
D) increase inherent risk.
Answer
Terms: Control risk and planned audit risk model
Diff: Moderate
Objective: LO 9-5
AACSB: Reflective thinking skills

4) Which of the following underlies the application of generally accepted auditing standards?
A) the elements of materiality and relative risk
B) the element of internal control
C) the element of corroborating evidence
D) the element of reasonable assurance
Answer
Terms: Underlies application of generally accepted auditing standards
Diff: Challenging
Objective: LO 9-2 and LO 9-5
AACSB: Reflective thinking skills

5) Why do auditors use the audit risk model when planning an audit?

6) The risk of material misstatement is a combination of two client controlled factors: inherent risk and control risk. What is inherent risk, why is it important and give examples of inherent risk factors.

7) The most important element of the audit risk model is control risk.
A) True
B) False
Answer
Terms: Audit risk model and control risk
Diff: Easy
Objective: LO 9-5
AACSB: Reflective thinking skills

8) The audit risk model that must be used for planning audit procedures and evaluating audit results is:
DR
IR × CR = AAR.
A) True
B) False
Answer
Terms: Audit risk model
Diff: Moderate
Objective: LO 9-5
AACSB: Reflective thinking skills
Learning Objective 9-6

1) The measurement of the auditor’s assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal controls is defined as:
A) Audit risk.
B) Inherent risk.
C) Sampling risk.
D) Detection risk.
Answer
Terms: Assessment of likelihood of material misstatements due to error or fraud
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

2) The risk that audit evidence for a segment will fail to detect misstatements exceeding tolerable misstatement is:
A) Audit risk.
B) Control risk.
C) Inherent risk.
D) Planned detection risk.
Answer
Terms: Risk audit evidence will fail to detect misstatements
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

3) As the risk of material misstatement increases, detection risk should:
A) medium increase.
B) decrease.
C) stay the same.
D) Is indeterminate.
Answer
Terms: Risk of material misstatement increases, detection risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

4) Inherent risk is ________ related to detection risk and ________ related to the amount of audit evidence.
A) directly, inversely
B) directly, directly
C) inversely, inversely
D) inversely, directly
Answer
Terms: Relationship of inherent risk, detection risk, and amount of audit evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
5) Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________.
A) detection risk
B) audit report risk
C) acceptable audit risk
D) inherent risk
Answer
Terms: Audit assurance, overall assurance and level of assuranc
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

6) If planned detection risk is reduced, the amount of evidence the auditor accumulates will:
A) increase.
B) decrease.
C) remain unchanged.
D) be indeterminate.
Answer
Terms: Planned detection risk and amount of evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

7) Planned detection risk
I. determines the amount of substantive evidence the auditor plans to accumulate.
II. is dependent on inherent risk and control risk.
A) I only
B) II only
C) I and II
D) None of the above
Answer
Terms: Planned detection risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

8) Inherent risk is often high for an account such as:
A) inventory.
B) land.
C) cash.
D) notes payable.
Answer
Terms: Inherent risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
9) Inherent risk and control risk:
A) are inversely related to each other.
B) are inversely related to detection risk.
C) are directly related to detection risk.
D) are directly related to audit risk.
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

10) To what extent do auditors typically rely on internal controls of their public company clients?
A) extensively
B) only very little
C) infrequently
D) never
Answer
Terms: Extent auditor rely on internal controls of public company client
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
Topic: Public

11) Auditors typically rely on internal controls of their private company clients:
A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements.
B) only if the controls are determined to be effective.
C) only if the client asks an auditor to test controls.
D) only if the controls are sufficient to increase Control Risk to an acceptable level.
Answer
Terms: Extent auditor rely on internal controls of private company client
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

12) Acceptable audit risk is ordinarily set by the auditor during planning and:
A) held constant for each major cycle and account.
B) held constant for each major cycle but varies by account.
C) varies by each major cycle and by each account.
D) varies by each major cycle but is constant by account.
Answer
Terms: Acceptable audit risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills
13) The risk of material misstatement refers to:
A) control risk and acceptable audit risk.
B) inherent risk.
C) the combination of inherent risk and control risk.
D) inherent risk and audit risk.
Answer
Terms: Risk of material misstatements
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

14) The risk of material misstatement differs from detection risk in that it:
A) arises because audit procedures have been misapplied.
B) can be controlled and changed by the auditor.
C) can be assessed in quantitative and non-quantitative terms.
D) is controllable by the client.
Answer
Terms: Difference between material misstatement and detection risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

15) Auditors may assess inherent risk and control risk:
A)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
Yes Yes

B)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
No No

C)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
Yes No

D)
Jointly to determine the risk of
material misstatement Separately and combine their effects in the audit risk model
No Yes

Answer
Terms: Auditor may assess inherent risk and control risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills
16) In a financial statement audit, inherent risk is evaluated to help an auditor asses which of the following?
A) The internal audit department’s objectivity in reporting a material misstatement of a financial statement assertion it detects to the audit committee.
B) The risk the internal control system will not detect a material misstatement of a financial statement assertion.
C) The risk that the audit procedures implemented will not detect a material misstatement of a financial statement assertion.
D) The susceptibility of a financial statement assertion to a material misstatement assuming there are no related controls.
Answer
Terms: Inherent risk assessment
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

17) Which of the following statements is not true?
A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required.
B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit evidence required.
C) Inherent risk is the susceptibility of the financial statements to material error, assuming no internal controls.
D) Inherent risk and control risk are assessed by the auditor and function independently of the financial statement audit.
Answer
Terms: Inherent risk
Diff: Challenging
Objective: LO 9-6
AACSB: Reflective thinking skills

18) Match nine of the terms (a-i) with the definitions provided below (1-9):

a. Business risk
b. Preliminary judgment about materiality
c. Inherent risk
d. Planned detection risk
e. Audit assurance
f. Acceptable audit risk
g. Tolerable misstatement
h. Control risk
i. Materiality

________ 1. A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.

________ 2. The risk that the auditor or audit firm will suffer harm because of a client relationship, even though the audit report rendered for the client was correct.

________ 3. A measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client’s internal controls.

________ 4. A measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued.

________ 5. The materiality allocated to any given account balance.

________ 6. The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.

________ 7. This term is synonymous with acceptable audit risk.

________ 8. The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed.

________ 9. A measure of the auditor’s assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control.

19) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high.
A) True
B) False
Answer
Terms: Relationship of acceptable audit risk, inherent risk, control risk, and planned detection risk.
Diff: Easy
Objective: LO 9-5 and LO 9-6
AACSB: Reflective thinking skills

20) Tolerable misstatement does not affect audit risk, inherent risk, control risk, or planned detection risk yet the combination of the tolerable misstatement and the four risks will determine the amount of planned audit evidence.
A) True
B) False
Answer
Terms: Tolerable misstatements; Audit risk, inherent risk, control risk, and planned detection risk
Diff: Challenging
Objective: LO 9-3 and LO 9-6
AACSB: Reflective thinking skills
21) A high detection risk equates to a low amount of audit evidence needed.
A) True
B) False
Answer
Terms: Detection risk and amount of evidence needed
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

22) For a private company client, auditors are required to test any internal controls they believe have not been operating effectively during the period under audit.
A) True
B) False
Answer
Terms: Auditors required to test internal controls for private companies
Diff: Easy
Objective: LO 9-6
AACSB: Reflective thinking skills

23) Insert risk and control risk are normally assessed for the each segment but sets audit risk at the financial statement level.
A) True
B) False
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

24) Acceptable audit risk and the amount of substantive evidence required are inversely related.
A) True
B) False
Answer
Terms: Acceptable audit risk and substantive evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

25) As control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase.
A) True
B) False
Answer
Terms: Control risk and substantive evidence
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills
26) Inherent risk and control risk are directly related.
A) True
B) False
Answer
Terms: Inherent risk and control risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

27) An acceptable audit risk assessment of low indicates a risky client requiring more extensive evidence, assignment of more experienced personnel, and/or a more extensive review of audit files.
A) True
B) False
Answer
Terms: Acceptable audit risk
Diff: Moderate
Objective: LO 9-6
AACSB: Reflective thinking skills

Learning Objective 9-7

1) If an auditor believes the chance of financial failure is high and there is a corresponding increase in business risk for the auditor, acceptable audit risk would likely:
A) be reduced.
B) be increased.
C) remain the same.
D) be calculated using a computerized statistical package.
Answer
Terms: Increase in business risk, acceptable audit risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

2) When management has an adequate level of integrity for the auditor to accept the engagement but cannot be regarded as completely honest in all dealings, auditors normally:
A) reduce acceptable audit risk and increase inherent risk.
B) reduce inherent risk and control risk.
C) increase inherent risk and control risk.
D) increase acceptable audit risk and reduce inherent risk.
Answer
Terms: Management integrity
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills
3) When the auditor is attempting to determine the extent to which external users rely on a client’s financial statements, they may consider several factors except for:
A) client size.
B) concentration of ownership.
C) types and amounts of liabilities.
D) assessment of detection risk.
Answer
Terms: Extent to which external users rely on client’s financial statements
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

4) There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit risk. Discuss three of these factors.
Answerusiness risk and acceptable audit risk are affected by:
• The degree to which external users will rely on the statements. For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal.
• The likelihood that a client will have financial difficulties after the audit report is issued. Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties.
• The auditor’s evaluation of management’s integrity. Business risk is greater and acceptable audit risk will be lower when the client’s management has questionable integrity.
Terms: Factors that affect business risk and acceptable audit risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills
5) Describe the audit risk model and each of its components.

6) Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk.
A) True
B) False
Answer
Terms: Audit assurance and planned detection risk
Diff: Moderate
Objective: LO 9-6 and LO 9-7
AACSB: Reflective thinking skills
7) If an auditor believes the client will have financial difficulties after the audit report is issued, and external users will be relying heavily on the financial statements, the auditor will probably set acceptable audit risk as low.
A) True
B) False
Answer
Terms: Auditor believes client will have financial difficulties after audit report is issued; External users rely heavily on financial statements
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

8) Engagement risk is effectively the audit firm’s business risk.
A) True
B) False
Answer
Terms: Engagement risk and business risk
Diff: Moderate
Objective: LO 9-7
AACSB: Reflective thinking skills

Learning Objective 9-8

1) Which of the following statements regarding inherent risk is correct?
A) Inherent risk is unaffected by the auditor’s experience with client’s organization.
B) Most auditors set a low inherent risk in the first year of an audit and increase it if experience shows that it was incorrect.
C) Most auditors set a high inherent risk in the first year of an audit and reduce it in subsequent years as they gain experience, even when there is inherent risk.
D) Inherent risk is dependent upon the strengths in client’s internal control system.
Answer
Terms: Inherent risk
Diff: Easy
Objective: LO 9-8
AACSB: Reflective thinking skills

2) Auditors begin their assessments of inherent risk during audit planning. Which of the following would not help in assessing inherent risk during the planning phase?
A) Obtaining client’s agreement on the engagement letter.
B) Obtaining knowledge about the client’s business and industry.
C) Touring the client’s plant and offices.
D) Identifying related parties.
Answer
Terms: Assessment of inherent risk during audit planning
Diff: Easy
Objective: LO 9-8
AACSB: Reflective thinking skills
3) Which of the following is not a primary consideration when assessing inherent risk?
A) nature of client’s business
B) existence of related parties
C) degree of separation of duties
D) susceptibility to defalcation
Answer
Terms: Assessing inherent risk
Diff: Challenging
Objective: LO 9-8
AACSB: Reflective thinking skills

4) Harker, CPA is in the audit planning phase of Dracule Industries. An understanding needs to be established regarding the responsibilities of Harker and Dracule’s Management. For each of the task items listed below indicate the responsible party from the list of choices given. Each choice may be used once, more than once or not at all.
Task to be performed:
1. Obtain an understanding of internal controls
2. Preparation of the financial statements
3. Assess inherent risk
4. Following GAAP or IFRS
5. Establish internal controls
6. Detect Material Error
7. Comply with laws and regulations
8. Assess the risk of the allowance for doubtful accounts estimate
9. Determine the known and likely errors or misstatements Responsible Party:
a. Auditor is responsible
b. Management is responsible
c. Both are responsible
d. Neither are responsible

1) As the acceptable level of detection risk increases, an auditor may change the:
A) timing of substantive tests by performing them at an interim date rather than year end.
B) timing of the tests on controls by performing them throughout the year rather than at one time.
C) assess the level of inherent risk to a lower amount.
D) increase the sample size to achieve a more effective test.
Answer
Terms: Detection risk
Diff: Moderate
Objective: LO 9-9
AACSB: Reflective thinking skills

2) In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or acceptable audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for planned detection risk and the amount of evidence you would plan to gather (“planned evidence”) using the terms high, medium, or low.
Acceptable audit risk
Inherent risk
Control risk
Planned detection risk
Planned evidence
SITUATION
1
Low
High
High
________
________
SITUATION
2
Low
Low
Low
________
________
SITUATION
3
High
Low
Medium
________
________
SITUATION
4
High
Low
Low
________
________

3) Dracule Industries is a privately owned business that sells medical product and devices to hospitals, clinics and the public. Certain changes have occurred in Dracule Industries during the year undergoing the audit. Harker needs to evaluate the effect these changes have on audit risk. Audit risk at the financial statement level is influenced by the risk of material misstatement; which include factors related to management, the industry and the entity or a combination thereof. For each of the following changes that have occurred during the year under audit identify the appropriate audit response for the list of responses. Each response can be used once, more than once or not at all.
Client changes:
1. An internal audit department has been established.
2. A new inventory control system has been installed that reduces the access of unauthorized parties.
3. Inexperienced accounting personnel were hired in the accounting department.
4. Excess cash was used to purchase complex derivatives.
5. Controls over the sales credit approval process have laxed.
6. New government regulations now apply to Dracule Industries.
7. Management has become overly aggressive in reaching target goals.
8. An expert was hired to help determine the value of the ore content in ending materials inventory. Possible effect on the audit:
a. Increase the acceptable level of detection risk.
b. Decrease the acceptable level of detection risk.
c. Change has no effect on the acceptable level of detection risk.

Auditing and Assurance Services, 14e (Arens)
Chapter 10 Section 404 Audits of Internal Control and Control Risk

Learning Objective 10-1

1) Which of the following is not one of the three primary objectives of effective internal control?
A) reliability of financial reporting
B) efficiency and effectiveness of operations
C) compliance with laws and regulations
D) assurance of elimination of business risk
Answer
Terms: Internal control objective
Diff: Easy
Objective: LO 10-1
AACSB: Analytic skills

2) The Public Company Accounting Oversight Board states that reasonable assurance allows a:
A) small likelihood of ineffective internal controls.
B) remote likelihood that material misstatements will not be prevented or detected by internal control.
C) likelihood that material misstatements will not be prevented or detected by internal control.
D) high likelihood that material misstatements will not be prevented or detected by internal control.
Answer
Terms: Reasonable assurance
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: Public

3) Which of the following is most correct regarding the requirements under Section 404 of the Sarbanes Oxley Act?
A) The audits of internal control and the financial statements provide reasonable assurance as to misstatements.
B) The audit of internal control provides absolute assurance of misstatement.
C) The audit of financial statements provides absolute assurance of misstatement.
D) The audits of internal control and the financial statements provide absolute assurance as to misstatements.
Answer
Terms: Sarbanes Oxley Act Section 404
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills

4) Which of management’s assertions with respect to implementing internal controls is the auditor primarily concerned?
A) efficiency of operations
B) reliability of financial reporting
C) effectiveness of operations
D) compliance with applicable laws and regulations
Answer
Terms: Management’s assertions
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills

5) To issue a report on internal control over financial reporting for a public company, an auditor must:
A) evaluate management’s assessment process.
B) independently assess the design and operating effectiveness of internal control.
C) evaluate management’s assessment process and independently assess the design and operating effectiveness of internal control.
D) test controls over significant account balances.
Answer
Terms: Internal control over financial reporting for public company
Diff: Moderate
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: Public

6) A company frequently sells products at a price below inventory cost. Essential controls in the risk assessment process would include:
A) adequate controls that address the risk of overstating inventory.
B) adequate controls that address the risk of not including a purchased item in inventory.
C) adequate controls that address the risk of understatement of inventory.
D) adequate controls that address the risk of overstatement of cost of goods sold.
Answer
Terms: Controls in risk assessment process
Diff: Moderate
Objective: LO 10-1
AACSB: Analytic skills

7) Internal controls are not designed to provide reasonable assurance that:
A) all frauds will be detected.
B) transactions are executed in accordance with management’s authorization.
C) access to assets is permitted only in accordance with management’s authorization.
D) company personnel comply with applicable rules and regulations.
Answer
Terms: Internal controls; reasonable assurance
Diff: Moderate
Objective: LO 10-1
AACSB: Analytic skills

8) Describe each of the three broad objectives management typically has for internal control. With which of these objectives is the auditor primarily concerned?

