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Flashcards in A4-2 Deck (115)
1

On receiving a client's bank cutoff statement, an auditor most likely would trace:

a.

Deposits in transit listed in the cutoff statement to the year-end bank reconciliation.

b.

Checks dated after year-end listed in the cutoff statement to the year-end outstanding checklist.

c.

Deposits recorded in the cash receipts journal after year-end to the cutoff statement.

d.

Prior-year checks listed in the cutoff statement to the year-end outstanding checklist.

Choice "d" is correct. The auditor should obtain bank cutoff statements that include transactions for 10 to 15 days after year-end. The outstanding checks and deposits in transit at year-end on the bank reconciliation should agree with the information in the bank cutoff statement.

Choice "a" is incorrect. Companies may have a tendency to overstate their cash balance. A company that is trying to improve its balance sheet will have a tendency to accelerate recording of deposits, so a deposit that wasn't really made until January might be erroneously listed as a deposit in transit at year-end. Tracing deposits from the cutoff statement to the year-end bank reconciliation won't identify this error, since there is no mention in this option of identifying the actual dates the deposits were made.

Choice "b" is incorrect. Checks dated after year-end would not be included in the year-end outstanding checklist.

Choice "c" is incorrect. Deposits recorded in the cash receipts journal after year-end do not affect the cash balance at year-end, and therefore the auditor would not perform audit procedures with respect to those deposits.

2

Which of the following characteristics most likely would be indicative of check kiting?

a.

Frequent ATM checking account withdrawals.

b.

Low average balance compared to high level of deposits.

c.

Many large checks that are recorded on Mondays.

d.

High turnover of employees who have access to cash.

Choice "b" is correct. Kiting occurs when a check drawn on one bank is deposited in another bank and no record is made of the disbursement in the balance of the first bank. Frequent kiting may result in a high level of deposits coupled with a low average balance.

Choice "d" is incorrect. High turnover of employees who have access to cash may be normal in certain industries, or it may be indicative of poor hiring policies, but it would not be indicative of check kiting.

Choice "c" is incorrect. More checks may arrive on Mondays simply because Monday's mail includes the mail from over the weekend. This characteristic is not particularly indicative of check kiting.

Choice "a" is incorrect. Frequent ATM checking account withdrawals indicate a frequent need for cash, but this situation is not particularly indicative of check kiting.

3

Which of the following fraudulent activities most likely could be perpetrated due to the lack of effective internal controls in the revenue cycle?

a.

Fictitious transactions may be recorded that cause an understatement of revenues and overstatement of receivables.

b.

The failure to prepare shipping documents may cause an overstatement of inventory balances.

c.

Authorization of credit memos by personnel who receive cash may permit the misappropriation of cash.

d.

Claims received from customers for goods returned may be intentionally recorded in other customers' accounts.

Choice "c" is correct. The function of cash receipts is part of the treasurer's department and should be separate from the role of posting credits to the A/R ledger. Failure to separate the recordkeeping function from the custodial function allows an individual to misappropriate cash and then cover up the theft by posting credits against the related A/R balance.

Choice "a" is incorrect. If fictitious transactions in the revenue cycle are recorded, then the impact on revenues and receivables would be the same; either both would be overstated (the most likely case) or both would be understated.

Choice "d" is incorrect. Even the lack of effective internal controls would not allow this fraud to be perpetrated for long, since the customers that submitted the claim would complain that the credit was not properly applied as soon as they received their next statement or invoice.

Choice "b" is incorrect. The failure to prepare shipping documents may cause inventory to be overstated, but it is unlikely to be perpetrated as a fraud since it does not allow theft of cash. In addition, the internal controls in the revenue cycle typically relate to sales, receivables, and cash, not to inventory.

4

In testing controls over cash disbursements, an auditor most likely would determine that the person who signs checks also:

a.

Reviews the monthly bank reconciliation.

b.

Is responsible for mailing the checks.

c.

Returns the checks to accounts payable.

d.

Is denied access to the supporting documents.


Explanation

Choice "b" is correct. Once signed, the check should be mailed to the payee by the check signer or an employee operating under the supervision of the check signer to prevent defalcations of checks. Generally this occurs in the treasurer's department. 

Choice "a" is incorrect. The check signer would not normally review bank reconciliations.

Choice "c" is incorrect. Accounts payable personnel should not have custody of signed checks since this would constitute a lack of segregation of duties between recording and custody. 

Choice "d" is incorrect. The check signer should have access to supporting documentation so that it can be reviewed before the check is signed.

5

Which of the following sets of information does an auditor usually confirm on one form?

a.

Accounts receivable and accrued interest receivable.

b.

Cash in bank and collateral for loans.

c.

Inventory on consignment and contingent liabilities.

d.

Accounts payable and purchase commitments.

Choice "b" is correct. The standard AICPA bank confirmation form includes spaces for the bank to confirm both cash balances on deposit at the bank and collateral pledged on loans originating from the bank. 

Choice "d" is incorrect. Purchase commitments are not typically confirmed on an accounts payable confirmation request. 

Choice "c" is incorrect. Contingent liabilities (confirmed in a letter of inquiry to the client's attorney or bank) and inventory on consignment (confirmed with the consignee) are not confirmed together. 

Choice "a" is incorrect. Accrued interest receivable (usually on investments held by a trust company) is not typically confirmed along with trade accounts receivable.

