3.10

Question 1

An auditor who performed analytical procedures that compared current-year financial information to the comparable prior period noted a significant increase in net income. Given this result, which of the following expectations of recorded amounts would be unreasonable?

Answer 1

A decrease in retained earnings.

An increase in net income results either in an increase in retained earnings or in unchanged retained earnings if the entire amount of net income is used to pay dividends. Retained earnings is not expected to decrease given an increase in net income.

Question 2

If specific information that implies the existence of possible noncompliance with laws and regulations that could have a material effect on the financial statements comes to an auditor’s attention, the auditor should next

Answer 2

Apply audit procedures specifically directed to ascertaining whether noncompliance has occurred.

The auditor should apply audit procedures specifically directed to ascertaining whether noncompliance has occurred. When the auditor becomes aware of information about possible noncompliance, the auditor should obtain (1) an understanding of the nature of the act and the circumstances in which it occurred and (2) further information to evaluate the effect on the financial statements.

Question 3

Which of the following nonfinancial information would an auditor most likely consider in performing analytical procedures during the planning phase of an audit?

Answer 3

Square footage of selling space.

Although analytical procedures used in planning the audit often use only financial data, sometimes relevant nonfinancial information is considered as well. For example, number of employees, square footage of selling space, volume of goods produced, and similar information may contribute to accomplishing the purpose of the procedures.

Question 4

Which of the following is considered a fraudulent activity?

Answer 4

Misappropriation of assets.

Fraud is an intentional act involving the use of deception that results in misstatement of the financial statements. Two types of fraud that are relevant to the auditor are (1) misstatements arising from fraudulent financial reporting and (2) misstatements arising from misappropriation of assets.

Question 5

The audit plan usually cannot be finalized until the

Answer 5

Understanding of the entity and its environment has been completed.

The auditor must obtain an understanding of the entity and its environment, including internal control, to assess the risks of material misstatement of the financial statements, whether due to fraud or error.

Question 6

When performing analytical procedures as risk assessment procedures, the auditor most likely would develop expectations by reviewing which of the following sources of information?

Answer 6

Unaudited information from internal quarterly reports.

Analytical procedures applied as risk assessment procedures (analytical procedures used to plan the audit) at the beginning of the audit may improve the understanding of the client’s business and significant transactions and events since the last audit. They also may identify unusual transactions or events and amounts, ratios, and trends that might indicate matters with audit implications (AU-C 315). The unaudited information included in the quarterly reports will give the auditor a sufficient overview to identify areas that may represent specific audit risks.

Question 7

Prior to the audit, an auditor usually discusses the general audit strategy with the client’s management. Which of the following details do management and the auditor usually agree upon at this time?

Answer 7

The schedules and analyses that the client’s staff should prepare.

The terms of the engagement should be documented in an engagement letter that states the following: (1) objective and scope of the audit, (2) responsibilities of the auditor and management, (3) inherent limitations of the audit and internal control, (4) the financial reporting framework, and (5) the expected form and content of audit reports. The engagement letter also includes other relevant information, such as fees, billings, and assistance to be provided by the client’s staff.

Question 8

Which of the following matters does an auditor usually include in the engagement letter?

Answer 8

Arrangements regarding fees and billing.

The engagement letter documents the terms of the auditor’s agreement with management or those charged with governance. It includes (1) the objective and scope of the audit; (2) the responsibilities of the auditor and management; (3) the inherent limitations of the audit and internal control; (4) the financial reporting framework; (5) the expected form and content of reports; and (6) other relevant information, such as fee arrangements, billings, and assistance by the client’s staff (AU-C 210).

Question 9

Which of the following is a true statement about the required documentation in an audit performed in accordance with generally accepted auditing standards?

Answer 9

A documented audit plan describing the necessary procedures to be performed is required.

An audit plan should be developed and documented based on the overall audit strategy. This strategy, the audit plan, significant changes in them, and the reasons for changes are documented. The audit plan records the nature, timing, and extent of risk assessment procedures and further procedures performed at the assertion level to respond to assessed risks. It also records other planned procedures required by GAAS. Thus, the audit plan is a record of the planning of the audit procedures that can be reviewed prior to their performance (AU-C 300 and AS No. 9).

Question 10

Which of the following is an example of an inherent risk that an auditor should consider?

Answer 10

Technological developments that may render inventory obsolete.

Inherent risk is the susceptibility of a financial statement assertion to a material misstatement before consideration of any related controls. Inherent risk is higher for some assertions and related transactions, balances, and disclosures. For example, it may be higher for complex calculations or amounts with significant estimation uncertainty. Business risks also may affect inherent risk. For example, technological developments might make a product obsolete, causing inventory to be overstated.