9) The Sarbanes-Oxley Act of 2002 requires that public companies issue an internal control report.
A) True
B) False
Answer
Terms: Sarbanes-Oxley Act
Diff: Easy
Objective: LO 10-1
AACSB: Reflective thinking skills
Topic: SOX

10) The primary emphasis by auditors when evaluating and testing internal control is on controls over classes of transactions rather than controls over account balances.
A) True
B) False
Answer
Terms: Evaluating and testing internal controls
Diff: Moderate
Objective: LO 10-1
AACSB: Reflective thinking skills

Learning Objective 10-2

1) Which of the following is responsible for establishing a private company’s internal control?
A) Senior Management
B) Internal Auditors
C) Senior Management and auditors
D) Audit committee
Answer
Terms: Internal control
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

2) Two key concepts that underlie management’s design and implementation of internal control are:
A) costs and materiality.
B) absolute assurance and costs.
C) inherent limitations and reasonable assurance.
D) collusion and materiality.
Answer
Terms: Internal control design and implementation
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills

3) The PCAOB places responsibility for the reliability of internal controls over the financial reporting process to:
A) the company’s board of directors.
B) the audit committee of the board of directors.
C) the CEO and the CFO.
D) the CFO and the Independent Auditors.
Answer
Terms: PCAOB; internal control responsibility
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

4) Which of the following parties provides an assessment of the effectiveness of internal control over financial reporting for public companies?
A)
Management Financial statement auditors
Yes Yes

B)
Management Financial statement auditors
No No

C)
Management Financial statement auditors
Yes No

D)
Management Financial statement auditors
No Yes

Answer
Terms: Internal control effectiveness
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

5) An act of two or more employees to steal assets and cover their theft by misstating the accounting records would be referred to as:
A) collusion.
B) a material weakness.
C) a control deficiency.
D) a significant deficiency.
Answer
Terms: Employees steal assets
Diff: Easy
Objective: LO 10-2
AACSB: Ethical understanding and reasoning abilities

6) Sarbanes-Oxley requires management to issue an internal control report that includes two specific items. Which of the following is one of these two requirements?
A) A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
B) A statement that management and the board of directors are jointly responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
C) A statement that management, the board of directors, and the external auditors are jointly responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
D) A statement that the external auditors are solely responsible.
Answer
Terms: Sarbanes-Oxley; Internal control report
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: SOX
7) When management is evaluating the design of internal control, management evaluates whether the control can do which of the following?
A)
Detect material misstatements Correct material misstatements
Yes Yes

B)
Detect material misstatements Correct material misstatements
No No

C)
Detect material misstatements Correct material misstatements
Yes No

D)
Detect material misstatements Correct material misstatements
No Yes

Answer
Terms: Internal control design
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills
Topic: SOX

8) When one material weakness is present at the end of the year, management of a public company must conclude that internal control over financial reporting is:
A) insufficient.
B) inadequate.
C) ineffective.
D) inefficient.
Answer
Terms: Internal control weakness; Public company
Diff: Easy
Objective: LO 10-2
AACSB: Analytic skills
Topic: Public

9) The auditors primary purpose in auditing the client’s system of internal control over financial reporting is:
A) to prevent fraudulent financial statements from being issued to the public.
B) to evaluate the effectiveness of the company’s internal controls over all relevant assertions in the financial statements.
C) to report to management that the internal controls are effective in preventing misstatements from appearing on the financial statements.
D) to efficiently conduct the Audit of Financial Statements.
Answer
Terms: Primary purpose to audit system of internal control
Diff: Moderate
Objective: LO 10-2
AACSB: Analytic skills
Topic: Public
10) Management must disclose material weaknesses in internal control in its audit report:
A) whenever the weakness is deemed significant to a single class of transactions.
B) whenever the weakness is significant to overall financial reporting objectives.
C) if the weakness exists at the end of the year.
D) only if the auditor identifies the weakness as significant.
Answer
Terms: Material weaknesses in internal control
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

11) In performing the audit of internal control over financial reporting the auditor emphasizes internal control over class of transactions because:
A) the accuracy of accounting system outputs depends heavily on the accuracy of inputs and processing.
B) the class of transaction is where most fraud schemes occur.
C) account balances are less important to the auditor then the changes in the account balances.
D) classes of transactions tests are the most efficient manner to compensate for inherent risk.
Answer
Terms: Internal control over class of transactions
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: Public

12) Internal controls can never be regarded as completely effective. Even if company personnel could design an ideal system, its effectiveness depends on the:
A) adequacy of the computer system.
B) proper implementation by management.
C) ability of the internal audit staff to maintain it.
D) competency and dependability of the people using it.
Answer
Terms: Internal control effectiveness
Diff: Moderate
Objective: LO 10-2
AACSB: Ethical understanding and reasoning abilities

13) Even with the most effectively designed internal control, the auditor must obtain audit evidence, beyond testing the controls, for every:
A) transaction.
B) financial statement account.
C) material financial statement account.
D) financial statement account that will be relied upon by third parties.
Answer
Terms: Effectively designed internal controls; testing of controls
Diff: Moderate
Objective: LO 10-2
AACSB: Analytic skills
14) Of the following statements about internal controls, which one is least likely to be correct?
A) No one person should be responsible for the custodial responsibility and the recording responsibility for an asset.
B) Transactions must be properly authorized before such transactions are processed.
C) Because of the cost-benefit relationship, a client may apply controls on a test basis.
D) Control procedures reasonably ensure that collusion among employees cannot occur.
Answer
Terms: Internal controls
Diff: Moderate
Objective: LO 10-2
AACSB: Reflective thinking skills

15) The Sarbanes-Oxley Act requires:
A) all public companies to issue reports on internal controls.
B) all public companies to define adequate internal controls.
C) the auditor of public companies to design effective ICFR.
D) the auditor of public companies to provide recommendations to correct material weaknesses.
Answer
Terms: Sarbanes-Oxley Act
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills
Topic: SOX

16) The financial statements may not correctly reflect accounting frameworks such as AAP or IFRS if the:
A) controls affecting the reliability of financial reporting are inadequate.
B) company’s controls do not promote efficiency.
C) company’s controls do not promote effectiveness.
D) company’s controls do not promote compliance with applicable rules and regulations.
Answer
Terms: Financial statements reflect accounting frameworks
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills

17) The primary emphasis by auditors is on controls over:
A) classes of transactions.
B) account balances.
C) both A and B, because they are equally important.
D) both A and B, because they vary from client to client.
Answer
Terms: Primary emphasis by auditors on controls
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills
18) An auditor should consider two key issues when obtaining an understanding of a client’s internal controls. These issues are:
A) the effectiveness and efficiency of the controls.
B) the frequency and effectiveness of the controls.
C) the design and implementation of the controls.
D) the implementation and efficiency of the controls.
Answer
Terms: Key issues understanding client’s internal controls
Diff: Challenging
Objective: LO 10-2
AACSB: Reflective thinking skills

19) When a company designs and implements internal controls, cost of the controls is not a valid consideration.
A) True
B) False
Answer
Terms: Design and implement internal control; cost
Diff: Easy
Objective: LO 10-2
AACSB: Reflective thinking skills

Learning Objective 10-3

1) Which of the following activities would be least likely to strengthen a company’s internal control?
A) separating accounting from other financial operations
B) maintaining insurance for fire and theft
C) fixing responsibility for the performance of employee duties
D) carefully selecting and training employees
Answer
Terms: Not strengthen internal control
Diff: Easy
Objective: LO 10-3
AACSB: Analytic skills

2) Which of the following components of the control environment define the existing lines of responsibility and authority?
A) Organizational Structure
B) Management philosophy and operating style
C) Human resource policies and practices
D) Management integrity and ethical values
Answer
Terms: Control environment components; Responsibility and authority
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

3) Which of the following factors may increase risks to an organization?
A)
Geographic dispersion of
company operations Presence of new information technologies
Yes Yes

B)
Geographic dispersion of
company operations Presence of new information technologies
No No

C)
Geographic dispersion of
company operations Presence of new information technologies
Yes No

D)
Geographic dispersion of
company operations Presence of new information technologies
No Yes

Answer
Terms: Increase risks to an organization
Diff: Moderate
Objective: LO 10-3
AACSB: Analytic skills

4) Which of the following statements is most correct with respect to separation of duties?
A) Employees should not have temporary and permanent custody of assets.
B) Employees who authorize transactions should not have custody of related assets.
C) It is permissible to allow an employee to open cash receipts and record those receipts.
D) Employees who authorize transactions should have recording responsibility for these transactions.
Answer
Terms: Separation of duties
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

5) Authorizations can be either general or specific. Which of the following is not an example of a general authorization?
A) Automatic reorder points for raw materials inventory.
B) A sales manager’s authorization for a sales return.
C) Credit limits for various classes of customers.
D) A sales price list for merchandise.
Answer
Terms: General or specific authorizations
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
6) Which of the following is correct with respect to the design and use of business documents?
A) Not all documents used for internal purposes need to be prenumbered.
B) Documents should be designed for single purposes only to avoid confusion in their use.
C) Documents should be designed to be understandable only by those who use them.
D) Documents designed for external use must be prenumbered.
Answer
Terms: Design and use of business documents
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

7) Which of the following best describes the purpose of control activities?
A) the actions, policies and procedures that reflect the overall attitudes of management
B) the identification and analysis of risks relevant to the preparation of financial statements
C) the policies and procedures that help ensure that necessary actions are taken to address risks to the achievement of the entity’s objectives
D) activities that deal with the ongoing assessment of the quality of internal control by management
Answer
Terms: Control activities
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

8) Which of the following deal with ongoing or periodic assessment of the quality of internal control by management?
A) Quality monitoring activities
B) Monitoring activities
C) Oversight activities
D) Management activities
Answer
Terms: Quality of internal control
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

9) Which of the following best describes an entity’s accounting information and communication system?
A)
Monitor
transactions Record and
process
transactions Initiate transactions
Yes Yes Yes

B)
Monitor
transactions Record and
process
transactions Initiate transactions
No No No

C)
Monitor
transactions Record and
process
transactions Initiate transactions
Yes No No

D)
Monitor
transactions Record and
process
transactions Initiate transactions
No Yes Yes

Answer
Terms: Accounting information and communication system
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

10) An audit procedure that would most likely be used by an auditor in performing tests of control procedures in which the segregation of functions and that leaves no “audit” trail is:
A) inspection.
B) observation.
C) reperformance.
D) reconciliation.
Answer
Terms: Tests of control procedures; segregation of functions
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

11) Internal controls normally include procedures designed to provide reasonable assurance that:
A) employees act with integrity when performing their assigned tasks.
B) transactions are executed in accordance with management’s authorization.
C) decision processes leading to management’s authorization of transactions are sound.
D) collusive activities would be detected by segregation of employee duties.
Answer
Terms: Internal controls; reasonable assurance
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
12) Which of the following is not one of the subcomponents of the control environment?
A) management’s philosophy and operating style
B) organizational structure
C) adequate separation of duties
D) commitment to competence
Answer
Terms: Subcomponents of control environment
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

13) It is important for the CPA to consider the competence of the clients’ personnel because their competence bears directly and importantly upon the:
A) cost/benefit relationship of the system of internal control.
B) achievement of the objectives of internal control.
C) comparison of recorded accountability with assets.
D) timing of the tests to be performed.
Answer
Terms: Competence of client personnel
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

14) Proper segregation of functional responsibilities calls for separation of:
A) authorization, execution, and payment.
B) authorization, recording, and custody.
C) custody, execution, and reporting.
D) authorization, payment, and recording.
Answer
Terms: Segregation of functional responsibilities
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

15) Which of the following is correct regarding management’s documentation of internal controls?
A) inadequate documentation is not a control deficiency
B) documentation needs to focus on interim controls
C) documentation needs to have some focus on controls designed to detect fraud
D) documentation should only focus on system design
Answer
Terms: Documentation of internal control
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills
16) Which of the following groups establishes and maintains the company’s internal controls?
A) Internal auditors
B) Board of Directors
C) Management
D) Audit committee
Answer
Terms: Establishes and maintains company’s internal control
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

17) The independent auditor should acquire an understanding of the internal audit function as it relates to the independent auditor’s study and evaluation of internal control because the:
A) audit programs, working papers, and reports of internal auditors can often be used as a substitute for the work of the independent auditor’s staff.
B) procedures performed by the internal audit staff may eliminate the independent auditor’s need for an extensive study and evaluation of internal control.
C) work performed by internal auditors may be a factor in determining the nature, timing, and extent of the independent auditor’s procedures.
D) understanding of the internal audit function is an important substantive test to be performed by the independent auditor.
Answer
Terms: Understanding of internal audit functions
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills

18) To promote operational efficiency, the internal audit department would ideally report to:
A) line management.
B) senior management.
C) Chief Accounting Officer.
D) audit committee.
Answer
Terms: Operational efficiency
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

19) Hanlon Corp. maintains a large internal audit staff that reports directly to the chief financial officer. Audit reports prepared by the internal auditors indicate that the system is functioning as it should and that the accounting records are reliable. An independent auditor will probably:
A) eliminate tests of controls.
B) increase the depth of the study and evaluation of administrative controls.
C) avoid duplicating the work performed by the internal audit staff.
D) place limited reliance on the work performed by the internal audit staff.
Answer
Terms: Internal audit
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills
20) External financial statement auditors must obtain evidence regarding what attributes of an internal audit (IA) department if the external auditors intend to rely on IA’s work?
A) Integrity
B) Objectivity
C) Competence
D) All of the above
Answer
Terms: External auditor reliance on internal auditors’ work
Diff: Challenging
Objective: LO 10-3
AACSB: Reflective thinking skills

21) To obtain an understanding of an entity’s control environment, an auditor should concentrate on the substance of management’s policies and procedures rather than their form because:
A) management may establish appropriate policies and procedures but not act on them.
B) the board of directors may not be aware of management’s attitude toward the control environment.
C) the auditor may believe that the policies and procedures are inappropriate for that particular entity.
D) the policies and procedures may be so weak that no reliance is contemplated by the auditor.
Answer
Terms: Substance of management’s policies and procedures
Diff: Challenging
Objective: LO 10-3
AACSB: Analytic skills

22) Control activities help assure that the necessary actions are taken to address risks to the achievement of the company’s objectives. List the five types of control activities.

several of these principles.

24) Management’s identification and analysis of risk is an ongoing process and is a critical component of effective internal control. An important first step is for management to identify factors that may increase risk. Identify at least five factors, observable by management, which may lead to increased risk in a typical business organization.

25) Separation of duties is essential in preventing errors and intentional misstatements on the financial statements. List below the four general guidelines.

26) In developing an understanding of the client’s accounting information system the auditor follows a sequential process. Describe the process below:

27) The internal control framework developed by COSO includes five so-called “components” of internal control. Discuss each of these five components.

28) Discuss what is meant by the term “control environment” and identify four control environment subcomponents that the auditor should consider.

29) Adequate separation of duties is an important control activity. Discuss the four general guidelines for separation of duties to prevent both intentional and unintentional misstatements that are of significance to auditors.