6

The usefulness of the standard bank confirmation request may be limited because the bank employee who completes the form may:

a.

Not believe that the bank is obligated to verify confidential information to a third party.

b.

Not have access to the client's cutoff bank statement.

c.

Be unaware of all the financial relationships that the bank has with the client.

d.

Sign and return the form without inspecting the accuracy of the client's bank reconciliation.

Choice "c" is correct. A bank employee may not have access to all information about transactions with the audit client and thus may be unaware of all the financial relationships the bank has with the client.

Choice "a" is incorrect. Standard bank confirmations contain a signature from an authorized client employee and are a very commonly used audit procedure. It is unlikely that a bank would refuse the request since it has been authorized by the client.

Choice "d" is incorrect. The confirmation is used to verify the bank balance as of year-end. Bank employees generally would not have access to the client's bank reconciliation.

Choice "b" is incorrect. Even though it is likely that the bank would have access to a cutoff bank statement, the detail on this statement is unnecessary to confirm the final balance.

7

Which of the following procedures would an auditor most likely perform in searching for unrecorded liabilities?

a.

Compare a sample of purchase orders issued just after year-end with the year-end accounts payable trial balance.

b.

Vouch a sample of accounts payable entries recorded just before year-end to the unmatched receiving report file.

c.

Scan the cash disbursements entries recorded just before year-end for indications of unusual transactions.

d.

Vouch a sample of cash disbursements recorded just after year-end to receiving reports and vendor invoices.

Choice "d" is correct. The auditor is able to detect liabilities not recorded at year-end by comparing cash payments made after the balance sheet date to the related receiving reports and vendor invoices; any payments made on transactions dated before year-end reflect a liability that should have been recorded.

Choice "b" is incorrect. Vouching a sample of recorded accounts payable entries to unmatched receiving reports does not test the completeness of the listing. Unrecorded liabilities would not be included in recorded accounts payable entries.

Choice "a" is incorrect. Purchase orders issued after year-end should not be included in the year-end balance of accounts payable. This would be an example of an overstated liability, rather than an unrecorded one.

Choice "c" is incorrect. Examination of cash disbursements entries made just prior to the balance sheet date relates to liabilities that have been paid, which would not be considered to be outstanding liabilities at year-end.

8

An auditor traced a sample of purchase orders and the related receiving reports to the purchases journal and the cash disbursements journal. The purpose of this substantive audit procedure most likely was to:

a.

Determine that purchases were properly recorded.

b.

Test whether payments were for goods actually ordered.

c.

Identify unusually large purchases that should be investigated further.

d.

Verify that cash disbursements were for goods actually received.

Choice "a" is correct. In general, an audit procedure can be restated as the question to be answered. In this case, tracing a sample of purchase orders and related receiving reports to the purchases journal and the cash disbursements journal seeks to answer the question, "Were all purchases properly recorded?" (the completeness assertion).

Choice "c" is incorrect. Tracing a sample of source documents to summary records would not identify unusually large transactions requiring additional attention. 

Choice "d" is incorrect. In order to verify that cash disbursements were for goods actually received, a sample of cash disbursements should be vouched back to receiving reports.

Choice "b" is incorrect. In order to verify that cash disbursements were for goods actually ordered, a sample of cash disbursements should be vouched back to purchase orders.

9

Sound internal control dictates that, immediately upon receiving checks from customers by mail, a responsible employee should:

a.

Add the checks to the daily cash summary.

b.

Prepare a duplicate listing of checks received.

c.

Verify that each check is supported by a prenumbered sales invoice.

d.

Record the checks in the cash receipts journal.

Choice "b" is correct. Upon receipt of cash, a remittance listing should be prepared.

Choice "a" is incorrect. Recording the check in the daily cash summary would ordinarily be done by a second party after the initial listing has been prepared.

Choice "c" is incorrect. Verifying that each check is supported by a valid invoice is not necessary.

Choice "d" is incorrect. Recording the check in the cash receipts journal would ordinarily be done by a second party after the initial listing has been prepared.

10

To provide assurance that each voucher is submitted and paid only once, an auditor most likely would examine a sample of paid vouchers and determine whether each voucher is:

a.

Supported by a vendor's invoice.

b.

Approved for authorized purchases.

c.

Stamped "paid" by the check signer.

d.

Prenumbered and accounted for.

Choice "c" is correct. By stamping the voucher "paid," the check signer cancels the voucher so it cannot be resubmitted for payment.

Choice "a" is incorrect. Even invoices that are supported by prenumbered sales invoices can be resubmitted for payment if they are not canceled, resulting in duplicate payments. 

Choice "d" is incorrect. Accounting for the sequence of prenumbered vouchers would only test whether all vouchers are present. It would not prevent a voucher from being paid twice. 

Choice "b" is incorrect. Proper authorization would help ensure that payments were properly authorized, but would not prevent duplicate payments.

11

Which of the following procedures most likely would not be an internal control designed to reduce the risk of errors in the billing process?

a.

Reconciling the control totals for sales invoices with the accounts receivable subsidiary ledger.

b.

Using computer programmed controls on the pricing and mathematical accuracy of sales invoices.

c.

Comparing control totals for shipping documents with corresponding totals for sales invoices.

d.

Matching shipping documents with approved sales orders before invoice preparation.