Question 11

A basic premise underlying analytical procedures is that

Answer 11

Plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary.

A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Variability in these relationships can be explained by, for example, unusual events or transactions, business or accounting changes, misstatements, or random fluctuations.

Question 12

An auditor assesses the risks of material misstatement because they

Answer 12

Affect the level of detection risk that the auditor may accept.

Control risk and inherent risk are the components of the risk of material misstatement (RMM). The auditor determines the appropriate level of detection risk based on the assessment of RMMs and the acceptable level of audit risk.

Question 13

The most likely reason the audit cannot reasonably be expected to bring all noncompliance with laws and regulations by the client to the auditor’s attention is that

Answer 13

Noncompliance by clients often relates to operating aspects rather than accounting aspects.

Some noncompliance, such as violations of tax law, has a direct effect on the financial statements. Other noncompliance, such as violations of environmental protection laws, relates more to an entity’s operating aspects than to its financial and accounting aspects, and their financial statement effect is indirect. An audit in accordance with GAAS usually does not include audit procedures specifically designed to detect noncompliance that has such indirect effects. Thus, no assurance is provided that such noncompliance will be detected or that resulting contingent liabilities will be disclosed. However, an audit should be designed to provide reasonable assurance that noncompliance having a direct and material effect on the financial statements will be detected.

Question 14

If not already done to form an overall conclusion, the auditor should perform analytical procedures relating to which of the following transaction cycles?

Answer 14

Revenues.

Revenue is an account for which expectations can be developed by the auditor. It is a key account that should be predictable.

Question 15

Which of the following would be considered an analytical procedure?

Answer 15

Comparing inventory balances to recent sales activities.

Analytical procedures are evaluations of financial data made by a study of plausible relationships among financial and nonfinancial data. Comparing inventory balances with recent sales activities is a study of a plausible relationship between these activities.

Question 16

When an auditor obtains an understanding of the entity and its environment, including its internal control, which of the following is the most likely order of performing the steps A through C below?

A = Tests of controls
B = Preparation of a flowchart documenting the understanding of the client’s internal control 
C = Substantive procedures

Answer 16

BAC

The auditor obtains an understanding of internal control. This understanding may include flowcharting the system. Next, the auditor must assess the risks of material misstatement, whether due to fraud or error. In response to this assessment, the auditor performs further audit procedures. These procedures ordinarily include tests of controls to evaluate their operating effectiveness when (1) the auditor intends to rely on the controls to determine substantive procedures or (2) substantive procedures alone are insufficient.

Question 17

Usually, the decision to notify parties outside the client’s organization regarding noncompliance with laws and regulations is the responsibility of the

Answer 17

Management.

Deciding whether to contact parties other than personnel within the client’s organization about noncompliance with laws and regulations is the responsibility of management. However, the auditor’s responsibility to report externally may be expanded in special engagements. For example, in audits of governmental units in accordance with the Single Audit Act, the auditor may be required to report on the unit’s compliance with laws and regulations applicable to federal financial assistance programs (AU-C 250).

Question 18

An auditor who discovers that a client’s employees have paid small bribes to public officials most likely would withdraw from the engagement if the

Answer 18

Employees’ actions affect the auditor’s ability to rely on management’s representations.

The auditor’s response to detected illegal acts is to consider the effects on the financial statements and the implications for other aspects of the audit, especially the reliability of management’s representations. The auditor should consider the qualitative and quantitative materiality of the act, consider the adequacy of disclosure, and communicate material problems to those charged with governance. Even when an illegal act is not material to the financial statements, the loss of management credibility may result in a need to end the relationship with the client.

Question 19

Ordinarily, the predecessor auditor permits the auditor to review the predecessor’s audit documentation relating to

Contingencies:
Balance Sheet accounts:

Answer 19

Yes
Yes

The Code of Professional Conduct protects the confidentiality of client information. Accordingly, the predecessor auditor cannot permit the auditor to review the predecessor’s audit documentation without management’s specific consent. Moreover, the auditor and the predecessor auditor must keep in confidence information obtained from each other. However, the predecessor auditor ordinarily is expected to cooperate with the auditor and respond fully. Audit documentation records the audit procedures performed, relevant evidence obtained, and conclusions reached. The auditor ordinarily reviews audit documentation related to planning, internal control, audit results, and other matters of continuing accounting and auditing significance, such as the analysis of balance sheet accounts, and those relating to contingencies.

Question 20

In an audit of a nonissuer’s financial statements, projected misstatement is

Answer 20

An auditor’s best estimate of misstatements in a population extrapolated from misstatements identified in an audit sample.

Projected misstatement is the auditor’s best estimate of the misstatement in populations based on audit samples.