30) As a client’s information system becomes more complex, it is likely that an auditor will increase reliance on controls and decrease substantive tests to support a control risk assessment.
A) True
B) False
Answer
Terms: Complex information system
Diff: Easy
Objective: LO 10-3
AACSB: Analytic skills

31) Adequate documents and records is a subcomponent of the control environment.
A) True
B) False
Answer
Terms: Control environment
Diff: Easy
Objective: LO 10-3
AACSB: Reflective thinking skills

32) The chart of accounts is a control and is closely related to the controls related to adequate documents and records.
A) True
B) False
Answer
Terms: Chart of accounts
Diff: Easy
Objective: LO 10-3
AACSB: Reflective thinking skills

33) Auditing standards prohibit reliance on the work of internal auditors due to the lack of independence of the internal auditors.
A) True
B) False
Answer
Terms: Auditing standards; internal auditors
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills
34) If an auditor wishes to rely on the work of internal auditors (IA), the auditor must obtain satisfactory evidence related to the IA’s competence, integrity, and objectivity.
A) True
B) False
Answer
Terms: Internal auditors
Diff: Moderate
Objective: LO 10-3
AACSB: Reflective thinking skills

Learning Objective 10-4

1) When the auditor attempts to understand the operation of the accounting system by tracing a few transactions through the accounting system, the auditor is said to be:
A) tracing.
B) vouching.
C) performing a walk-through.
D) testing controls.
Answer
Terms: Tracing transactions through accounting system
Diff: Easy
Objective: LO 10-4
AACSB: Analytic skills

2) The purpose of phase 3 in the “process for understanding internal control and assessing control risk” is to:
A) design, perform and evaluate tests of controls.
B) obtain and document an understanding of internal control design an operation.
C) assess control risk.
D) decide planned detection risk and substantive tests.
Answer
Terms: Process for understanding internal control and assessing risk
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

3) Narratives, flowcharts, and internal control questionnaires are three common methods of:
A) testing the internal controls.
B) documenting the auditor’s understanding of internal controls.
C) designing the audit manual and procedures.
D) documenting the auditor’s understanding of a client’s organizational structure.
Answer
Terms: Narratives, flowcharts, and internal control questionnaires
Diff: Easy
Objective: LO 10-4
AACSB: Reflective thinking skills
4) Audit evidence concerning proper segregation of duties normally is best obtained by:
A) direct personal observation of the employee who applies control procedures.
B) making inquiries of co-workers about the employee who applies control procedures.
C) preparation of a flowchart of duties performed and available personnel.
D) inspection of third-party documents containing the initials of who applied control procedures.
Answer
Terms: Evidence of proper segregation of duties
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

5) Audit evidence regarding the separation of duties is normally best obtained by:
A) preparing flowcharts of operational processes.
B) preparing narratives of operational processes.
C) observation of employees applying control activities.
D) inquiries of employees applying control activities.
Answer
Terms: Audit evidence of separation of duties
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

6) Section 404 requires auditors to perform walkthroughs to assist in understanding internal control.
A) True
B) False
Answer
Terms: Walkthroughs; understanding internal control
Diff: Easy
Objective: LO 10-4
AACSB: Reflective thinking skills
Topic: Public

7) Procedures used to obtain an understanding of internal control are normally performed on fewer transactions than procedures used to test controls.
A) True
B) False
Answer
Terms: Understanding internal controls
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

8) For most uses, flowcharts are superior to narratives as a method of communicating the characteristics of internal control.
A) True
B) False
Answer
Terms: Flowcharts
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills
9) When documenting their understanding of a client’s internal controls, auditors are required to use narratives.
A) True
B) False
Answer
Terms: Understanding internal controls; narratives
Diff: Moderate
Objective: LO 10-4
AACSB: Reflective thinking skills

Learning Objective 10-5

1) The person responsible for reconciling sales invoices to customer orders does not access to the company’s master price list in order to correctly compute sales. This is an example of a(n):
A) operating deficiency.
B) design deficiency.
C) training deficiency.
D) management deficiency.
Answer
Terms: Reconciling sales invoices to correctly compute sales
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills

2) You are performing the audit of internal control for Clifton Company. Which of the following would represent a material weakness in internal control?
A) The company’s audit committee has experienced unusual turnover of members.
B) The company’s CFO was indicted for embezzling from the company.
C) Bank reconciliations are done monthly.
D) The CEO was forced to resign due to an inappropriate relationship with an outside vendor.
Answer
Terms: Material weaknesses in internal control
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
Topic: Public

3) The employee in charge of authorizing credit to the company’s customers does not fully understand the concept of credit risk. This lack of knowledge would constitute:
A) a deficiency in operation of internal controls.
B) a deficiency in design of internal controls.
C) a deficiency of management.
D) not constitute a deficiency.
Answer
Terms: Lack of knowledge
Diff: Moderate
Objective: LO 10-5
AACSB: Ethical understanding and reasoning abilities

4) Section 404 requires auditors to evaluate the effectiveness of the audit committee’s oversight of the company’s:
A)
External financial
reporting Efficiency of
operations Internal control over financial reporting
Yes No Yes

B)
External financial
reporting Efficiency of
operations Internal control over financial reporting
No No Yes

C)
External financial
reporting Efficiency of
operations Internal control over financial reporting
Yes Yes No

D)
External financial
reporting Efficiency of
operations Internal control over financial reporting
No Yes No

Answer
Terms: Effectiveness of audit committee’s oversight
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
Topic: Public

5) Once auditors determine that entity level controls are designed and placed in the operation they:
A) make a preliminary assessment for each transaction-related audit objective for each major type of transaction.
B) make a preliminary assessment of control risk.
C) obtain an understanding of the design and implementation of internal control.
D) prepare audit documentation in order to opine on the company’s internal control system.
Answer
Terms: Entry level controls
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills

6) Which of the following is the correct definition of “control deficiency”?
A) A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis.
B) A control deficiency exists if one or more deficiencies exist that adversely affect a company’s ability to prepare external financial statements reliably.
C) A control deficiency exists if the design or operation of controls results in a more than remote likelihood that controls will not prevent or detect misstatements.
D) A control deficiency exists if the design or operation of controls results in a more than probable likelihood that controls will prevent or detect misstatements.
Answer
Terms: Control deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
7) Which of the following deficiency exists if a necessary control is missing or not properly formulated?
A) control
B) significant
C) design
D) operating
Answer
Terms: Control deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

8) To determine if significant internal control deficiencies are material weaknesses, they must be evaluated on their:
A)
Likelihood Significance
Yes Yes

B)
Likelihood Significance
No No

C)
Likelihood Significance
Yes No

D)
Likelihood Significance
No Yes

Answer
Terms: Internal control deficiencies are material weaknesses
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
9) Significant deficiencies need to be communicated to the company’s audit committee because:
A) they represent material weaknesses that allow fraud to be perpetrated.
B) they represent significant design flaws in internal controls.
C) they represent falsification of accounting records.
D) they represent disclosure of information related to issuance of a “going-concern” opinion.
Answer
Terms: Significant deficiencies
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
10) Before making the final assessment of internal control at the end of an integrated audit, the auditor must:
A)
Test controls Perform substantive tests of details
Yes Yes

B)
Test controls Perform substantive tests of details
No No

C)
Test controls Perform substantive tests of details
Yes No

D)
Test controls Perform substantive tests of details
No Yes

Answer
Terms: Final assessment of internal control for integrated audit
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
Topic: Public

11) Significant deficiencies and material weaknesses in internal control of a public company must be reported in writing to which of the following?
A) the Public Company Accounting Oversight Board
B) members of management who are responsible for the related area of the company
C) audit committee of the company’s board of directors
D) the AICPA
Answer
Terms: Internal controls; significant deficiencies; material weaknesses
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills
Topic: Public

12) Significant deficiencies are matters that come to an auditor’s attention and should be communicated to an entity’s audit committee because they represent:
A) material frauds perpetrated by high-level management.
B) internal control deficiencies that could adversely affect a company’s ability to initiate, record, process, or report external financial statements reliably.
C) flagrant violations of the entity’s documented conflict-of-interest policies.
D) intentional attempts by client personnel to limit the scope of the auditor’s field work.
Answer
Terms: Significant deficiencies; audit committee
Diff: Moderate
Objective: LO 10-5
AACSB: Analytic skills
13) How must significant deficiencies and material weaknesses be communicated to those charged with governance?
A) Either oral or written communication is acceptable.
B) Oral communication is required.
C) Written communication is required.
D) Written communication is required for material weaknesses, but oral communication is allowed for significant deficiencies.
Answer
Terms: Significant deficiencies and material weaknesses; governance
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

14) When considering internal control, an auditor should be aware of the concept of reasonable assurance, which recognizes that the:
A) segregation of incompatible functions is necessary to ascertain that internal control is effective.
B) employment of competent personnel provides assurance that the objectives of internal control will be achieved.
C) establishment and maintenance of internal control is an important responsibility of the management and not of the auditor.
D) concept allows for only a remote likelihood that material misstatements will not be prevented or detected on a timely basis.
Answer
Terms: Internal control; reasonable assurance
Diff: Challenging
Objective: LO 10-5
AACSB: Analytic skills

15) When planning an audit, the auditor’s assessed level of control risk is:
A) determined by using actuarial tables.
B) calculated by using the audit risk model.
C) a judgment issue, based on auditor knowledge.
D) calculated by using the formulas provided in the AICPA’s auditing standards.
Answer
Terms: Assessed level of control risk
Diff: Challenging
Objective: LO 10-5
AACSB: Reflective thinking skills

16) When a compensating control exists, the absence of a key control:
A) is no longer a concern because there is no longer a significant deficiency or material weakness.
B) is still a major concern to the auditor.
C) could cause a material loss, so it must be tested using substantive procedures.
D) is magnified and must be removed from the sampling process and examined in its entirety.
Answer
Terms: Compensating control; key control
Diff: Challenging
Objective: LO 10-5
AACSB: Analytic skills
17) You are the audit manager for a new audit client. Your staff auditors are unsure of what constitutes a control deficiency. Discuss the definition of control deficiency. In your response include at least two examples of control deficiencies.
Answer control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis in the normal course of performing assigned functions.

Design Deficiency exists if a necessary control is missing or not properly designed.

Operating Deficiency exists if a well-designed control does not operate as designed or if the person performing the control is insufficiently qualified or authorized.
Terms: Control deficiency; Design deficiency; Operating deficiency
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

18) Define the following terms: control deficiency, significant deficiency, and material weakness.

19) Describe the auditor’s responsibilities related to required communications between the auditor and those charged with governance (remove auditor committee) regarding internal control.

20) The text suggested a five-step approach to identify deficiencies, significant deficiencies, and material weaknesses. Describe this approach.

21) The most important component of internal control is risk assessment.
A) True
B) False
Answer
Terms: Internal control risk assessment
Diff: Moderate
Objective: LO 10-5
AACSB: Reflective thinking skills

Learning Objective 10-6

1) If the results of tests of controls support the design and operations of controls as expected, the auditor uses ________ control risk as the preliminary assessment.
A) a lower
B) the same
C) a higher
D) either a lower or higher
Answer
Terms: Control risk as preliminary assessment
Diff: Moderate
Objective: LO 10-6
AACSB: Analytic skills

2) An auditor is likely to use four types of procedures to support the operating effectiveness of internal controls. Which of the following would generally NOT be used?
A) make inquiries of appropriate client personnel
B) examine documents, records, and reports
C) reperform client procedures
D) inspect design documents
Answer
Terms: Operating effectiveness of internal controls
Diff: Moderate
Objective: LO 10-6
AACSB: Reflective thinking skills

3) After considering a client’s internal controls, an auditor has concluded that it is well designed and is functioning as intended. Under these circumstances the auditor would most likely:
A) perform tests of controls to the extent outlined in the audit program.
B) determine the control procedures that should prevent or detect errors and irregularities.
C) not increase the extent of predetermined substantive tests.
D) determine whether transactions are recorded to permit preparation of financial statements in conformity with generally accepted accounting principles.
Answer
Terms: Internal control design and functioning
Diff: Challenging
Objective: LO 10-6
AACSB: Analytic skills

4) In evaluating the operational effectiveness of internal controls the auditor is likely to use four types of audit procedures. List the procedures below.

5) When internal controls are highly effective in processing accounting transactions, the extent of substantive tests should be reduced.
A) True
B) False
Answer
Terms: Processing accounting transactions; substantive tests
Diff: Easy
Objective: LO 10-6
AACSB: Analytic skills

6) When internal controls over a given financial statement account are assessed as highly effective, the auditor need not obtain audit evidence for that account beyond testing the controls.
A) True
B) False
Answer
Terms: Internal controls highly effective
Diff: Moderate
Objective: LO 10-6
AACSB: Analytic skills

Learning Objective 10-7

1) In performing an audit of internal control over financial reporting which of the following is the auditor required to do?
A) Test routine and nonroutine transactions equally.
B) Form an opinion on the effectiveness of internal for financial reporting.
C) Rely on the work on internal auditors in order to promote audit efficiency.
D) Use the audit conclusions before starting the audit of financial statements.
Answer
Terms: Internal control audit requirements of auditor
Diff: Easy
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: SOX

2) The criterion that is most likely to be used as a framework in evaluating a company’s internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act is the Enterprise Risk Management framework.
A) True
B) False
Answer
Terms: Section 404 of the Sarbanes-Oxley Act
Diff: Challenging
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: SOX

3) To issue an unqualified opinion on internal control over financial reporting, there must be no identified material weaknesses and no restrictions on the scope of the audit.
A) True
B) False
Answer
Terms: Unqualified opinion on internal control
Diff: Moderate
Objective: LO 10-7
AACSB: Reflective thinking skills
Topic: Public

Learning Objective 10-8

1) A control available in a small company, which may be necessitated because of lack of competent personnel, is:
A) a wider segregation of duties.
B) a voucher system.
C) fewer transactions to process.
D) the owner-manager’s direct involvement in the control process.
Answer
Terms: Control; smaller company; competent personnel
Diff: Easy
Objective: LO 10-8
AACSB: Ethical understanding and reasoning abilities

2) When auditing a private company, the auditor should obtain an understanding of internal control sufficient to:
A) provide reasonable protection against client fraud and defalcations by client employees.
B) assess control risk.
C) provide a basis for suggestions to the client for improving the accounting system.
D) provide a method for safeguarding assets, checking the accuracy and reliability of accounting data, promoting operational efficiency, and encouraging adherence to prescribed managerial policies.
Answer
Terms: Internal control understanding; Private company
Diff: Easy
Objective: LO 10-8
AACSB: Reflective thinking skills

3) In the audit of a private company, the auditor will test internal controls when control risk is initially assessed at:
A)
Low Moderate High
Yes No Yes

B)
Low Moderate High
No No Yes

C)
Low Moderate High
Yes Yes No

D)
Low Moderate High
No Yes No

Answer
Terms: Control risk
Diff: Moderate
Objective: LO 10-8
AACSB: Analytic skills
4) The auditor’s consideration of a private company’s internal control is:
A) required by GAAP.
B) required by GAAS.
C) required by the IRS.
D) recommended by the SEC.
Answer
Terms: Private company’s internal control
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

5) Which of the following may represent the biggest challenge smaller public companies face in implementing effective internal control?
A) a lack of expertise
B) reduced importance
C) limited resources
D) limited available guidance
Answer
Terms: Internal control biggest challenge
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills
Topic: Public

6) Which of the following is most correct for audits of non-public companies?
A) an audit of internal control is required
B) an audit of internal control is not required
C) an audit of the design of internal controls is required
D) an audit of the operational effectiveness of internal controls is required
Answer
Terms: Audits of non-public companies
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

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

a. Control environment
b. Control activities
c. Independent checks on performance
d. Internal control
e. Monitoring
f. Separation of duties
g. General authorization
h. Specific authorization
i. Risk assessment

________ 1. Management’s ongoing and periodic assessment of the quality of internal control performance to determine that controls are operating as intended and are modified when needed.

________ 2. Company-wide policies for the approval of all transactions within stated limits.

________ 3. The actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about internal control and its importance to the entity.

________ 4. Segregation of the following activities in an organization: custody of assets, accounting, authorization, and operational responsibility.

________ 5. Management’s identification and analysis of risks relevant to the preparation of financial statements in accordance with an applicable accounting framework.

________ 6. Policies and procedures that help ensure that necessary actions are taken to address risks in the achievement of the entity’s objectives.

________ 7. A process designed to provide reasonable assurance regarding the achievement of management’s objectives in the following categories: (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with applicable laws and regulations.

8) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably set a high assessment of control risk.
A) True
B) False
Answer
Terms: Control activities; control risk
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills

9) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably reassess whether the client is auditable.
A) True
B) False
Answer
Terms: Control activities
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills
10) Auditors of private companies may rely on prior periods’ tests of controls.
A) True
B) False
Answer
Terms: Private companies; test of controls
Diff: Easy
Objective: LO 10-8
AACSB: Reflective thinking skills

11) In an audit of a non-public company, the less control risk there is, the smaller the amount of planned substantive evidence that is required.
A) True
B) False
Answer
Terms: Non-public company; control risk; substantive evidence
Diff: Easy
Objective: LO 10-8
AACSB: Analytic skills

12) For proper internal control, there should be adequate separation of duties. However, the extent of separation of duties considered “adequate” does not depend on the size of the organization.
A) True
B) False
Answer
Terms: Separation of duties
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

13) In an audit of a non-public company, the auditor’s assessment of control risk and the extent of tests of controls are inversely related.
A) True
B) False
Answer
Terms: Non-public companies; control risk
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills

14) Smaller companies usually have less extensive internal controls than larger companies which result in more frauds being committed at small companies.
A) True
B) False
Answer
Terms: Internal controls for smaller companies
Diff: Moderate
Objective: LO 10-8
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 11 Fraud Auditing

Learning Objective 11-1

1) Which of the following best defines fraud in a financial statement auditing context?
A) Fraud is an unintentional misstatement of the financial statements.
B) Fraud is an intentional misstatement of the financial statements.
C) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on materiality.
D) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on consistency.
Answer©
Terms: Definition of fraud in financial statement auditing
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

2) Companies may intentionally understate earnings when income is high to create a reserve of “earnings” that may be used in future years to increase earnings. This practice is known as:
A) performance-based management.
B) earnings management.
C) asset management.
D) expense management.
Answer
Terms: Intentionally understate earnings; Reserve earnings
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

3) Which of the following is a category of fraud?
A)
Fraudulent financial reporting Misappropriation of assets
Yes Yes

B)
Fraudulent financial reporting Misappropriation of assets
No No

C)
Fraudulent financial reporting Misappropriation of assets
Yes No

D)
Fraudulent financial reporting Misappropriation of assets
No Yes

Answer
Terms: Category of fraud
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills
4) With respect to misappropriation of assets, most frauds involve:
A)
Inventory or liquid asset theft Intentional misstatements of amounts
Yes Yes

B)
Inventory or liquid asset theft Intentional misstatements of amounts
No No

C)
Inventory or liquid asset theft Intentional misstatements of amounts
Yes No
Yes No
D)
Inventory or liquid asset theft Intentional misstatements of amounts
No Yes

Answer
Terms: Misappropriation of assets fraud
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

5) ________ is fraud that involves theft of an entity’s assets.
A) Fraudulent financial reporting
B) A “cookie jar” reserve
C) Misappropriation of assets
D) Income smoothing
Answer
Terms: Fraud that involves theft of entity’s assets
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

6) Which of the following would the auditor be most concerned about regarding a heightened risk of intentional misstatement?
A) senior management emphasizes that it is very important to beat analyst estimates of earnings every reporting period
B) senior management emphasizes that budgeted amounts for expenses are to be achieved for each reporting period or explained in the variance analysis report
C) senior management emphasizes that job rotation is a worthwhile corporate objective
D) senior management emphasizes that job evaluations are based on performance
Answer
Terms: Heightened risk of intentional misstatement
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills
7) Which of the following is a form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings?
A) fraudulent financial reporting
B) expense smoothing
C) income smoothing
D) each of the above is correct
Answer
Terms: Form of earnings management where revenues and expenses are shifted between periods
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

8) Who is most likely to perpetrate fraudulent financial reporting?
A) members of the board of directors
B) production employees
C) management of the company
D) the internal auditors
Answer
Terms: Fraudulent financial reporting
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

9) Misappropriation of assets is normally perpetrated by:
A) members of the board of directors.
B) employees at lower levels of the organization.
C) management of the company.
D) the internal auditors.
Answer
Terms: Misappropriation of assets normally perpetrated by
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

10) Determine from the following the factor that would most likely elevate the auditor’s concern about the risk of financial statement fraud.
A) company cannot borrow debt capital without restrictive covenants
B) company finds it difficult to sell equity capital for expansion
C) company has a significant portion of liquid assets on its balance sheet
D) company reports substantial net income but ever decreasing cash flow from operations
Answer
Terms: Most likely elevate auditor’s concern about risk of financial statement fraud
Diff: Moderate
Objective: LO 11-1
AACSB: Analytic skills
11) Define fraud and distinguish between the two main categories of fraud.