Choice "a" is correct. Reconciling control totals for sales invoices with the accounts receivable subsidiary ledger is not an effective control related to the billing process, since errors that exist in the preparation of invoices would likely carry through to accounts receivable.

Choice "c" is incorrect. Comparing shipping totals with sales invoice totals is an effective control to reduce billing errors.

Choice "b" is incorrect. Computer controls related to pricing and mathematical accuracy will reduce billing errors.

Choice "d" is incorrect. Matching shipping documents with approved sales orders ensures that invoices are properly authorized and only goods ordered have been shipped.

12

Which of the following internal control activities is not usually performed in the vouchers payable department?

a.

Matching the vendor's invoice with the related receiving report.

b.

Indicating the asset and expense accounts to be debited.

c.

Approving vouchers for payment by having an authorized employee sign the vouchers.

d.

Accounting for unused prenumbered purchase orders and receiving reports.

Choice "d" is correct. Accounting for unused prenumbered purchase orders and receiving reports is an effective control, but it would not typically be performed in the vouchers payable department. 

Choice "a" is incorrect. Reconciling the vendor invoice with the related receiving report is typically performed by a vouchers payable clerk.

Choice "c" is incorrect. The vouchers payable department is responsible for approving vouchers for payment.

Choice "b" is incorrect. Indicating the asset and expense accounts to be debited is not an internal control procedure.

13

Which of the following tests of controls most likely would help assure an auditor that goods shipped are properly billed?

a.

Inspect unused sales invoices for consecutive prenumbering.

b.

Scan the sales journal for sequential and unusual entries.

c.

Compare the accounts receivable ledger to daily sales summaries.

d.

Examine shipping documents for matching sales invoices.

Choice "d" is correct. Tracing from a sample of shipping documents to matching sales invoices would provide support for the completeness assertion for billing.

Choice "b" is incorrect. Scanning the sales journal for sequential and unusual entries tests the completeness and existence assertions for sales, but would not provide assurance that shipped goods were properly billed.

Choice "c" is incorrect. Comparing the accounts receivable ledger to the daily sales summary helps ensure that all sales were recorded as receivables and all receivables were recorded as sales, but it does not provide assurance that shipped goods were properly billed.

Choice "a" is incorrect. Inspecting the consecutive numbering of unused sales invoices might identify fictitious sales, but it would not ensure that goods that have been shipped were properly billed.

14

Which of the following internal controls most likely would assure that all billed sales are correctly posted to the accounts receivable ledger?

a.

The accounts receivable ledger is reconciled daily to the control account in the general ledger.

b.

Each sales invoice is supported by a prenumbered shipping document.

c.

Daily sales summaries are compared to daily postings to the accounts receivable ledger.

d.

Each shipment on credit is supported by a prenumbered sales invoice.

Choice "c" is correct. Comparison of daily sales summaries to daily postings to the accounts receivable ledger would ensure the completeness of the accounts receivable ledger. 

Choice "b" is incorrect. Comparison of sales invoices to shipping documents verifies occurrence of the sale, not completeness of the accounts receivable ledger.

Choice "a" is incorrect. Reconciliation of the accounts receivable ledger to the general ledger would not assure the accuracy and completeness of the accounts receivable ledger because a sale which was improperly excluded from receivables would likely be omitted from both ledgers.

Choice "d" is incorrect. Ensuring that all shipments are billed verifies completeness of sales transactions, but does not provide evidence that all sales are recorded in the accounts receivable ledger. In other words, the fact that a shipment was billed does not mean that the invoice was also recorded in the accounts receivable ledger.

15

Under properly designed internal control, the same employee most likely would match vendors' invoices with receiving reports and also:

a.

Cancel vendors' invoices after payment.

b.

Reconcile the accounts payable ledger.

c.

Recompute the calculations on vendors' invoices.

d.

Post the detailed accounts payable records.

Choice "c" is correct. Matching vendor's invoices with receiving reports provides authorization for payment and is generally performed in the accounts payable department. Recalculation of vendor invoices is compatible with this authorization function.

Choice "d" is incorrect. Posting the accounts payable records (recording) is incompatible with matching (authorization). Generally these functions would be performed by two different employees.

Choice "b" is incorrect. This review procedure (independent verification) should be performed by someone independent of the employee who approved the invoice for payment.

Choice "a" is incorrect. Payment and cancellation of vendor invoices should be performed by someone (generally the treasurer) other than the individual authorizing payment.

16

The objective of auditing procedures applied to segment information is to provide the auditor with a reasonable basis for concluding whether:

a.

Sufficient audit evidence has been obtained to allow the auditor to be associated with the segment information.

b.

A separate opinion on the segment information is necessary due to inconsistent application of accounting principles.

c.

The information is useful for comparing a segment of one enterprise with a similar segment of another enterprise.

d.

The information is presented in conformity with the GAAP rules on segment information.

Choice "d" is correct. The auditor's objective is to provide a reasonable basis for concluding whether segment information is presented in conformity with GAAP.

Choice "c" is incorrect. The auditor is not required to see that segment information included is comparable to other enterprises.

Choice "a" is incorrect. Sufficient audit evidence must be obtained to ensure that segment information is presented in accordance with GAAP, not to allow the auditor to be associated with such information.

Choice "b" is incorrect. The inclusion of segment information is a GAAP requirement, and a separate opinion is not required.

17

To determine whether internal control relative to the revenue cycle of a wholesaling entity is operating effectively in minimizing the failure to prepare sales invoices, an auditor most likely would select a sample of transactions from the population represented by the:

a.