12) In the context of financial statement auditing, fraud is defined as an intentional misstatement of a material fact regarding balances, transactions or presentation of the financial statements.
A) True
B) False
Answer
Terms: Fraud in financial statement auditing
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

13) The two main categories of fraud are fraudulent financial reporting and misappropriation of assets.
A) True
B) False
Answer
Terms: Categories of fraud; Fraudulent financial reporting and misappropriation of assets
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

14) “Cookie jar reserves” are often created by companies whenever their earnings are high to create reserves for future periods when earnings need to be “boosted” upward.
A) True
B) False
Answer
Terms: Cookie jar reserves
Diff: Easy
Objective: LO 11-1
AACSB: Reflective thinking skills

15) Misappropriation of assets is normally perpetrated at the lowest levels of the organization hierarchy.
A) True
B) False
Answer
Terms: Misappropriation of assets
Diff: Moderate
Objective: LO 11-1
AACSB: Reflective thinking skills
16) Fraudulent financial reporting usually involves manipulation of amounts rather than disclosures.
A) True
B) False
Answer
Terms: Fraudulent financial reporting
Diff: Moderate
Objective: LO 11-1
AACSB: Reflective thinking skills

Learning Objective 11-2

1) Which of the following is one of the conditions for fraud described in SAS No. 99?
A)
Attitudes/rationalization Risk Factors Opportunities
Yes No Yes

B)
Attitudes/rationalization Risk Factors Opportunities
No Yes Yes

C)
Attitudes/rationalization Risk Factors Opportunities
Yes No No

D)
Attitudes/rationalization Risk Factors Opportunities
No Yes No

Answer
Terms: Conditions for fraud described in SAS No. 99
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills

2) Financial statement manipulation risk is arguably present for all companies’ financial statements. However, the risk is elevated for companies that:
A) are heavily regulated.
B) have foreign subsidiaries.
C) have to make significant judgments for accounting estimates.
D) operate in stable economic environments.
Answer
Terms: Financial statement manipulation risk is elevated
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills
3) Which of the following is not a factor that relates to opportunities to commit fraudulent financial reporting?
A) Lack of controls related to the calculation and approval of accounting estimates.
B) Ineffective oversight of financial reporting by the board of directors.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer
Terms: Factor relates to opportunities to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

4) Fraud is more prevalent in smaller businesses and not-for-organizations because it is more difficult for them to maintain:
A) adequate separation of duties.
B) adequate compensation.
C) adequate financial reporting standards.
D) adequate supervisory boards.
Answer
Terms: Fraud more prevalent in smaller business and not-for-profit organizations
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

5) Which of the following is a factor that relates to incentives or pressures to commit fraudulent financial reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit, and information technology staff.
Answer
Terms: Factor that relates to incentives or pressures to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

6) Which of the following is a factor that relates to attitudes or rationalization to commit fraudulent financial reporting?
A) Significant accounting estimates involving subjective judgments.
B) Excessive pressure for management to meet debt repayment requirements.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.
Answer
Terms: Factor that relates to attitudes or rationalization to commit fraudulent financial reporting
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
7) Which of the following is not a factor that relates to opportunities to misappropriate assets?
A) Inadequate internal controls over assets.
B) Presence of large amounts of cash on hand.
C) Inappropriate segregation of duties or independent checks on performance.
D) Adverse relationships between management and employees.
Answer
Terms: Factor that relates to opportunities to misappropriate assets
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

8) Which of the following is a factor that relates to incentives to misappropriate assets?
A) Significant accounting estimates involving subjective judgments.
B) Significant personal financial obligations.
C) Management’s practice of making overly aggressive forecasts.
D) High turnover of accounting, internal audit and information technology staff.
Answer
Terms: Factor that relates to incentives to misappropriate assets
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

9) Which of the following does NOT represent an increased opportunity to commit fraud?
A) Related Party Transactions
B) the company founder is the CEO and Chairman of the Board
C) the financial statements involve accounting estimates
D) the company is a new audit client for the CPA firm
Answer
Terms: Increased opportunity to commit fraud
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

10) In the fraud triangle, fraudulent financial reporting and misappropriation of assets:
A) share little in common.
B) share most of the same risk factors.
C) share the same three conditions.
D) share most of the same conditions.
Answer
Terms: Fraud triangle
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
11) List and briefly describe the three conditions for fraud arising from fraudulent financial reporting and misappropriation of assets as described in SAS No. 99.

12) List and briefly describe examples of risk factors for each condition of fraud for fraudulent financial reporting.

13) These two conditions are generally present when material misstatements due to fraud occur—incentives and opportunities.
A) True
B) False
Answer
Terms: Conditions present when material misstatements due to fraud occur
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills
14) Fraud is more prevalent in large businesses than small businesses and not-for-profit organizations.
A) True
B) False
Answer
Terms: Fraud prevalence in organizations
Diff: Easy
Objective: LO 11-2
AACSB: Reflective thinking skills

15) The same three fraud triangle risk conditions apply to fraudulent financial reporting and misappropriation of assets.
A) True
B) False
Answer
Terms: Fraud triangle risk conditions
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

16) “An attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act ….” describes the opportunities condition included in the fraud triangle.
A) True
B) False
Answer
Terms: Opportunities conditions included in fraud triangle
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

17) An example of a fraud risk factor describing incentives/pressures is “ineffective board of director oversight over financial reporting.”
A) True
B) False
Answer
Terms: Fraud risk factor describing incentives/pressures
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

18) An example of a fraud risk factor describing opportunities is “ineffective board of director oversight over financial reporting.”
A) True
B) False
Answer
Terms: Fraud risk factor describing opportunities
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills
19) Auditors should consider risk factors related to incentives, opportunities, and attitudes whenever they assess the likelihood of material misstatements due to fraud.
A) True
B) False
Answer
Terms: Risk factors related to incentives, opportunities, and attitudes
Diff: Moderate
Objective: LO 11-2
AACSB: Reflective thinking skills

Learning Objective 11-3

1) Auditor’s need to exhibit professional skepticism when auditing a client. This auditing standard is best expressed by which of the following?
A) the auditor neither assumes dishonesty or honesty of management
B) the auditor assumes dishonesty of management
C) the auditor assumes honesty of management
D) the auditor assumes management lacks integrity
Answer
Terms: Professional skepticism when auditing a client
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

2) SAS No. 99 requires auditors to document which of the following matters related to the auditor’s consideration of material misstatements due to fraud?
A) Reasons supporting a conclusion that there is not a significant risk of material improper expense recognition.
B) Procedures performed to obtain information necessary to identify and assess the risks of material fraud.
C) Results of the internal auditor’s procedures performed to address the risk of management override of controls.
D) Discussions with management regarding separation of duties.
Answer
Terms: SAS No. 99 requires auditors to document matters related to auditor consideration of material misstatements due to fraud
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

3) As part of the brainstorming sessions, auditors are directed to emphasize:
A)
The need for professional
skepticism The audit team’s response to potential fraud risks
Yes Yes

B)
The need for professional
skepticism The audit team’s response to potential fraud risks
No No

C)
The need for professional
skepticism The audit team’s response to potential fraud risks
Yes No

D)
The need for professional
skepticism The audit team’s response to potential fraud risks
No Yes

Answer
Terms: Auditors directed to emphasize in brainstorming sessions
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

4) While performing their audit, the audit team uncovers fraud that is likely to have an immaterial affect on the financial statements taken as whole. In this case the auditors should:
A) plan on additional audit procedures to determine the exact amount of the fraud.
B) communicate with legal authorities as to the identity of the fraudsters.
C) disclose the fraud to the appropriate level of management or to the audit committee.
D) call the whistleblower hotline and name the suspected individuals.
Answer
Terms: Audit team uncovers fraud that is immaterial to financial statements
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

5) Which of the following most accurately defines professional skepticism as it is used in auditing standards?
A) It either assumes management is honest or slightly dishonest, but neither all the time.
B) It neither assumes that management is dishonest nor assumes unquestioned honesty.
C) It assumes management is honest most of the time.
D) It assumes that management is dishonest in only rare instances.
Answer
Terms: Professional skepticism and auditing standards
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills
6) Which of the following is not a likely source of information to assess fraud risks?
A) Communications among audit team members.
B) Inquiries of management.
C) Analytical procedures.
D) Consideration of fraud risks discovered during recent audits of other clients.
Answer
Terms: Source of information to assess fraud risks
Diff: Challenging
Objective: LO 11-3
AACSB: Reflective thinking skills

7) Explain professional skepticism and the need for maintaining professional skepticism during an audit.

8) Briefly discuss the brainstorming session required by SAS No. 99. Be sure to include a list of ideas that should be addressed in the session.

9) Describe the sources of information gathered to assess fraud risks.

10) Financial statements of all companies are potentially subject to manipulation.
A) True
B) False
Answer
Terms: Financial statements subject to manipulation
Diff: Easy
Objective: LO 11-3
AACSB: Reflective thinking skills

11) Information and idea exchange sessions by the audit team are required by SAS No. 99.
A) True
B) False
Answer
Terms: Information and idea exchange by audit team sessions required by SAS No. 99
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

12) SAS No. 99 does not specifically indicate which members of an audit engagement team must attend a brainstorming session.
A) True
B) False
Answer
Terms: SAS No. 99 and audit engagement team brainstorming session
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

13) The presence of fraud risk factors increases the likelihood of fraud and may suggest that fraud is being perpetrated.
A) True
B) False
Answer
Terms: Presence of fraud risk factors
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

14) Professional skepticism requires auditors to “either assume that management is dishonest or they have questionable honesty.”
A) True
B) False
Answer
Terms: Professional skepticism
Diff: Moderate
Objective: LO 11-3
AACSB: Reflective thinking skills

Learning Objective 11-4

1) Which of the following is the best reason for management to emphasize fraud prevention and deterrence?
A) collusion and false documentation make fraud detection difficult to detect
B) collusion is impossible to detect
C) false Documentation is impossible to detect
D) all of the above are equally valid reasons
Answer
Terms: Reason for management to emphasize fraud prevention and deferrence
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

2) Which of the following parties is responsible for implementing internal controls to minimize the likelihood of fraud?
A) External auditors
B) Audit committee members
C) Management
D) Committee of Sponsoring Organizations
Answer
Terms: Party responsible for implementing internal controls to minimize likelihood of fraud
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

3) Research indicates that the most effective way to prevent and deter fraud is to:
A) implement programs and controls that are based on core values embraced by the company.
B) hire highly ethical employees.
C) communicate expectations to all employees on an annual basis.
D) terminate employees who are suspected of committing fraud.
Answer
Terms: Most effective way to prevent and deter fraud
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

4) Fraud awareness training should be:
A) broad and all-encompassing.
B) extensive and include details for all functional areas.
C) specifically related to the employee’s job responsibility.
D) focused on employees understanding the importance of ethics.
Answer
Terms: Fraud awareness training
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

5) Which party has the primary responsibility to oversee an organization’s financial reporting and internal control process?
A) the board of directors
B) the audit committee
C) management of the company
D) the financial statement auditors
Answer
Terms: Party with primary responsibility to oversee organization’s financial reporting and internal control processes
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

6) Management is responsible for:
A)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
Yes Yes

B)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
No No

C)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
Yes No

D)
Identifying and measuring fraud risks Taking steps to mitigate identified risks
No Yes

Answer
Terms: Management is responsibilities with fraud risks
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

7) The “tone at the top” provides a foundation upon which a more detailed code of conduct can be developed to provide specific guidance for the organization and its employees. Components of a code of conduct may include sections on 1) general employee conduct, 2) relationships with clients and suppliers and 3) conflicts of interest. Give a narrative description of what might be included in each of the above components of a code of conduct.

8) Senior management is responsible for promoting a culture of honesty and ethics. Describe what that implies for the organization.

9) Management and the board of directors are responsible for setting the “tone at the top.”
A) True
B) False
Answer
Terms: Responsibility for setting tone at the top
Diff: Easy
Objective: LO 11-4
AACSB: Reflective thinking skills

10) The audit committee is responsible for determining an organization’s financial reporting and internal control processes.
A) True
B) False
Answer
Terms: Responsibility for determining organization financial reporting and internal control
Diff: Moderate
Objective: LO 11-4
AACSB: Reflective thinking skills

11) The board of directors has the primary oversight responsibility to assess fraud risks and establish corporate governance programs and controls to prevent, deter, and detect fraud.
A) True
B) False
Answer
Terms: Primary responsibility to assess fraud risks and establish corporate governance programs
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills

12) One of the strongest internal corporate governance mechanisms over senior management is the audit committee of the board of directors.
A) True
B) False
Answer
Terms: Strongest internal corporate governance mechanisms
Diff: Challenging
Objective: LO 11-4
AACSB: Reflective thinking skills

Learning Objective 11-5

1) As part of designing and performing procedures to address management override of controls, auditors must perform which of the following procedures?
A)
Examine all journal entries above the level of materiality Review accounting estimates for biases
Yes Yes

B)
Examine all journal entries above the level of materiality Review accounting estimates for biases
No No

C)
Examine all journal entries above the level of materiality Review accounting estimates for biases
Yes No

D)
Examine all journal entries above the level of materiality Review accounting estimates for biases
No Yes

Answer
Terms: Designing and performing procedures to address override controls
Diff: Moderate
Objective: LO 11-5
AACSB: Reflective thinking skills

2) Auditors may identify conditions during fieldwork that change or support a judgment about the initial assessment of fraud risks. Which of the following is not a condition which should alert an auditor that the initial assessment should be changed?
A) preliminary assessment of control risk has been modified
B) discrepancies in the accounting records
C) unusual relationships between the auditor and management
D) missing or conflicting evidence
Answer
Terms: Alert auditor to change initial assessment of fraud risks
Diff: Moderate
Objective: LO 11-5
AACSB: Reflective thinking skills
3) Auditors are required to perform certain procedures in every audit to address the risk of management override of internal controls. What are these procedures?

4) Because fraud perpetrators are often knowledgeable about audit procedures, SAS No. 99 requires auditors to incorporate unpredictability into the audit plan.
A) True
B) False
Answer
Terms: SAS No. 99 requires auditors to incorporate unpredictability into audit plan
Diff: Challenging
Objective: LO 11-5
AACSB: Reflective thinking skills

5) All misstatements the auditor finds during the audit should be evaluated for any indication of fraud.
A) True
B) False
Answer
Terms: All misstatements found during audit should be evaluated for indication of fraud
Diff: Challenging
Objective: LO 11-5
AACSB: Reflective thinking skills

Learning Objective 11-6

1) According to SAS No. 99, auditors are required to assume that which of the following has significant risk of fraud?
A) overstated assets
B) understated liabilities
C) improper revenue recognition
D) overstated expenses
Answer
Terms: SAS No. 99 requires auditors to assume significant risk of fraud
Diff: Moderate
Objective: LO 11-6
AACSB: Reflective thinking skills
2) Company management is often under pressure to increase revenue and/or net income. One approach is to use a “bill and hold” arrangement. This is an example of which of the following?
A) adjustments to revenue accounts
B) fictitious revenue recorded
C) premature revenue recognized
D) alteration of cutoff documents
Answer
Terms: Bill and hold arrangement to increase revenue and/or net income
Diff: Moderate
Objective: LO 11-6
AACSB: Reflective thinking skills

3) A company is concerned with the theft of cash after the sale has been recorded. One way in which fraudsters conceal the theft is by a process called “lapping”. Which of the following best describes lapping?
A) reduce the customer’s account by recording a sales return
B) write off the customer’s account
C) apply the payment from another customer to the customer’s account
D) reduce the customer’s account by recording a sales allowance
Answer
Terms: Lapping; Theft of cash
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills

4) Analytical procedures can be very effective in detecting inventory fraud. Which of the following analytical procedures would NOT be useful in detecting fraud?
A) Gross margin percentage
B) Inventory Turnover
C) Cost of sales percentage
D) Accounts payable turnover
Answer
Terms: Analytical procedures to detect inventory fraud
Diff: Challenging
Objective: LO 11-6
AACSB: Reflective thinking skills
5) What are the three main types of revenue manipulations employed to commit fraudulent financial reporting and give an example for each type?

6) You are conducting an audit and you are concerned about revenue recognition issues because of timing concerns due to proper cutoff and channel stuffing (sales to distributors above “normal” business needs. Describe at least two audit procedures that would best address your concerns?

7) The most common fraud in the acquisition and payment cycle is for the fraudster to issue payments to fictitious vendors and deposit the cash in fictitious accounts. What procedures could the company take to prevent this type of fraud?

Learning Objective 11-7

1) The audit team has identified and documented fraud risk. Their next step should be to:
A) evaluate factors that should reduce risk.
B) develop programs to test for fraud.
C) proceed with performing tests of controls.
D) proceed with performing substantive tests of balances.
Answer
Terms: Identified and documented fraud risk
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills

2) Which of the following is least likely to uncover fraud?
A) External auditors
B) Internal auditors
C) Internal controls
D) Management
Answer
Terms: Lease likely to uncover of fraud risks
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills
3) Which of the following is not a category of inquiry used by auditors?
A) Assessment inquiry
B) Declarative inquiry
C) Interrogative inquiry
D) Informational inquiry
Answer
Terms: Category of inquiry used by auditors
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

4) ________ inquiry is used when the auditor seeks responses from the interviewee about his or her knowledge of an event or circumstance.
A) Assessment
B) Declarative
C) Interrogative
D) Informational
Answer
Terms: Inquiry used when auditor seeks responses
Diff: Challenging
Objective: LO 11-7
AACSB: Analytic skills

5) ________ inquiry is used to ascertain whether information already obtained is correct, factual or truthful.
A) Assessment
B) Declarative
C) Interrogative
D) Informational
Answer
Terms: Inquiry used to ascertain whether information already obtained is correct
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

6) When the auditor suspects that fraud may be present, SAS No. 99 requires the auditor to:
A) terminate the engagement with sufficient notice given to the client.
B) issue an adverse opinion or a disclaimer of opinion.
C) obtain additional evidence to determine whether material fraud has occurred.
D) re-issue the engagement letter.
Answer
Terms: SAS No. 99 requires auditor to do when fraud is suspected
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills
7) With whom should the auditor communicate whenever he or she determines that senior management fraud may be present, even if the matter might be considered inconsequential?
A) PCAOB
B) audit committee
C) an appropriate level of management that is at least one level above those involved
D) the internal auditors
Answer
Terms: Auditor communicate with whom when senior management fraud may be present
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills

8) What types of inquiry techniques might an auditor use when making inquiries of client personnel? What are the uses of each technique?

9) PCAOB Standard 5 indicates that material fraud by senior management is a material weakness.
A) True
B) False
Answer
Terms: Senior management fraud
Diff: Moderate
Objective: LO 11-7
AACSB: Reflective thinking skills
Topic: Public

10) Auditors must issue a qualified opinion on internal control whenever senior management commits fraud that is considered a material weakness.
A) True
B) False
Answer
Terms: Opinion issued on internal control with senior management fraud
Diff: Challenging
Objective: LO 11-7
AACSB: Reflective thinking skills
Topic: Public
Auditing and Assurance Services, 14e (Arens)
Chapter 12 The Impact of Information Technology on the Audit Process

Learning Objective 12-1

1) IT has several significant effects on an organization. Which of the following would not be important from an auditing perspective?
A) organizational changes
B) the visibility of information
C) the potential for material misstatement
D) None of the above; i.e., they are all important.
Answer
Terms: IT effects on organization
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills

2) Which of the following is not a benefit of using IT-based controls?
A) ability to process large volumes of transactions
B) ability to replace manual controls with computer-based controls
C) reduction in misstatements due to consistent processing of transactions
D) reduction in internal control evaluation in setting control risk
Answer
Terms: Not a benefit of using IT-based controls
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills

3) Discuss how the integration of IT into accounting systems enhances internal control.
Answernhancements to internal control resulting from the integration of IT into accounting systems include:
• Computer controls replace manual controls. Replacing manual procedures with programmed controls that apply checks and balances to each processed transaction and that process information consistently can reduce human error that is likely to occur in traditional manual environments.
• Higher quality information is available. IT systems typically provide management with more and higher quality information faster than most manual systems.
Terms: Integration of IT into accounting systems enhances internal control
Diff: Moderate
Objective: LO 12-1
AACSB: Reflective thinking skills

4) Control risk may be reduced for a company with a complex IT system when compared to a company that relies primarily on manual controls.
A) True
B) False
Answer
Terms: Control risk reduced for company with complex IT system
Diff: Easy
Objective: LO 12-1
AACSB: Reflective thinking skills
Learning Objective 12-2

1) Which of the following is a significant risk to the auditor regarding an audit in a highly automated information environment?
A) does not place enough reliance on the processed information
B) places too much reliance on the processed information
C) processed information may not reveal the sources of the information
D) does not understand the processed information produced by the automated environment
Answer
Terms: Risk to auditor regarding audit in highly automated information environment
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

2) Which of the following is not a risk specific to IT environments?
A) reliance on the functioning capabilities of hardware and software
B) increased human involvement
C) loss of data due to insufficient backup
D) unauthorized access
Answer
Terms: Risks specific to IT environment
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

3) Which of the following is not an enhancement to internal control that will occur as a consequence of increased reliance on IT?
A) computer controls replace manual controls
B) higher quality information is available
C) computer-based controls provide opportunities to improve separation of duties
D) manual controls replace automated controls
Answer
Terms: Enhancements to internal control which occur as consequence of increased reliance on IT
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

4) Which of the following is not a risk in an IT system?
A) need for IT experienced staff
B) separation of IT duties from accounting functions
C) improved audit trail
D) hardware and data vulnerability
Answer
Terms: Risks in an IT system
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills
5) Which of the following may present itself as the biggest risk to centralizing information responsibilities that were traditionally separate?
A) IT personnel with access to software and master files may misappropriate assets
B) IT personnel with access to software and master files may lack the accounting skills necessary to provide useful information to management
C) IT personnel with access to software and master files may not understand the linkages between general and application controls
D) IT personnel with access to software and master files may not be able to convert the company’s operational policies to an IT environment
Answer
Terms: Biggest risk to centralizing information responsibilities
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills

6) An important characteristic of IT is uniformity of processing. Therefore, a risk exists that:
A) auditors will not be able to access data quickly.
B) auditors will not be able to determine if data is processed consistently.
C) erroneous processing can result in the accumulation of a great number of misstatements in a short period of time.
D) all of the above.
Answer
Terms: Characteristics of IT and risk
Diff: Moderate
Objective: LO 12-2
AACSB: Reflective thinking skills

7) What are three specific risks to IT systems?

8) One potential disadvantage of IT systems is the reduction or elimination of source documents, which reduces the visibility of the audit trail.
A) True
B) False
Answer
Terms: Disadvantage of IT systems
Diff: Easy
Objective: LO 12-2
AACSB: Reflective thinking skills
Learning Objective 12-3

1) Old and new systems operating simultaneously in all locations is a test approach known as:
A) pilot testing.
B) horizontal testing.
C) integrative testing.
D) parallel testing.
Answer
Terms: Old and new systems operating simultaneously
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

2) Which of the following is a component of general controls?
A) processing controls
B) output controls
C) back-up and contingency planning
D) input controls
Answer
Terms: Component of general controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

3) Which of the following statements related to application controls is correct?
A) Application controls relate to various aspects of the IT function including software acquisition and the processing of transactions.
B) Application controls relate to various aspects of the IT function including physical security and the processing of transactions in various cycles.
C) Application controls relate to all aspects of the IT function.
D) Application controls relate to the processing of individual transactions.
Answer
Terms: Application controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

4) General controls include all of the following except:
A) systems development.
B) online security.
C) processing controls.
D) hardware controls.
Answer
Terms: General controls
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills
5) Which of the following describes the process of implementing a new system in one part of the organization, while other locations continue to use the current system.
A) parallel testing
B) online testing
C) pilot testing
D) control testing
Answer
Terms: Process implementing new system in one part of organization
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

6) To determine that user ID and password controls are functioning, an auditor would most likely:
A) test the system by attempting to sign on using invalid user identifications and passwords.
B) write a computer program that simulates the logic of the client’s access control software.
C) extract a random sample of processed transactions and ensure that the transactions were appropriately authorized.
D) examine statements signed by employees stating that they have not divulged their user identifications and passwords to any other person.
Answer
Terms: ID and password controls function by testing
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

7) When IT programs or files can be accessed from terminals, users should be required to enter a(n):
A) echo check.
B) parity check.
C) self-diagnosis test.
D) authorized password.
Answer
Terms: Required for access to IT programs or files from terminals
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

8) Typical controls developed for manual systems which are still important in IT systems include:
A) management’s authorization of transactions.
B) competent personnel.
C) adequate preparation of input source documents.
D) all of the above.
Answer
Terms: Typical controls developed for manual systems still important in IT systems
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
9) Which of the following controls prevent and detect errors while transaction data are processed?
A) Software
B) Application
C) Processing
D) Transaction
Answer
Terms: Controls that prevent and detect errors while transaction data are processed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

10) Which of the following is not a characteristic associated with converting from a manual to an IT system?
A) It usually centralizes data.
B) It permits higher quality and more consistent controls over operations.
C) It may eliminate the control provided by division of duties of independent persons who perform related functions and compare results.
D) It may take the recordkeeping function and the document preparation function away from those who have custody of assets and put those functions into the IT center.
Answer
Terms: Characteristic associated with converting from manual to IT system
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

11) Output controls need to be designed for which of the following data integrity objectives?
A) detecting errors after the processing is completed
B) preventing errors before the processing is completed
C) detecting errors in the general ledger adjustment process
D) preventing errors in separation of duties for IT personnel
Answer
Terms: Output controls need to be designed for
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

12) Which of the following statements is correct?
A) Auditors should evaluate application controls before evaluating general controls.
B) Auditors should evaluate application controls and general controls simultaneously.
C) Auditors should evaluate general controls before evaluating application controls.
D) None of these statements is correct.
Answer
Terms: Auditors evaluation of application controls and general controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
13) Auditors should evaluate which of the following before evaluating application controls because of the potential for pervasive effects.
A) input controls
B) control environment
C) processing controls
D) general controls
Answer
Terms: Evaluate before evaluating application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

14) A control that relates to all parts of the IT system is called a(n):
A) general control.
B) systems control.
C) universal control.
D) applications control.
Answer
Terms: Control that relates to all parts of IT system
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

15) Controls which apply to a specific element of the system are called:
A) user controls.
B) general controls.
C) systems controls.
D) applications controls.
Answer
Terms: Controls which apply to a specific element of the syste,
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

16) Which of the following is not an example of an applications control?
A) Back-up of data to a remote site for data security.
B) There is a preprocessing authorization of the sales transactions.
C) There are reasonableness tests for the unit selling price of a sale.
D) After processing, all sales transactions are reviewed by the sales department.
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
17) Which of the following is least likely to be used in obtaining an understanding of client general controls?
A) examination of system documentation
B) inquiry of client personnel (e.g., key users)
C) walk through of a sales transaction
D) reviews of questionnaires completed by client IT personnel
Answer
Terms: Understanding of client general controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

18) Which of the following is not a general control?
A) computer performed validation tests of input accuracy
B) equipment failure causes error messages on monitor
C) separation of duties between programmer and operators
D) adequate program run instructions for operating the computer
Answer
Terms: General control
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

19) Controls which are built in by the manufacturer to detect equipment failure are called:
A) input controls.
B) data integrity controls.
C) hardware controls.
D) manufacturer’s controls.
Answer
Terms: Controls built in by manufacturer to detect equipment failure
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

20) Which of the following best describes the test data approach?
A) auditors process their own test data using the client’s computer system and application program
B) auditors process their own test data using their own computers that simulate the client’s computer system
C) auditors use auditor-controlled software to do the same operations that the client’s software does, using the same data files
D) auditors use client-controlled software to do the same operations that the client’s software does, using auditor created data files
Answer
Terms: Control risk matrix
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
21) Controls which are designed to assure that the information processed by the computer is authorized, complete, and accurate are called:
A) input controls.
B) processing controls.
C) output controls.
D) general controls.
Answer
Terms: Controls designed to assure information processed by computer is authorized, complete, and accurate
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

22) Programmers should be allowed access to:
A) user controls.
B) general controls.
C) systems controls.
D) applications controls.
Answer
Terms: Programmers should be allowed access
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

23) Which of the following tests determines that every field in a record has been completed?
A) Validation
B) Sequence
C) Completeness
D) Programming
Answer
Terms: Tests to determine that every field in a record has been completed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

24) In an IT-intensive environment, most processing controls are:
A) input controls.
B) operator controls.
C) programmed controls.
D) documentation controls.
Answer
Terms: IT intensive environment and processing controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
25) Output controls are not designed to assure that data generated by the computer are:
A) accurate.
B) distributed only to authorized people.
C) complete.
D) used appropriately by management.
Answer
Terms: Output controls are not designed
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

26) Auditors usually obtain information about general and application controls through:
A) interviews with IT personnel.
B) examination of systems documentation.
C) reading program change requests.
D) all of the above methods.
Answer
Terms: General and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

27) An internal control deficiency occurs when computer personnel:
A) participate in computer software acquisition decisions.
B) design flowcharts and narratives for computerized systems.
C) originate changes in customer master files.
D) provide physical security over program files.
Answer
Terms: Internal control deficiency
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

28) General controls have which of the following effects on the operating effectiveness of application controls?
A) nominal
B) pervasive
C) mitigating
D) worsening
Answer
Terms: General controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
29) When auditing a client that uses batch processing the problem with error detection is that:
A) transaction trails in a batch system are available only for a limited period of time.
B) there are time delays in processing transactions in a batch system.
C) errors in some transactions cause rejection of other transactions in the batch.
D) random errors are more likely in a batch system than in an online system.
Answer
Terms: Batch processing and problem with error detection
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

30) Which of the following computer-assisted auditing techniques inserts an audit module in the client’s application system to identify specific types of transactions?
A) parallel simulation testing
B) test data approach
C) embedded audit module
D) generalized audit software testing
Answer
Terms: Computer-assisted auditing techniques allows fictitious and real transactions
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

31) In an IT system, automated equipment controls or hardware controls are designed to:
A) correct errors in the computer programs.
B) monitor and detect errors in source documents.
C) detect and control errors arising from the use of equipment.
D) arrange data in a logical sequential manner for processing purposes.
Answer
Terms: Equipment or hardware controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

32) If a control total were to be computed on each of the following data items, which would best be identified as a hash total for a payroll IT application?
A) gross wages earned
B) employee numbers
C) total hours worked
D) total debit amounts and total credit amounts
Answer
Terms: Hash total for payroll IT application
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
33) Which of the following is not an application control?
A) preprocessing authorization of sales transactions
B) reasonableness test for unit selling price of sale
C) post-processing review of sales transactions by the sales department
D) logging in to the company’s information systems via a password
Answer
Terms: Application controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

34) Application controls vary across the IT system. To gain an understanding of internal control for a private company, the auditor must evaluate the application controls for every:
A) audit area.
B) material audit area.
C) audit area in which the client uses the computer.
D) audit area where the auditor plans to reduce assessed control risk.
Answer
Terms: Application controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

35) Which of the following is not a general control?
A) sSeparation of IT duties
B) systems development.
C) processing controls
D) hardware controls
Answer
Terms: General control
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

36) In comparing (1) the adequacy of the hardware controls in the system with (2) the organization’s methods of handling the errors that the computer identifies, the independent auditor is:
A) unconcerned with both (1) and (2).
B) equally concerned with (1) and (2).
C) less concerned with (1) than with (2).
D) more concerned with (1) than with (2).
Answer
Terms: Concern of adequacy of hardware controls and methods of handling errors that computer identifies
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills
37) The most important output control is:
A) distribution control, which assures that only authorized personnel receive the reports generated by the system.
B) review of data for reasonableness by someone who knows what the output should look like.
C) control totals, which are used to verify that the computer’s results are correct.
D) logic tests, which verify that no mistakes were made in processing.
Answer
Terms: Output controls
Diff: Challenging
Objective: LO 12-3
AACSB: Reflective thinking skills

38) Briefly define general controls and application controls.