Sales order file.

b.

Sales invoice file.

c.

Shipping document file.

d.

Customer order file.


Explanation

Choice "c" is correct. Shipping documents provide evidence that a sale occurred, and therefore selecting from a population of shipping documents allows the auditor to test whether corresponding invoices exist for each sale.

Choices "a" and "d" are incorrect. The existence of customer orders and sales orders does not necessarily imply that a sale occurred. For example, the particular item requested may be out of stock. In such cases, there would properly be no sales invoice.

Choice "b" is incorrect. Since the weakness the auditor is concerned about involves missing sales invoices, selecting from a sample of existing sales invoices would not identify this problem.

18

Which of the following events occurring in the year under audit would most likely indicate that internal controls utilized in previous years may be inadequate in the year under audit?

a.

The frequency of accounts payable check runs was changed from biweekly to weekly.

b.

The chief financial officer waived approvals on all checks to one vendor to expedite payment.

c.

The entity announced that the internal audit function would be eliminated after the balance sheet date.

d.

The audit committee chairperson unexpectedly resigned during the year under audit.

Choice "b" is correct. Vouchers should be approved before payment occurs. Overriding this control to expedite payment may result in unauthorized payments being made. The auditor would need to consider this change in evaluating current controls and determining the nature, timing, and extent of testing.

Choice "c" is incorrect. If the internal audit function is being eliminated after the balance sheet date, there would be little effect on the current year's audit.

Choice "d" is incorrect. Resignation of the audit committee chairperson would not imply that internal controls are less adequate than in the past, as long as a new, competent person steps up to become chair.

Choice "a" is incorrect. Changing the frequency of the accounts payable check runs from biweekly to weekly would not automatically imply that controls are inadequate. The auditor would need to review the new procedures to determine whether adequate controls were still in place.

19

An auditor who uses a transaction cycle approach to assessing control risk most likely would test control activities related to transactions involving the sale of goods to customers with the:

a.

Purchase of merchandise inventory.

b.

Payment of accounts payable.

c.

Collection of receivables.

d.

Sale of long-term debt.


Explanation

Choice "c" is correct. The revenue cycle includes sales, receivables, and cash receipts, so an auditor using a transaction cycle approach would be likely to test sales and receivables together.

Choice "a" is incorrect. Purchases are part of the expenditures cycle while sales are part of the revenue cycle, so an auditor using a transaction cycle approach would be unlikely to test these items together.

Choice "b" is incorrect. Payables are part of the expenditures cycle while sales are part of the revenue cycle, so an auditor using a transaction cycle approach would be unlikely to test these items together.

Choice "d" is incorrect. Sale of long-term debt falls within the "other liabilities" transaction cycle while sales are part of the revenue cycle, so an auditor using a transaction cycle approach would be unlikely to test these items together.

20

Tracing copies of computer-prepared sales invoices to copies of the corresponding computer-prepared shipping documents provides evidence that:

a.

No duplicate shipments to customers were made.

b.

Entries in the accounts receivable subsidiary ledger were for sales actually shipped.

c.

Sales billed to customers were actually shipped.

d.

Shipments to customers were properly billed.

Choice "c" is correct. Tracing from invoices to shipping documents would provide evidence that sales billed to customers were actually shipped. An invoice for which the corresponding shipping documents could not be located might be indicative of fictitious sales (i.e., sales that were recorded but never actually shipped).

Choice "d" is incorrect. The auditor would need to start with shipping documents and trace to invoices to ensure that shipments were properly billed.

Choice "b" is incorrect. An invoice may exist for which no entry was made in the accounts receivable subsidiary ledger. Therefore, the auditor would need to trace from entries in the accounts receivable subsidiary ledger (and not from invoices) to shipping documents, to obtain evidence that recorded receivables were for sales actually shipped.

Choice "a" is incorrect. Tracing from invoices to shipping documents would not necessarily indicate when a duplicate shipment was made, as the auditor would not necessarily realize that two sets of shipping documents related to the same invoice.

21

Which of the following fraudulent activities most likely could be perpetrated due to the lack of effective internal controls in the revenue cycle?

a.

Obsolete items included in inventory balances are rarely reduced to the lower of cost or market value.

b.

Merchandise received is not promptly reconciled to the outstanding purchase order file.

c.

The write-off of receivables by personnel who receive cash permits the misappropriation of cash.

d.

Fictitious transactions are recorded that cause an understatement of revenue and overstatement of receivables.

Choice "c" is correct. The function of cash receipts is part of the treasurer's department and should be separate from the role of writing off receivables. Failure to separate the recordkeeping function from the custodial function allows an individual to misappropriate cash and then cover up the theft by writing off the related receivable balance.

Choice "b" is incorrect. Internal controls in the revenue cycle typically relate to sales, receivables, and cash, not to the purchase and receipt of goods.

Choice "a" is incorrect. Internal controls in the revenue cycle typically relate to sales, receivables, and cash, not to inventory valuation.

Choice "d" is incorrect. If fictitious transactions in the revenue cycle are recorded, then the impact on revenues and receivables would be the same; either both would be overstated (the most likely case) or both would be understated.

22

An auditor observes the mailing of monthly statements to a client's customers and reviews evidence of follow-up on errors reported by the customers. This test of controls most likely is performed to support management's financial statement assertions of:

~Understandability and classification
~Existence
a.

Yes

Yes

b.

No

Yes

c.

No

No

d.

Yes

No

Choice "b" is correct. In testing the existence or occurrence assertion, the auditor is concerned that fictitious or overstated receivables may have been recorded. Observing the mailing of monthly statements and reviewing evidence of follow-up on errors reported by customers provides evidence that procedures are in place to identify and correct such errors.

Choice "a" is incorrect. Follow up of errors in monthly statements does not provide any evidence to support understandability and classification.

Choice "d" is incorrect. Follow up of errors in monthly statements does not provide any evidence to support understandability and classification, but does provide evidence regarding the existence of receivables.

Choice "c" is incorrect. Follow up of errors in monthly statements does provide evidence regarding the existence of receivables, since customers will be likely to report discrepancies.

23

In the Bank Transfer Schedule below, which of the following cash transfers results in a misstatement of cash at December 31, 20X1?

~Disbursement date per books
~Disbursement date per bank
~Receipt date per books
~Receipt date per bank
a.

01/04/X2

01/11/X2

01/04/X2

01/04/X2

b.

01/04/X2

01/05/X2

12/31/X1

01/04/X2

c.

12/31/X1

01/05/X2

12/31/X1

01/04/X2

d.

12/31/X1

01/04/X2

12/31/X1

12/31/X1

Choice "b" is correct. Since the disbursement was not recorded until January 20X2 while the receipt was recorded in December 20X1, cash will be overstated at December 31, 20X1.

Choices "c" and "d" are incorrect. Both the disbursement and the receipt are recorded in 20X1, so there will be no misstatement of cash at December 31, 20X1.

Choice "a" is incorrect. Both the disbursement and the receipt are recorded in 20X2, so there will be no misstatement of cash at December 31, 20X1.

24

After making inquiries about credit granting policies, an auditor selects a sample of sales transactions and examines evidence of credit approval. This test of controls most likely supports management's financial statement assertion(s) of:

~Rights and obligations
~Allocation and valuation
a.

Yes

No

b.

No

No

c.

Yes

Yes

d.

No

Yes

Choice "d" is correct. By ensuring that credit approval is obtained before goods are shipped to customers, the auditor is testing management's assertion that accounts receivable are collectible (allocation and valuation). Ensuring that credit approval is obtained before goods are shipped does not support the rights and obligations assertion.

Choices "c", "a", and "b" are incorrect, based on the above explanation.

25

An auditor's tests of controls for completeness for the revenue cycle usually include determining whether:

a.

Each invoice is supported by a customer purchase order.

b.

Each receivable is collected subsequent to the year end.

c.

Each credit memo is properly approved.

d.

An invoice is prepared for each shipping document.

Choice "d" is correct. The auditor often traces a sample of shipping documents to sales invoices to test completeness of sales.

Choice "b" is incorrect. Subsequent collections are used to verify the existence and valuation of year-end receivables.

Choice "a" is incorrect. Vouching sales orders to supporting documentation provides evidence of the existence of sales, not completeness.

Choice "c" is incorrect. Verifying proper approval of credit memos provides evidence regarding the accuracy of receivables, not the completeness of sales.

26

Which of the following describes a weakness in accounts payable procedures?

a.

The accounts payable clerk manually verifies arithmetic on the vendor invoice.

b.

The accounts payable system compares the receiving report to the vendor invoice.

c.

The accounts payable manager issues purchase orders.

d.

The accounts payable clerk files invoices and supporting documentation after payment.

Choice "c" is correct. Purchase orders should be issued by the purchasing department, not the accounts payable department.

Choice "d" is incorrect. The accounts payable clerk should file invoices and supporting documentation after payment.

Choice "a" is incorrect. Mathematical accuracy of the invoice should be verified in the accounts payable department, prior to approving the invoice for payment.

Choice "b" is incorrect. The purchase order, receiving report, and vendor invoice should be compared in the accounts payable department, prior to approving the invoice for payment.

27

Which of the following situations most likely could lead to an embezzlement scheme?

a.

Each vendor invoice is matched with the related purchase order and receiving report by the vouchers payable bookkeeper who personally approves the voucher for payment.

b.

Access to blank checks and signature plates is restricted to the cash disbursements bookkeeper who personally reconciles the monthly bank statement.

c.

The accounts receivable bookkeeper receives a list of payments prepared by the cashier and personally makes entries in the customers' accounts receivable subsidiary ledger.

d.

Vouchers and supporting documentation are examined and then canceled by the treasurer who personally mails the checks to vendors.


Explanation

Choice "b" is correct. Good internal control for cash includes the separation of cash handling, recordkeeping, and reconciliation of bank statements. If the same person who disburses cash (via blank checks and signature plates) also reconciles the bank statement, there is an opportunity for that person to embezzle cash and cover it up.

Choice "c" is incorrect. It is appropriate for the accounts receivable bookkeeper to receive a list of payments prepared by the cashier and make entries in the customers' accounts receivable subsidiary ledger.

Choice "a" is incorrect. It is appropriate for the vouchers payable bookkeeper to match each vendor invoice with the related purchase order and receiving report before approving the voucher for payment.

Choice "d" is incorrect. It is appropriate for the treasurer to examine and cancel vouchers and supporting documentation, and to mail the checks to vendors.