39) Identify the three categories of application controls, and give one example of each.
Answerpplication controls fall into three categories:
• Input controls. Key verification and check digits are examples of input controls.
• Processing controls. One example is a reasonableness test for the unit selling price of a sale.
• Output controls. One example is post-processing review of sales transactions by the sales department.
Terms: Three categories of application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

40) One category of general controls is physical and online security. Describe the control and give at least three examples of implementation of the control.
Answerccess to hardware is restricted; passwords and finger print recognition limit access to data files; encryption and firewalls protect data integrity from outside sources.
Terms: General control of physical and online security
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
41) Processing controls include the following tests:

Validation
Sequence
Data Reasonableness
Completeness

Describe what each control is designed to do:

42) What are the two software testing strategies that companies typically use? Which strategy is more expensive?

43) Discuss the four areas of responsibility under the IT function that should be segregated in large companies.

44) Identify the six categories of general controls and give one example of each.

45) Parallel testing is used when old and new systems are operated simultaneously in all locations.
A) True
B) False
Answer
Terms: Parallel testing
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

46) Programmers should design the formatting for transactions data.
A) True
B) False
Answer
Terms: Programmer’s responsibilities
Diff: Easy
Objective: LO 12-3
AACSB: Reflective thinking skills

47) In IT systems, if general controls are effective, it increases the auditor’s ability to rely on application controls to reduce control risk.
A) True
B) False
Answer
Terms: Effective general controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
48) Parallel testing is more expensive than pilot testing.
A) True
B) False
Answer
Terms: Parallel testing
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

49) The effectiveness of automated controls depends solely on the competence of the personnel performing the controls.
A) True
B) False
Answer
Terms: Effectiveness of automated controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

50) Knowledge of both general and application controls is crucial for auditors in understanding how accounting information is recorded and reported.
A) True
B) False
Answer
Terms: Knowledge of general and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
Topic: Public

51) Logic tests and completeness tests are examples of application controls.
A) True
B) False
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

52) Auditors normally link controls and deficiencies in general controls to specific transaction-related audit objectives.
A) True
B) False
Answer
Terms: General controls linked to specific transaction-related audit objectives
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
53) Output controls focus on preventing errors during processing.
A) True
B) False
Answer
Terms: Output controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

54) Processing controls is a category of application controls.
A) True
B) False
Answer
Terms: Processing controls and application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

55) Controls that relate to a specific use of the IT system, such as the processing of sales or cash receipts, are called application controls.
A) True
B) False
Answer
Terms: Application controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

56) IT controls are classified as either input controls or output controls.
A) True
B) False
Answer
Terms: IT controls, input controls, and output controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills

57) Tests of controls are normally performed only if the auditor believes the client’s internal control may be effective.
A) True
B) False
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 12-3
AACSB: Reflective thinking skills
Learning Objective 12-4

1) The audit procedure which is least useful in gathering evidence on significant computer processes is:
A) documentation.
B) observation.
C) test decks.
D) generalized audit software.
Answer
Terms: Audit procedure least useful in gathering evidence
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

2) When the client uses a computer but the auditor chooses to use only the non-IT segment of internal control to assess control risk, it is referred to as auditing around the computer. Which one of the following conditions need not be present to audit around the computer?
A) Application controls need to be integrated with general controls.
B) The source documents must be available in a non-machine language.
C) The documents must be filed in a manner that makes it possible to locate them.
D) The output must be listed in sufficient detail to enable the auditor to trace individual transactions.
Answer
Terms: Client uses computer but auditor chooses to use non-IT segment of internal control to assess control risk
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

3) An auditor’s flowchart of the client’s IT system is a graphical representation that depicts the auditor’s:
A) program for tests of controls.
B) understanding of the system of how the IT system functions.
C) understanding of the types of errors that are probable given the present system.
D) documentation of the study and evaluation of the system.
Answer
Terms: Auditor flowchart of client IT system
Diff: Easy
Objective: LO 12-4
AACSB: Reflective thinking skills

4) Programmers should do all but which of the following?
A) Test programs for proper performance.
B) Evaluate representational faithfulness of transaction data input.
C) Develop flowcharts for new applications.
D) Programmers should perform each of the above.
Answer
Terms: Programmers should do
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
5) Which of the following audit procedures used to obtain an understanding of the client’s general controls would the auditor use to identify program changes in application software?
A) interviews with IT personnel
B) examination of system documentation
C) reviews of detailed questionnaires completed by the IT staff
D) review of the client’s IT architecture
Answer
Terms: Audit procedure to obtain understanding of client general controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

6) The process of assessing control risk considering only non IT controls is known as?
A) the single-stage audit.
B) the test deck approach.
C) auditing around the computer.
D) generalized audit software (GAS).
Answer
Terms: Assessing control risk considering only non-IT controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

7) Companies with non-complex IT environments often rely on desktops and networked servers to perform accounting system functions. Which of the following is not an audit consideration in such an environment?
A) limited reliance on automated controls
B) unauthorized access to master files
C) vulnerability to viruses and other risks
D) excess reliance on automated controls
Answer
Terms: Audit consideration in companies with non-complex IT environments
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

8) General controls in smaller companies are usually less effective than in more complex IT environments.
A) True
B) False
Answer
Terms: General controls in smaller companies
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
9) When the auditor decides to “audit around the computer” to obtain an understanding of the client’s internal controls related to the IT system.
A) True
B) False
Answer
Terms: Audit around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

10) “Auditing around the computer” is acceptable only if the auditor has access to the client’s data in a machine-readable language.
A) True
B) False
Answer
Terms: Auditing around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

11) “Auditing around the computer” is most appropriate when the client has not maintained detailed output or source documents in a form readable by humans.
A) True
B) False
Answer
Terms: Auditing around the computer
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills
12) When a client uses desktops and networked servers for the accounting functions, the auditor should normally rely only on non-IT controls or may take a substantive approach to the audit.
A) True
B) False
Answer
Terms: Client uses desktop and network servers, auditor relies on non-IT controls
Diff: Moderate
Objective: LO 12-4
AACSB: Reflective thinking skills

Learning Objective 12-5

1) The auditor’s objective in determining whether the client’s automated controls can correctly handle valid and invalid transactions as they arise is accomplished through the:
A) test data approach.
B) generalized audit software approach.
C) microcomputer-aided auditing approach.
D) generally accepted auditing standards.
Answer
Terms: Client control can correctly handle valid and invalid transactions
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills
2) The audit approach in which the auditor runs his or her own program on a controlled basis to verify the client’s data recorded in a machine language is:
A) the test data approach.
B) called auditing around the computer.
C) the generalized audit software approach.
D) the microcomputer-aided auditing approach.
Answer
Terms: Audit approach where auditor runs own program on a controlled basis
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

3) When performing a parallel simulation the auditor may use generalized audit software (GAS). Which of the following is not seen as an advantage to using GAS?
A) Auditors can learn the software in a short period of time
B) Can be applied to a variety of client’s after detailed customizations
C) Can be applied to a variety of client’s with minimal adjustments to the software
D) Greatly accelerates audit testing over manual procedures
Answer
Terms: Parallel simulation
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

4) When using the test data approach:
A) test data should include data that the client’s system should accept or reject.
B) application programs tested must be virtually identical to those used by employees.
C) select data may remain in the client system after testing.
D) none of the above statements is correct.
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

5) An auditor who is testing IT controls in a payroll system would most likely use test data that contain conditions such as:
A) time tickets with invalid job numbers.
B) overtime not approved by supervisors.
C) deductions not authorized by employees.
D) payroll checks with unauthorized signatures.
Answer
Terms: IT controls in payroll system and use of test data
Diff: Challenging
Objective: LO 12-5
AACSB: Reflective thinking skills
6) Describe three computer auditing techniques available to the auditor.
Answeromputer auditing techniques available to the auditor are:
• Test data approach. Using this approach, the auditor develops different types of transactions that are processed under his or her own control using the client’s computer programs on the client’s IT equipment.
• Parallel simulation. Using parallel simulation, the auditor writes a computer program that replicates some part of the client’s application system. The client’s data is then processed using the auditor’s computer program. The auditor then compares the output generated by his or her program with that generated by the client’s program to test the correctness of the client’s program. Generalized audit software may be used.
• Embedded audit module. Using this approach, the auditor inserts an audit module in the client’s application system to capture transactions with characteristics that are of interest to the auditor.
Terms: Computer auditing techniques
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

7) Discuss the advantages and benefits of using generalized audit software.
Answerdvantages and benefits of using generalized audit software include:
• they are developed in such a manner that most of the audit staff can be trained to use the program even if they have little formal IT education.
• a single program can be applied to a wide range of tasks without having to incur the cost or inconvenience of developing individualized programs.
• generalize audit software can perform tests much faster and in more detail than using traditional manual procedures.
Terms: Advantages and disadvantages using generalized audit software
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

8) Auditors often use Generalized Audit Software during their testing of a client’s internal controls. For the following uses of the software provide a description and an example.

Verify extensions and footings
Print confirmation requests
Compare data on separate files

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

a. Application controls
b. Auditing around the computer
c. Auditing through the computer
d. Error listing
e. General controls
f. Generalized audit software
g. Hardware controls
h. Input controls
i. Output controls
j. Parallel simulation
k. Parallel testing
l. Pilot testing
m. Processing controls
n. Test data approach

________ 1. The new and old systems operate simultaneously in all locations.

________ 2. Controls that relate to all parts of the IT system.

________ 3. Involves the use of a computer program written by the auditor that replicates some part of a client’s application system.

________ 4. A method of auditing IT systems which uses data created by the auditor to determine whether the client’s computer program can correctly process valid and invalid transactions.

________ 5. Controls such as review of data for reasonableness, designed to assure that data generated by the computer is valid, accurate, complete, and distributed only to authorized people.

________ 6. Controls that apply to processing of transactions.

________ 7. A new system is implemented in one part of the organization while other locations continue to rely on the old system.

________ 8. Controls such as proper authorization of documents, check digits, and adequate documentation, designed to assure that the information to be processed by the computer is authorized, complete, and accurate.

10) The test data approach requires the auditor to insert an audit module in the client’s application system to test how transaction data is processed.
A) True
B) False
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

11) The objective of the computer audit technique known as the test data approach is to determine whether the client’s computer programs can correctly process valid and invalid transactions.
A) True
B) False
Answer
Terms: Test data approach
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

12) Parallel simulation is used primarily to test internal controls over the client’s IT systems, whereas the test data approach is used primarily for substantive testing.
A) True
B) False
Answer
Terms: Parallel simulation
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills

13) One common use of generalized audit software is to help the auditor identify weaknesses in the client’s IT control procedures.
A) True
B) False
Answer
Terms: Generalized audit software
Diff: Moderate
Objective: LO 12-5
AACSB: Reflective thinking skills
Learning Objective 12-6

1) A database management system:
A) allows clients to create databases that include information that can be shared across multiple applications.
B) stores data on different files for different purposes, but always knows where they are and how to retrieve them.
C) allows quick retrieval of data, but at a cost of inefficient use of file space.
D) allows quick retrieval of data, but it needs to update files continually.
Answer
Terms: Database management system
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

2) When auditing client’s using database management systems the auditor is principally aware of elevated risk due to:
A) multiple users can access and update accounting files.
B) the accounting information is only in one place.
C) the database administrator may lack appropriate accounting knowledge.
D) multiple users could all access the data simultaneously causing system shutdown.
Answer
Terms: Database management systems and elevated risk
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

3) General controls may include firewalls which are used to protect:
A) erroneous internal handling of data.
B) against insufficient documentation of transactions.
C) illogical programming commands.
D) unauthorized use of system resources.
Answer
Terms: General controls use firewalls to protect
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

4) What tools do companies use to limit access to sensitive company data?
A)
Encryption techniques Digital signatures Firewall
Yes Yes Yes

B)
Encryption techniques Digital signatures Firewall
Yes No No

C)
Encryption techniques Digital signatures Firewall
No Yes Yes

D)
Encryption techniques Digital signatures Firewall
Yes Yes No

Answer
Terms: Tools companies use to limit access to sensitive data
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

5) Rather than maintain an internal IT center, many companies outsource their basic IT functions such as payroll to an:
A) external general service provider.
B) external application service provider.
C) internal control service provider.
D) internal auditor.
Answer
Terms: Outsourced services
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills

6) When the auditor is obtaining an understanding of a service center’s internal controls the auditor should:
A) use the same criteria used to evaluate the client’s internal controls.
B) use different criteria because the service center resides outside the company.
C) use the same criteria used to evaluate the client’s internal controls but omit tests of transactions.
D) use different criteria for the service center by including substantive tests of balances.
Answer
Terms: Service center’s internal controls
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

7) Many clients have outsourced the IT functions. The difficulty the independent auditor faces when a computer service center is used is to:
A) gain the permission of the service center to review their work.
B) find compatible programs that will analyze the service center’s programs.
C) determine the adequacy of the service center’s internal controls.
D) try to abide by the Code of Professional Conduct to maintain the security and confidentiality of client’s data.
Answer
Terms: Outsourced IT functions
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

8) Service auditors do not issue which of the following types of reports?
A) report on implemented controls
B) report on controls that have been implemented and tested for design effectiveness
C) report on controls that have been implemented and tested for operating effectiveness
D) each of the above is issued
Answer
Terms: Service auditors and types reports
Diff: Challenging
Objective: LO 12-6
AACSB: Reflective thinking skills

9) What do auditing standards require when a company outsources some of their IT requirements to an Application Service Provider?

10) Firewalls can protect company data and software programs.
A) True
B) False
Answer
Terms: Firewalls protect company data
Diff: Easy
Objective: LO 12-6
AACSB: Reflective thinking skills

11) LANs link equipment within a single or small cluster of buildings and are used only for intercompany purposes.
A) True
B) False
Answer
Terms: LANs link equipment
Diff: Easy
Objective: LO 12-6
AACSB: Reflective thinking skills
12) When auditing a client whose information is processed by an outside service provider, it is not acceptable for the auditor to rely on the audit report of another independent auditor who has previously tested the internal controls of the service provider, rather than testing the service provider’s controls himself or herself.
A) True
B) False
Answer
Terms: Information processed by outside service provider
Diff: Moderate
Objective: LO 12-6
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 13 Overall Audit Plan and Audit Program

Learning Objective 13-1

1) Shown below (1 through 5) are the five types of tests which auditors use to determine whether financial statements are fairly stated. Which three are substantive tests?
1. risk assessment procedures
2. tests of controls
3. tests of transactions
4. analytical procedures
5. tests of details of balances
A) 1, 2, and 3.
B) 3, 4, and 5.
C) 2, 3, and 5.
D) 2, 3, and 4.
Answer
Terms: Three types of substantive tests which auditors use
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

2) Collectively, procedures performed to obtain an understanding of the entity and its environment, including internal controls, represent the auditor’s:
A) audit strategy.
B) tests of controls.
C) risk assessment procedures.
D) tests of transactions.
Answer
Terms: Procedures performed to obtain understanding of entity and environment, including internal controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

3) Which of the following would not be considered further audit procedures?
A) tests of controls
B) substantive analytical procedures
C) tests of details of balances
D) risk assessment procedures
Answer
Terms: Not considered a further audit procedure
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

4) Which of the following procedures would most likely be performed in response to the auditor’s assessment of the risk of monetary misstatements in the financial statements?
A) Ratio analysis
B) Tests of controls
C) Tests of details of balances
D) Risk assessment procedures
Answer
Terms: Procedure performed in response to auditor’s assessment of risk of monetary misstatement
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

5) Which of the following further audit procedures are used to determine whether all six transaction related audit objectives have been achieved for each class of transactions?
A) tests of controls
B) risk assessment procedures
C) substantive tests
D) preliminary analytical procedures
Answer
Terms: Further audit procedures to determine whether all six transaction related audit objectives have been achieved
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

6) You are auditing Rodgers and Company. After performing substantive analytical procedures you conclude that, for the accounts tested, the client’s balance appears reasonable. This may indicate that:
A) details test of balances can be eliminated for those accounts.
B) certain test of balances procedures may be eliminated for those accounts.
C) control tests may be eliminated for those accounts.
D) control tests may be reduced for those accounts.
Answer
Terms: After performing substantive analytic procedures
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

7) The purpose of tests of controls is to provide reasonable assurance that the:
A) accounting treatment of transactions and balances is valid and proper.
B) internal control procedures are functioning as intended.
C) entity has complied with GAAP disclosure requirements.
D) entity has complied with requirements of quality control.
Answer
Terms: Purpose of tests of controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