28

An auditor is determining if internal control relative to the revenue cycle of a wholesaling entity is operating effectively in minimizing the failure to prepare sales invoices. The auditor most likely would select a sample of transactions from the population represented by the:

a.

Shipping document file.

b.

Cash receipts file.

c.

Customer order file.

d.

Sales invoice file.

Choice "a" is correct. Shipping documents provide evidence that a sale occurred, and tracing from shipping documents to sales invoices might identify instances in which a sale occurred but the associated invoice was not prepared (i.e., if no related invoice can be found).

Choice "b" is incorrect. Selecting a sample of transactions from the cash receipts file is not an appropriate means of identifying sales for which no invoice was prepared, since it will only include sales for which payment has been received. If an invoice was not prepared and mailed, it is unlikely that the customer will have made such a payment.

Choice "c" is incorrect. Selecting a sample of transactions from the customer order might result in items being selected which are not valid sales, for example, if the order has not yet been filled.

Choice "d" is incorrect. Selecting a sample of transactions from the sales invoice file will prevent the auditor from ever identifying sales for which no invoice exists, since there would be no invoice to select in such cases.

29

Which of the following procedures would best detect a liability omission by management?

a.

Review and check mathematical accuracy of financial statements.

b.

Inquiry of senior support staff and recently departed employees.

c.

Review purchase contracts and other legal documents.

d.

Review articles of incorporation and corporate bylaws.

Choice "c" is correct. Reviewing purchase contracts and other legal documents might aid the auditor in identifying omitted liabilities (for example, an obligation to make a certain purchase, or a document evidencing a lawsuit).

Choice "b" is incorrect. Inquiry of senior support staff and recently departed employees is unlikely to detect a liability omission by management, since management probably would not have allowed this information to become well-known among employees.

Choice "a" is incorrect. If a liability is mistakenly omitted from recording, it will not be in the financial statements. Therefore, such an omission is unlikely to be detected by checking the mathematical accuracy of the financial statements.

Choice "d" is incorrect. While reviewing the articles of incorporation and corporate bylaws provides good background information about a company, these procedures would be unlikely to provide evidence regarding omission of a liability in the current year's financial statements.

30

Which of the following best represents a key control for ensuring sales are properly authorized when assessing control risks for sales?

a.

Sales orders are sent to the credit department for approval.

b.

The use of an approved price list to determine unit selling price.

c.

The separation of duties between the billing department and the cash receipts approval department.

d.

Copies of approved sales orders sent to the shipping, billing, and accounting departments.

Choice "a" is correct. Proper authorization for sales involves obtaining credit approval before filling the order.

Choice "c" is incorrect. Separation of duties between billing and cash receipts relates to the prevention of theft of cash, not to proper authorization of sales.

Choice "b" is incorrect. The use of an approved price list to determine selling price relates to the accuracy and appropriateness of selling price, not to the proper authorization of the sale.

Choice "d" is incorrect. Sending copies of approved sales orders to shipping, billing, and accounting provides information necessary to ensure that the proper goods are shipped, the invoice is prepared appropriately, and the sale and receivable are properly recorded. However, since it is copies of approved sales orders that are being sent, this procedure comes too late in the process to assure that sales were properly authorized in the first place.

31

An auditor most likely would limit substantive audit tests of sales transactions when control risk is assessed as low for the occurrence assertion concerning sales transactions and the auditor has already gathered evidence supporting:

a.

Shipping and receiving activities.

b.

Opening and closing inventory balances.

c.

Cutoffs of sales and purchases.

d.

Cash receipts and accounts receivable.

Choice "d" is correct. Examination of accounts receivable and cash receipts provides the auditor with evidence with respect to both the completeness and the occurrence of sales transactions, thus limiting the need to test sales transactions.

Choice "b" is incorrect. Examination of beginning and ending inventory balances may provide limited evidence of the occurrence of purchases and the cost of goods sold, but not of sales.

Choice "a" is incorrect. Examination of shipping and receiving activities would not necessarily reduce the testing of sales transactions.

Choice "c" is incorrect. Cutoffs of sales and purchases provides evidence regarding the sales occurring close to year-end, not necessarily all sales for the year.

32

If the business environment is experiencing a recession, the auditor most likely would focus increased attention on which of the following accounts?

a.

Purchase returns and allowances.

b.

Allowance for doubtful accounts.

c.

Common stock.

d.

Noncontrolling interest of a subsidiary purchased during the year

Choice "b" is correct. During an economic downturn, it is more likely that customers will default on payments owed. The auditor should therefore focus increased attention on the allowance for doubtful accounts, to ensure that it has been adjusted to appropriately reflect this increased risk.

Choice "a" is incorrect. A recession is not likely to affect purchase returns and allowances, though it might result in a decline in purchases.

Choice "c" is incorrect. A recession is not likely to directly affect the common stock account.

Choice "d" is incorrect. A recession is not likely to directly affect a pre-existing, noncontrolling interest in a subsidiary.

33

An independent auditor asked a client's internal auditor to assist in preparing a standard financial institution confirmation request for a payroll account that had been closed during the year under audit. After the internal auditor prepared the form, the controller signed it and mailed it to the bank. What was the major flaw in this procedure?

a.

The form was prepared by the internal auditor.

b.

The account was closed, so the balance was zero.

c.

The internal auditor did not sign the form.

d.

The form was mailed by the controller.