8) In the context of an audit of financial statements, substantive tests are audit procedures that:
A) may be eliminated under certain conditions.
B) are designed to discover significant subsequent events.
C) are designed to test for dollar misstatements.
D) will increase proportionately with the auditor’s reliance on internal control.
Answer
Terms: Substantive tests are audit procedures
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

9) Which of the following is true?
A) tests of details of balances focus on the ending balances for accounts in the client’s ending trial balance
B) tests of details of balances focus on the transactions during the period
C) tests of details of balances focus on the auditor’s understanding of internal controls
D) tests of details of balances focus on comparisons of recorded amounts to expectations developed by the auditor
Answer
Terms: Tests of details of balances focus on
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

10) A system walkthrough is primarily used to:
A) test balances.
B) test details of transactions.
C) gain an understanding of internal controls.
D) determine acceptance of the client.
Answer
Terms: System walkthrough
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

11) Risk assessment procedures are performed by auditors during an audit in order to:
A) determine the risk of material misstatement in the financial statements.
B) determine the amount of testing of internal control.
C) determine the extent of testing of details of balances.
D) determine the extent of testing of transactions.
Answer
Terms: Risk assessment procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills
Topic: Public

12) Tests of controls are directed toward the control’s:
A) efficiency.
B) effectiveness.
C) efficiency and effectiveness.
D) cost benefit ratio.
Answer
Terms: Tests of controls directed toward
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

13) A procedure designed to test for monetary misstatements directly affecting the correctness of financial statement balances is a:
A) test of controls.
B) substantive test.
C) test of attributes.
D) monetary-unit sampling test.
Answer
Terms: Procedure designed to test for monetary misstatements directly affecting correctness of financial statements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

14) Which of the following is not a direct result of performing analytical procedures?
A) identify areas of potential misstatements
B) reduce detailed audit tests
C) understand the client’s business
D) identify specific errors in the accounts
Answer
Terms: Not a direct result of performing analytical procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

15) The primary emphasis in most tests of details of balances is on the:
A) balance sheet accounts.
B) revenue accounts.
C) cash flow statement accounts.
D) expense accounts.
Answer
Terms: Primary emphasis in most tests of details of balances
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

16) Which of the following statements is not true?
A) Analytical procedures emphasize the overall reasonableness of transactions and balances.
B) Tests of controls are concerned with evaluating whether controls are sufficiently effective to justify reducing control risk and thereby reducing analytical review procedures.
C) Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the general ledger.
D) Tests of details of balances emphasize the ending balances in the general ledger.
Answer
Terms: Tests of controls
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

17) Many auditors perform extensive analytical procedures on audits because:
A) they are required by GAAS.
B) they pinpoint errors in accounts.
C) they indicate areas of potential risk and misstatement.
D) they are required for tests of controls.
Answer
Terms: Auditors perform extensive analytical procedures
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

18) When controls are deemed ineffective and assessed control risk is at the maximum for a private company, which of the following would normally be true?
A) no emphasis placed on the controls
B) relatively little emphasis placed on the controls
C) moderate emphasis placed on the controls
D) heavy emphasis placed on the controls
Answer
Terms: Controls deemed ineffective and assessed control risk is at maximum
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

19) Which of the following is ordinarily designed to detect material dollar errors on the financial statements?
A) Tests of controls
B) Analytical review procedures
C) Computer controls
D) Tests of details of balances
Answer
Terms: Designed to detect material dollar errors on the financial statements
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

20) List each of the five types of audit tests and list at least two types of evidence that may be obtained from each type of test.

21) Describe the five types of audit tests. Identify which of the five types are substantive tests, and which are used to reduce assessed control risk.

22) Discuss the purposes of (1) substantive tests of transactions, (2) tests of controls, and (3) tests of details of balances. Give an example of each.

23) There are three stages of the audit in which analytical procedures are performed. Identify each of these three stages and, for each stage, discuss the purpose of performing analytical procedures in that stage. Also indicate in which stage(s) analytical procedures are required by current professional auditing standards.
Answernalytical procedures are performed in the audit planning stage to help the auditor decide the other evidence needed to satisfy sufficient competent evidence requirements. Analytical procedures can also be performed as substantive tests in the testing phase of the audit. Analytical procedures are performed in the audit completion phase as a final test of reasonableness. Auditing standards require that analytical procedures be performed in the planning and completion phases of every audit.
Terms: Analytical procedures in stages of audit
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

24) There are seven types of audit evidence: physical examination, confirmation, documentation, observation, inquiries of the client, reperformance, and analytical procedures. For each of the following types of audit tests, indicate the type(s) of evidence that can be obtained through the test: (1) tests of controls, (2) substantive tests of transactions, (3) analytical procedures, and (4) tests of details of balances.

25) One difference between the procedures used to obtain an understanding of internal control and procedures used to test those controls is that tests of controls are more extensive.
A) True
B) False
Answer
Terms: Procedures to understand internal controls vs. tests of controls
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

26) Tests of controls provide evidence about the likelihood for misstatements in a client’s financial statements.
A) True
B) False
Answer
Terms: Tests of controls; Misstatements in client’s financial statements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

27) An exception in a test of control provides only an indication of the likelihood of monetary misstatements in the financial statements because tests of controls do not reveal whether monetary misstatements have actually occurred.
A) True
B) False
Answer
Terms: Exception in test of control; Indication of likelihood of monetary misstatements
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

28) An exception in a substantive test of transactions provides an indication of the likelihood of monetary misstatements in the financial statements because substantive tests of transactions do reveal whether monetary misstatements have actually occurred.
A) True
B) False
Answer
Terms: Exception in substantive test of transactions
Diff: Easy
Objective: LO 13-1
AACSB: Reflective thinking skills

29) When analytical procedures are performed during substantive testing, they are typically more focused and extensive than when performed as part of audit planning.
A) True
B) False
Answer
Terms: Analytical procedures performed during substantive testing
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

30) Tests of controls should be performed after substantive tests of transactions.
A) True
B) False
Answer
Terms: Tests of controls and substantive tests of transactions
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

31) Substantive tests of transactions focus on the changes in the beginning and ending of the year balances, particularly for the balance sheet.
A) True
B) False
Answer
Terms: Substantive tests of transactions
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills
32) If tests of controls reveal that controls are sufficiently effective to justify reducing control risk, the auditor is justified in reducing substantive audit tests.
A) True
B) False
Answer
Terms: Tests of controls and control risk
Diff: Moderate
Objective: LO 13-1
AACSB: Reflective thinking skills

33) Analytical procedures are normally designed at the account level, whereas tests of controls and substantive tests of transactions are normally designed at the transaction-related objective level.
A) True
B) False
Answer
Terms: Analytical procedures designed at the account level
Diff: Challenging
Objective: LO 13-1
AACSB: Reflective thinking skills

34) Procedures to obtain an understanding of internal control may suffice for tests of controls when the auditor is assessing control risk in a well defined transaction cycle that has not contained material misstatements in prior audits.
A) True
B) False
Answer
Terms: Procedures to obtain an understanding of internal control
Diff: Challenging
Objective: LO 13-1
AACSB: Reflective thinking skills

Learning Objective 13-2

1) In order to promote audit efficiency the auditor considers cost in selecting audit tests to perform. Which of the following audit tests would be the most costly?
A) Analytical Procedures
B) Risk Assessment Procedures
C) Tests of Controls
D) Tests of Details of Balances
Answer
Terms: Most costly audit test
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

2) An exception or deficiency found in a test of controls:
A) indicates a financial statement misstatement.
B) indicates that a financial statement misstatement may be likely.
C) indicates that the financial statements are misstated.
D) indicates that an adverse opinion is warrarnted on the Audit of Internal Control.
Answer
Terms: Exception or deficiency in test of controls
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

3) If no material differences are found using analytical procedures and the auditor concludes that misstatements are not likely to have occurred:
A) other substantive tests may be reduced.
B) it will be necessary to increase the tests of balances.
C) it will not be necessary to perform tests of balances.
D) it will be necessary to increase the tests of transactions.
Answer
Terms: If no material differences are found using analytical procedures
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

4) Which of the following audit tests is usually the most costly to perform?
A) Analytical procedures
B) Tests of controls
C) Tests of balances
D) Substantive tests of transactions
Answer
Terms: Most costly audit test
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

5) An increased extent of tests of controls is most likely to occur when:
A) it is a first-year audit.
B) the auditor is doing a “fraud audit.”
C) controls are effective and the preliminary control risk assessment is low.
D) controls are ineffective and the preliminary control risk assessment is high.
Answer
Terms: Increased extent of tests of controls most likely to occur
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

6) When an auditor believes that analytical procedures indicate a reasonable possibility of misstatement, the auditor usually would:
A)
Perform additional tests of controls Decide to modify tests of details of balances
Yes Yes

B)
Perform additional tests of controls Decide to modify tests of details of balances
No No

C)
Perform additional tests of controls Decide to modify tests of details of balances
Yes No

D)
Perform additional tests of controls Decide to modify tests of details of balances
No Yes

Answer
Terms: Analytical procedures indicate reasonable possibility of misstatement
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

7) If the results of the tests of controls, substantive tests of transactions, and analytical procedures are not consistent with the predictions, tests of details of balances will be:
A) eliminated.
B) increased.
C) unaffected.
D) changed.
Answer
Terms: Results of tests of controls, substantive tests of transactions, and analytical procedures
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

8) The auditor would design which of the following audit tests to detect possible monetary errors in the financial statements?
A) Control tests
B) Analytical procedures
C) Risk assessment procedures
D) Tests of operating effectives of controls over revenue and cash
Answer
Terms: Audit tests to detect possible monetary errors in the financial statements
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

9) The reliance the auditor places on substantive tests in relation to the reliance placed on internal control varies in a relationship that is ordinarily:
A) parallel.
B) inverse.
C) direct.
D) equal.
Answer
Terms: Reliance auditor places on substantive tests and internal controls
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

10) A deficiency uncovered in the audit of internal control is explained by which of the following in relation to a financial statement misstatement?
A) the amount of the misstatement
B) the likelihood of the misstatement
C) the amount, likelihood, and classification of the misstatement
D) the amount and the classification of the misstatement
Answer
Terms: Deficiency uncovered in audit of internal control
Diff: Challenging
Objective: LO 13-2
AACSB: Reflective thinking skills

11) Which of the following is not a valid basis for omitting an audit test in forming an opinion on the clients financial statements?
A) the difficulty and expense involved in testing a particular item
B) the relative risk involved
C) the degree of reliance on the relevant internal controls
D) the relationship between the cost of obtaining evidence and its usefulness
Answer
Terms: Not a valid basis for omitting an audit test in forming an opinion
Diff: Challenging
Objective: LO 13-2
AACSB: Reflective thinking skills

12) Three factors the auditor considers when assessing control risk are: the auditor’s belief concerning the effectiveness of internal controls, the results of tests of controls, and the cost-effectiveness of a reduced assessed control risk. Identify the combination of conditions for these three factors that is required before a reduction in substantive testing is permitted.
Answer reduction in substantive testing is permitted when (1) the auditor identifies specific controls he or she believes have been operating effectively during the period under audit, (2) the auditor believes it will be cost-effective to test those controls, and (3) the results of tests of controls indicate that the controls have indeed been operating effectively.
Terms: Three factors auditor considers when assessing control risk and conditions before reduction in substantive testing
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills
13) Tests of controls are generally more costly to perform than analytical procedures.
A) True
B) False
Answer
Terms: Cost of tests of controls vs. analytical procedures
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

14) Substantive tests of details of balances are the most costly type of audit test to perform.
A) True
B) False
Answer
Terms: Substantive tests of details of balances cost
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

15) Analytical procedures are the least costly type of audit test.
A) True
B) False
Answer
Terms: Analytical procedures cost
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

16) If inherent risk is increased to medium from low, tests of details of balances can be reduced.
A) True
B) False
Answer
Terms: Inherent risk; Details of balances
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

17) The extent of tests of details of balances cannot be reduced when transaction-related audit objectives have been satisfied by tests of controls or substantive tests of transactions.
A) True
B) False
Answer
Terms: Extent of details of balances; Transaction-related audit objectives; Tests of controls and substantive tests of transactions
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

18) Tests of controls and substantive tests of transactions are normally conducted simultaneously on the same transactions.
A) True
B) False
Answer
Terms: Not considered a further audit procedure
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

19) Under normal circumstances, there should be no variation in the audit evidence mix from cycle to cycle for a given audit engagement.
A) True
B) False
Answer
Terms: Variation in audit evidence in cycles
Diff: Easy
Objective: LO 13-2
AACSB: Reflective thinking skills

20) Analytical procedures are the most expensive type of audit test to perform because of the expertise and training required to properly use them.
A) True
B) False
Answer
Terms: Analytical procedures cost
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

21) The results of tests of controls and substantive tests of transactions affect the design of tests of details of balances.
A) True
B) False
Answer
Terms: Results of tests of controls affect design of tests of details of balances
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

22) If the auditor’s preliminary assessment of control risk is decreased from high to medium, tests of controls can be reduced.
A) True
B) False
Answer
Terms: Auditor’s preliminary assessment of control risk
Diff: Moderate
Objective: LO 13-2
AACSB: Reflective thinking skills

Learning Objective 13-3

1) The most important consideration in developing the audit plan and audit program is the:
A) client’s size.
B) client’s industry.
C) audit firm’s available personnel.
D) audit risk model used in its planning form.
Answer
Terms: Most important consideration in developing the audit plan and audit program
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

2) Auditors who test manual controls that rely on IT-generated reports must consider:
A) the benefits of relying on IT-generated reports.
B) separation of duties related to the IT-generated reports.
C) the controls related to the accuracy of the information in the report.
D) whether the manual controls are approved by the audit committee.
Answer
Terms: Test manual controls that rely on IT-generated reports
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

3) Auditing standards recognize that in instances where a significant amount of audit evidence is in electronic form, it may not be possible to reduce detection risk to an acceptable level by performing only substantive tests.
A) True
B) False
Answer
Terms: Auditing standards; Evidence in electronic form reduces detection risk
Diff: Moderate
Objective: LO 13-3
AACSB: Reflective thinking skills

4) In the audit of a public company, computer controls must be tested if they are considered to be key controls for reducing the likelihood of material misstatements in the financial statements.
A) True
B) False
Answer
Terms: Audit of public company testing of computer controls
Diff: Challenging
Objective: LO 13-3
AACSB: Reflective thinking skills
Topic: Public

5) Procedures to obtain an understanding of internal control may suffice for tests of controls when the auditor is assessing automated controls.
A) True
B) False
Answer
Terms: Procedures to obtain understanding of internal control; Tests of controls; Automated controls
Diff: Challenging
Objective: LO 13-3
AACSB: Reflective thinking skills

Learning Objective 13-4

1) The evidence mix includes risk assessment procedures.
A) True
B) False
Answer
Terms: Evidence mix and risk assessment procedures
Diff: Moderate
Objective: LO 13-1 and LO 13-4
AACSB: Reflective thinking skills

Learning Objective 13-5

1) A document that details what the auditor will do to gather sufficient, appropriate evidence is the:
A) audit strategy.
B) audit program.
C) audit procedure.
D) audit risk model.
Answer
Terms: Document that details what the audit will do to gather sufficient, appropriate evidence
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

2) Auditors follow a four step approach to reduce assessed control risk. Which of the following is not one of the four?
A) Apply transaction related audit objectives to a class of transactions.
B) Indentify accounts that have high inherent risk.
C) Identify key controls that reduce control risk.
D) For potential misstatements, design appropriate substantive tests of transactions.
Answer
Terms: Approach to reduce assessed control risk
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

3) When designing tests of controls and substantive tests an auditor is gathering evidence to satisfy the transaction related audit objectives. What are the four steps the auditor would normally follow to reduce assessed control risk?

4) What are the four steps auditors follow when they plan to reduce assessed control risk?

5) Discuss the relationship of each of the following to the extent of planned tests of details of balances: (1) tolerable misstatement, (2) inherent risk, (3) control risk, and (4) acceptable audit risk.