Choice "d" is correct. The auditor should control the mailing of independent confirmations.

Choice "c" is incorrect. It is appropriate for a member of management, such as the controller, to sign the confirmation request.

Choice "a" is incorrect. It is acceptable for an internal auditor to provide direct assistance to the external auditor, such as by preparing confirmation forms.

Choice "b" is incorrect. Confirmations may be sent to accounts that show a zero balance, to test for understatement errors or to obtain information about loans.

34

To provide assurance that each voucher is submitted and paid only once, an auditor most likely would examine a sample of paid vouchers and determine whether each voucher is:

a.

Supported by a vendor's invoice and purchase order.

b.

Stamped "paid" by the check signer.

c.

Returned to the vouchers payable department.

d.

Prenumbered and accounted for.

Choice "b" is correct. To provide assurance that each voucher is submitted and paid only once, an auditor should verify that each voucher was stamped "paid" by the check signer.

Choice "c" is incorrect. Paid vouchers should be returned to the accounting department for posting of the payment and filing of the documents, but this does not prevent the voucher from inadvertently being paid twice before it is returned to accounting.

Choice "a" is incorrect. Vouchers should be supported by a vendor's invoice and purchase order, but this does not prevent the same voucher from inadvertently being paid twice.

Choice "d" is incorrect. Vouchers should be prenumbered and accounted for, but this does not prevent the same voucher from inadvertently being paid twice.

35

If the objective of an auditor's test of details is to detect a possible understatement of sales, the auditor most likely would trace transactions from the:

a.

Cash receipts journal to the sales journal.

b.

Sales invoices to the shipping documents.

c.

Sales journal to the cash receipts journal.

d.

Shipping documents to the sales invoices.

Choice "d" is correct. Detecting a possible understatement in sales is tantamount to testing completeness (i.e., if an understatement is found, sales are not complete). To test completeness, one needs to start with supporting documentation, such as shipping documents, and trace forward to recording in the accounting records, such as the sales invoices and sales journal. Should the auditor find a shipping document for which there is no entry in the sales journal, an understatement error (or a completeness problem) will have been discovered.

Choice "b" is incorrect. Tracing from the accounting records, such as sales invoices, to supporting documentation, such as shipping documents, tests for overstatement, or tests existence. Should the auditor find a sales invoice for which there is no shipping document, an overstatement error will have been discovered (i.e., perhaps a fictitious sale has been recorded).

Choice "a" is incorrect. Tracing from the cash receipts journal to the sales journal may help the auditor verify whether the receipt was properly recorded (i.e., once one knows to which sale the receipt relates, one can verify whether the appropriate customer balance was reduced), but it does not aid the auditor in detecting possible understatements of sales. In order to detect understatements, one must trace from supporting documentation to accounting records, not compare internal consistency among accounting records.

Choice "c" is incorrect. Tracing from the sales journal to the cash receipts journal aids the auditor in identifying sales for which payment has not yet been received, but it does not aid the auditor in detecting possible understatements of sales. In order to detect understatements, one must trace from supporting documentation to accounting records, not compare internal consistency among accounting records.

36

An auditor reviews the reconciliation of payroll tax forms that a client is responsible for filing in order to:

a.

Verify that payroll taxes are deducted from employees' gross pay.

b.

Identify potential liabilities for unpaid payroll taxes.

c.

Determine whether internal control activities are operating effectively.

d.

Uncover fictitious employees who are receiving payroll checks.

Choice "b" is correct. An auditor reviews the reconciliation of payroll tax forms that a client is responsible for filing in order to identify potential liabilities for unpaid payroll taxes.

Choice "a" is incorrect. Payroll deductions are verified by inspecting the payroll register and, for a sample of employees, tracing deductions back to employee authorization forms held in the personnel department.

Choice "c" is incorrect. Review of the reconciliation of payroll tax forms is a substantive test that would not indicate whether internal control activities with respect to payroll are operating effectively.

Choice "d" is incorrect. Review of the reconciliation of payroll tax forms would not uncover fictitious employees. The auditor would need to observe payroll distribution (or examine direct deposits) to ensure that all personnel being paid are actually employed by the company.

37

In performing a count of negotiable securities, an auditor records the details of the count on a security count worksheet. What other information is usually included on this worksheet?

a.

An acknowledgment by a client representative that the securities were returned intact.

b.

A description of the client's procedures that prevent the negotiation of securities by just one person.

c.

An evaluation of the client's internal control concerning physical access to the securities.

d.

An analysis of realized gains and losses from the sale of securities during the year.

Choice "a" is correct. After performing a count of negotiable securities, the auditor would generally obtain an acknowledgment from the client that the securities were returned intact. This helps maintain accountability for the securities, and reduces the likelihood of employee misappropriation (e.g., if a client employee were to steal a security and blame the auditor).

Choice "d" is incorrect. The auditor generally would not include an analysis of realized gains and losses on a security count worksheet, although this information would be included elsewhere in the audit documentation.

Choice "c" is incorrect. The auditor generally would not include an evaluation of the client's internal control on a security count worksheet, although this information would be included elsewhere in the audit documentation.

Choice "b" is incorrect. The auditor generally would not include a description of the client's control procedures on a security count worksheet, although this information might be included elsewhere in the audit documentation.

38

Which of the following controls would a company most likely use to safeguard marketable securities when an independent trust agent is not employed?

a.