6) Auditing standards require a written audit program.
A) True
B) False
Answer
Terms: Auditing standards; Audit program
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

7) When designing an audit program for tests of details of balances, the auditor should make assumptions about inherent risk and control risk, and predictions concerning the outcome of tests of controls, substantive tests of transactions, and analytical procedures.
A) True
B) False
Answer
Terms: Designing audit program; Inherent risk and control risk; Tests of controls, substantive tests of transactions, and analytical procedures
Diff: Easy
Objective: LO 13-5
AACSB: Reflective thinking skills

8) When testing details of balances, most audit procedures satisfy only one balance-related objective, but more than one audit procedure should be used to test each objective.
A) True
B) False
Answer
Terms: Testing details of balances and audit procedures
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

9) Substantive tests of transactions and control tests are often conducted simultaneously.
A) True
B) False
Answer
Terms: Substantive tests of transactions and control tests
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

10) Auditing standards require that tests of controls be performed on every audit engagement.
A) True
B) False
Answer
Terms: Auditing standards require tests of controls
Diff: Moderate
Objective: LO 13-5
AACSB: Reflective thinking skills

Learning Objective 13-6

1) Which of the following types of procedures will be performed in an audit of internal control over financial reporting?
A)
Procedures to obtain an understanding of internal control Ratio analysis
Yes Yes

B)
Procedures to obtain an understanding of internal control Ratio analysis
No No

C)
Procedures to obtain an understanding of internal control Ratio analysis
Yes No

D)
Procedures to obtain an understanding of internal control Ratio analysis
No Yes

Answer
Terms: Types of procedures performed in an audit of internal control
Diff: Moderate
Objective: LO 13-6
AACSB: Reflective thinking skills
Topic: Public

2) What type of test is used to obtain more types of evidence than any other?
A) Substantive tests of transactions
B) Tests of controls
C) Analytical procedures
D) Tests of details
Answer
Terms: Type of test used to obtain more types of evidence
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

3) Which audit tests involve physical examination and confirmation?
A) tests of controls
B) tests of transactions
C) tests of balances
D) analytical procedures
Answer
Terms: Audit tests that involve physical examination and confirmation
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills
4) Which of the following is generally not included in the “evidence mix”?
A) Tests of Controls
B) Substantive Tests of Transactions
C) Risk Assessment Procedures
D) Tests of details of balances
Answer
Terms: Evidence mix
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

5) Which of the following types of evidence is not available when using substantive tests of transactions?
A) Documentation
B) Confirmation
C) Inquiries of the client
D) Reperformance
Answer
Terms: Types of evidence not available when using substantive tests of transactions
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

6) Analytical procedures provide fewer types of evidence than any other type of audit test.
A) True
B) False
Answer
Terms: Analytical procedures and evidence
Diff: Challenging
Objective: LO 13-6
AACSB: Reflective thinking skills

Learning Objective 13-7

1) Presentation and disclosure related audit objectives would be performed in which phase of the audit process?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Presentation and disclosure related audit objective performed in what phase of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
2) Transaction related audit objectives would most likely be performed in which phase of the audit process?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Transaction related audit objectives performed in what phase of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

3) Analytical procedures must be performed in:
A) the planning and test of control stages.
B) conjunction with tests of transactions and tests of details of balances.
C) the planning and completion stages.
D) the planning, test of control, and completion stages.
Answer
Terms: Analytical procedures must be performed
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

4) Which of the following tests commonly occur together?
A) substantive tests of transactions and tests of controls
B) substantive tests of transactions and obtaining an understanding of internal controls
C) analytical procedures and tests of controls
D) tests of controls and tests of details of balances
Answer
Terms: Tests that occur together
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

5) Tests of controls and substantive tests of transactions are an important determinant of the extent of the auditor’s use of tests of details of balances. Which of the following is true?
A) They are likely to be performed prior to the clients end of the fiscal year.
B) They are likely to eliminate the need for tests of details of balances.
C) They are likely to have no impact on the planned tests of details of balances.
D) They are likely to be used only in the audit of internal control.
Answer
Terms: Tests of controls and substantive tests of transactions
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
6) When the auditor has completed the tests of details of balances and enters phase 4 of the audit process, she must still perform audit procedures for which of the following?
A) contingent liabilities and employee compensation
B) contingent liabilities and subsequent events
C) subsequent events and contractual commitments
D) subsequent events and unrecorded liabilities
Answer
Terms: Audit procedures performed in phase 4 of audit process
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

7) Which of the following audit tests would be regarded as a test of controls?
A) Comparison of the inventory pricing to vendors’ invoices.
B) Tests of the signatures on canceled checks to board of directors’ authorizations.
C) Tests of the additions to property, plant, and equipment by physical inspections.
D) Review of the specific items making up the balance in a given general ledger account.
Answer
Terms: Tests of controls audit tests
Diff: Moderate
Objective: LO 13-7
AACSB: Analytic skills

8) Which of the following audit tests form the basis for an auditor’s report on internal control over financial reporting?
A) Analytical procedures
B) Tests of transactions
C) Tests of controls
D) Tests of details of balances
Answer
Terms: Audit tests that form basis for auditor’s report on internal control
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Topic: Public

9) After finishing the review phase of the study and evaluation of internal control in an audit, the auditor should perform tests of controls on:
A) those controls that the auditor wants and plans to rely upon.
B) those controls in which material weaknesses were identified.
C) those controls that have a material effect upon the financial statement balances.
D) a random sample of the controls that were reviewed.
Answer
Terms: After finishing the review phase of study and evaluation of internal control in an audit, auditor should perform
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
10) At what point in the audit process are tests of details most appropriately designed?
A) plan and design audit approach
B) perform audit tests for controls and transactions
C) perform analytical procedures and tests of balances
D) complete the audit and issue the audit report
Answer
Terms: Audit process and test of details
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills

11) Which of the following is/are performed in an audit of internal control over financial reporting?
A)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
Yes Yes No

B)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
Yes No No

C)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
No Yes Yes

D)
Procedures to obtain an understanding of internal control Test of details of balances Analytical Procedures
No No Yes

Answer
Terms: Audit of internal control over financial reporting
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Topic: Public

12) Which of the following ultimately determines the specific audit procedures necessary to provide an independent auditor with a reasonable basis for the expression of an opinion?
A) the audit program
B) the auditor’s judgment
C) generally accepted auditing standards
D) the auditor’s working papers
Answer
Terms: Determines specific audit procedures
Diff: Challenging
Objective: LO 13-7
AACSB: Reflective thinking skills

13) In phase 4 of the audit, complete the audit and issue an audit report, there are five activities required. List below the activities.

14) In accumulating final evidence upon which to base an audit opinion, the auditor should perform four activities. List the activities below.

15) Discuss the major activities and procedures performed by the auditor in the plan and design of the audit approach.

16) The auditor must communicate significant deficiencies in internal control only after the entire audit is complete to ensure the auditor has a sufficient understanding of the circumstances surrounding the deficiency.
A) True
B) False
Answer
Terms: Auditor communicate significant deficiencies in internal control
Diff: Moderate
Objective: LO 13-7
AACSB: Reflective thinking skills
Auditing and Assurance Services, 14e (Arens)
Chapter 14 Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions

Learning Objective 14-1

1) Which of the following is not an account affected by the sales and collection cycle?
A) Cash
B) Accounts receivable
C) Allowance for doubtful accounts
D) Sales of Accounts Receivables
Answer
Terms: Sales and collection cycle
Diff: Easy
Objective: LO 14-1
AACSB: Reflective thinking skills

2) The auditor’s objectives for the sales and cash collections activities when the client is primarily an e-commerce business as compared to a “bricks and mortar” business are:
A) unchanged.
B) expanded.
C) mitigated.
D) decreased.
Answer
Terms: Auditor objectives for sales and cash collections
Diff: Moderate
Objective: LO 14-1
AACSB: Analytic skills

3) The overall objective in the audit of the sales and collection cycle is to evaluate whether the account balances affected by the cycle are fairly presented in accordance with Accounting standards.
A) True
B) False
Answer
Terms: Objective in audit of sales and collection cycle; Account balances fairly presented
Diff: Easy
Objective: LO 14-1
AACSB: Reflective thinking skills

4) The sales and collection cycle applies to businesses that transfer goods to customers or provides services to businesses.
A) True
B) False
Answer
Terms: Sales and collection cycle
Diff: Moderate
Objective: LO 14-1
AACSB: Reflective thinking skills
Learning Objective 14-2

1) Which of the following is not one of the five classes of transactions included in the sales and collection cycle?
A) Sales returns and allowances
B) Write-off of uncollectible accounts
C) Bad debt expense
D) Interest Income
Answer
Terms: Class of transactions; Sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

2) What event initiates a transaction in the sales and collection cycle?
A) receipt of cash
B) delivery of product to a customer
C) identification of a new customer
D) customer request for goods
Answer
Terms: Initiates transaction in sales and collection cycle
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

3) A ________ is a document that indicates a request for merchandise by a customer.
A) sales invoice
B) vendor invoice
C) customer order
D) sales order
Answer
Terms: Document indicates request for merchandise
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

4) A ________ is a document that is matched with the customer order to assure that the correct quantity and type of goods are shipped.
A) sales order
B) customer order
C) vendor invoice
D) sales invoice
Answer
Terms: Document matched with customer order
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

5) What critical event must take place before goods can be shipped in order to assure payment can be reasonably expected?
A) determination of correct delivery address
B) credit approval
C) matching of shipping document with sales invoice
D) receipt of sales order from the customer
Answer
Terms: Event must take place in order to assure payment
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

6) Before goods are shipped on account, a properly authorized person must:
A) prepare the sales invoice.
B) approve the journal entry.
C) approve the customer’s credit.
D) verify that the unit price is accurate.
Answer
Terms: Goods shipped on account; Properly authorized person
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

7) A document prepared to initiate shipment of the goods sold by an independent shipper is the:
A) sales order.
B) bill of lading.
C) sales invoice.
D) customer order.
Answer
Terms: Document prepared to initiate shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

8) The document used to indicate to the customer the amount of a sale and payment due date is the:
A) sales invoice.
B) bill of lading.
C) purchase order.
D) sales order.
Answer
Terms: Document used to indicate amount of sale and payment due date
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

9) In the sales and collection cycle when is, generally, the earliest point at which revenue can be recognized?
A) sales approval
B) credit approval
C) cash collection
D) shipment of goods
Answer
Terms: Sales and collection cycle; revenue recognized
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

10) Most companies recognize sales revenue when:
A) sales are invoiced.
B) goods are received by the customer.
C) goods are shipped.
D) Both B and C are correct, depending upon the company’s revenue recognition policies.
Answer
Terms: Recognize sales revenue
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

11) Which of the following is not a business function within the “Sales” class of transactions?
A) processing customer orders
B) granting credit
C) processing and recording sales returns and allowances
D) shipping goods
Answer
Terms: Business function within the sales class of transactions
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

12) The total of the individual account balances in the accounts receivable subsidiary ledger should equal the:
A) total sales for the period.
B) balance of the sales account in the general ledger.
C) total sales less the total cash received for the period.
D) balance of the accounts receivable account in the general ledger.
Answer
Terms: Accounts receivable subsidiary ledger
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

13) In the accounts receivable subsidiary ledger the length of time the account has been due can be useful to the client and the auditor in preparing the:
A) trial balance.
B) working trial balance.
C) accounts receivable trial balance.
D) aged accounts receivable trial balance.
Answer
Terms: Accounts receivable subsidiary ledger
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

14) A document sent to each customer showing his or her beginning accounts receivable balance and the amount and date of each sale, cash payment received, any debit or credit memo issued, and the ending balance is the:
A) accounts receivable subsidiary ledger.
B) monthly statement.
C) remittance advice.
D) sales invoice.
Answer
Terms: Document sent to customer showing beginning accounts receivable balance
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

15) The document that accompanies the customer’s payment is the:
A) credit memo.
B) remittance advice.
C) vendor invoice.
D) monthly statement.
Answer
Terms: Document that accompanies customer’s payment
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

16) The document that requires adjustments to the customers subsidiary ledger account is the:
A) bill of lading.
B) sales invoice.
C) credit memo.
D) monthly statement.
Answer
Terms: Document that requires adjustment to the customer’s account
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

17) A document that initiates shipment of goods and indicates the description of the merchandise, the quantity shipped, and customer name and address is the:
A) bill of lading.
B) sales invoice.
C) picking ticket.
D) vendor invoice.
Answer
Terms: Document that initiates shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

18) The ________ is a contract between a carrier (e.g., a trucking company) and the seller of goods that dictates the details surrounding the shipment of goods.
A) bill of lading
B) sales invoice
C) picking ticket
D) remittance advice
Answer
Terms: Contract that dictates details for shipment of goods
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

19) Some companies have customers send payments directly to a post office box address maintained by a bank. This is called a(n) ________ system.
A) direct deposit
B) funds transfer
C) lockbox
D) interbank transfer
Answer
Terms: Payments sent to post office box
Diff: Easy
Objective: LO 14-2
AACSB: Reflective thinking skills

20) In designing audit procedures for the sales returns and allowances account, the auditor would primarily rely on the following accounts, except for:
A) sales returns and allowances transaction file.
B) accounts receivable master file.
C) cash receipts journal.
D) sales returns and allowances will be recorded in all of the above.
Answer
Terms: Designing audit procedures sales returns and allowances
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

21) For a firm that practices good internal controls in the sales and collections cycle, the function of indicating credit approval should be recorded on which of the following documents?
A) sales order
B) sales invoice
C) customer order
D) remittance advice
Answer
Terms: Good internal controls in sales and collection cycle; Credit approval
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

22) When posting items from the sales journal, details of the journal and journal totals are posted to which items?
A)
Details of the journal are posted to Journal totals are posted to
The sales account The general ledger

B)
Details of the journal are posted to Journal totals are posted to
The sales account The accounts receivable subsidiary ledger

C)
Details of the journal are posted to Journal totals are posted to
The accounts receivable master file The general ledger

D)
Details of the journal are posted to Journal totals are posted to
The accounts receivable account in the general ledger The sales account in the general ledger

Answer
Terms: Posting from sales journal; Details of journal and journal totals posted
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

23) Credit memos are normally issued for what purpose(s)?
A) To adjust the customers balance to the amount owed to the company.
B) To assist in the aging of accounts receivable.
C) To reduce customer frustration and sales losses.
D) To inform the customer of the balance due.
Answer
Terms: Credit memos
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

24) Who is generally responsible for opening receipts when a company uses a lockbox to speed the handling of cash receipts?
A) company personnel
B) temporary employees in the town where the lockbox is located
C) bank employees
D) company controller
Answer
Terms: Opening receipts; Lockbox
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

25) One key internal control to prevent fictitious transactions in the sales and collection cycle is:
A) assign a specific customer number for each customer in the computer files.
B) to account for the integrity of the numerical sequence of sales orders.
C) to include the sales price list of all products in the computer files.
D) having bank reconciliations prepared by one who is independent of the treasury function.
Answer
Terms: Internal control; Fictitious transactions in sales and collection cycle
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

26) Which of the following is the appropriate point at which the auditor deems authorization to be critical?
A)
Credit granting Price authorization Shipment of goods
Yes Yes Yes

B)
Credit granting Price authorization Shipment of goods
Yes No Yes

C)
Credit granting Price authorization Shipment of goods
No Yes No

D)
Credit granting Price authorization Shipment of goods
Yes No No

Answer
Terms: Point authorization deemed critical
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

27) Sales should be recorded, at the earliest, when:
A) the order is received.
B) the order is received and credit is approved.
C) credit is approved and it is verified that there is enough inventory to fill the order.
D) the shipment takes place.
Answer
Terms: Sales recorded
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

28) Which of the following would least concern an auditor regarding the lack of a specific authorization to conduct the sales transaction?
A) granting of credit
B) shipment of goods
C) determination of discounts
D) selling of goods for cash
Answer
Terms: Specific authorization to conduct sales transactions
Diff: Moderate
Objective: LO 14-2
AACSB: Reflective thinking skills

29) Smith Manufacturing Company’s accounts receivable clerk has a friend who is also a Smith’s customer. The accounts receivable clerk has issued fictitious credit memos to his friend for goods supposedly returned. The most effective procedure for preventing this activity is to:
A) prenumber and account for all credit memorandums.
B) require receiving reports that provide evidence of returned inventory items to support all credit memorandums before they are approved.
C) have independent sales and accounts receivable departments.
D) mail monthly statements to customers.
Answer
Terms: Fictitious credit memos; Procedure to prevent activity
Diff: Moderate
Objective: LO 14-2
AACSB: Analytic skills

30) Explain each of the following types of documents and indicate the class of transactions in which they are commonly used.
1. Customer order
2. Shipping document
3. Remittance advice
4. Sales returns and allowance journal
5. Uncollectible account authorization form

31) You are an audit manager for Rodgers & Co. and have recently taken on as a client Manufacturing Company. You are in the initial stages of planning the audit and have decided to start gathering information about the Sales/Collection Cycle of the business. List below the classes of transactions that you need to gather audit evidence for in designing your audit procedures.

32) Customer billing is a critical process which auditors must understand. What are the most important aspects of billing and what are the related objectives?

33) Discuss the four business functions that result in sales transactions in a typical sales and collection cycle and, for each function, state the key documents and records involved.

34) Match seven of the terms for documents and records (a-k) with the descriptions provided below (1-7):

a. Customer order form
b. Sales order
c. Bill of lading
d. Sales invoice
e. Summary sales report
f. Accounts receivable master file
g. Monthly statement
h. Remittance advice
i. Prelisting of cash receipts
j. Credit memo
k. Uncollectible account authorization form

________ 1. A list prepared when cash is received by someone who has no responsibility for recording sales, accounts receivable, or cash, and has no access to the accounting records. It is used to verify whether cash received was recorded and deposited at the correct amounts and on a timely basis.

________ 2. A document indicating a reduction in the amount due from a custome