The internal auditor and the controller independently trace all purchases and sales of marketable securities from the subsidiary ledgers to the general ledger.

b.

The chairman of the board verifies the marketable securities, which are kept in a bank safe-deposit box, each year on the balance sheet date.

c.

Two company officials have joint control of marketable securities, which are kept in a bank safe-deposit box.

d.

The investment committee of the board of directors periodically reviews the investment decisions delegated to the treasurer.

Choice "c" is correct. Joint custody by two company officials over assets like cash and marketable securities helps safeguard the assets. Under joint custody, collusion is required for a defalcation to occur.

Choice "d" is incorrect. Review of investment decisions made by the treasurer might reduce the probability of poor investment policies, but would not be likely to safeguard marketable securities after purchase.

Choice "a" is incorrect. Tracing purchases and sales from the subsidiary ledger to the general ledger would help ensure that all existing securities are recorded in the financial statements, but would not help safeguard marketable securities.

Choice "b" is incorrect. An annual count by the chairman of the board might provide a small safeguard, but the infrequent performance of the control makes it a fairly weak one.

39

When there are numerous property and equipment transactions during the year, an auditor who plans to assess control risk at a low level usually performs:

a.

Tests of controls and limited tests of current year property and equipment transactions.

b.

Tests of controls and extensive tests of property and equipment balances at the end of the year.

c.

Analytical procedures for current year property and equipment transactions.

d.

Analytical procedures for property and equipment balances at the end of the year.

Choice "a" is correct. Since control risk is assessed at a low level, tests of controls would be required to evaluate the effectiveness of the internal controls to support that assessed level. Assuming controls are operating effectively, only limited substantive testing would be performed.

Choice "b" is incorrect. Extensive tests of property and equipment balances would not typically be required when control risk is assessed at a low level.

Choice "c" is incorrect. Since control risk is to be assessed at a low level, tests of controls would be required. Analytical procedures would not be particularly useful, since property and equipment transactions are subject to management discretion.

Choice "d" is incorrect. Analytical procedures would not be particularly useful, since property and equipment transactions are subject to management discretion. Year-end balances may therefore be unpredictable.

40

In determining the effectiveness of an entity's internal controls relating to the occurrence assertion for payroll transactions, an auditor most likely would inquire about and:

a.

Verify the preparation of the monthly payroll account bank reconciliation.

b.

Recompute the payroll deductions for employee fringe benefits.

c.

Inspect evidence of accounting for prenumbered payroll checks.

d.

Observe the segregation of duties concerning personnel responsibilities and payroll disbursement.

Choice "d" is correct. The occurrence assertion as it relates to payroll transactions would correspond to an audit objective to determine that payroll transactions actually occurred (i.e., that all payroll checks were issued to valid employees for hours actually worked). Segregation of duties between personnel and payroll departments is an important control to ensure that only valid employees receive paychecks.

Choice "c" is incorrect. Inspecting evidence related to prenumbering of payroll checks would relate to the completeness assertion.

Choice "b" is incorrect. Recomputing payroll deductions is a substantive test related to the accuracy assertion.

Choice "a" is incorrect. Verifying the preparation of the monthly payroll account bank reconciliation would provide significant evidence for the accuracy assertion for payroll transactions.

41

A weakness in internal control over recording retirements of equipment may cause an auditor to:

a.

Review the subsidiary ledger to ascertain whether depreciation was taken on each item of equipment during the year.

b.

Inspect certain items of equipment in the plant and trace those items to the accounting records.

c.

Select certain items of equipment from the accounting records and locate them in the plant.

d.

Trace additions to the "other assets" account to search for equipment that is still on hand but no longer being used.

Choice "c" is correct. Testing to see whether equipment listed in the accounting records is physically present in the plant and still in service is an effective way to test whether unrecorded disposals occurred.

Choice "b" is incorrect. Tracing from equipment found in service to accounting records would be performed to test the completeness assertion that all equipment on hand has been recorded, rather than testing the assertion that all recorded equipment is still in service.

Choice "a" is incorrect. Reviewing whether depreciation is still being taken would not provide evidence about unrecorded fixed asset disposals unless the auditor also performs a physical inspection of the assets being depreciated. Also, assets that are fully depreciated but still in service would not appear in depreciation records.

Choice "d" is incorrect. Examining additions to the other assets account would not be likely to lead to discovery of unrecorded fixed asset disposals, since newer assets are not likely to have been retired.

42

Which of the following explanations most likely would satisfy an auditor who questions management about significant debits to the accumulated depreciation accounts?

a.

Plant assets were retired during the year.

b.

The prior year's depreciation expense was erroneously understated.

c.

Overhead allocations were revised at year-end.

d.

The estimated remaining useful lives of plant assets were revised upward.

Choice "a" is correct. A debit to accumulated depreciation decreases the balance in that account. The retirement of plant assets necessitates the removal (decrease) of accumulated depreciation related to the retired asset by debiting accumulated depreciation.

Choice "d" is incorrect. Remember that correction of an estimate is given prospective, not retroactive, treatment. Therefore, there would not be any decrease in the accumulated depreciation taken in previous years, although future credits would be lower than previous credits had been.

Choice "b" is incorrect. If the prior year's depreciation expense were understated (i.e., too low), the entry to correct the error would be a credit to accumulated depreciation.

Choice "c" is incorrect. Revision of overhead allocations would not result in a debit to accumulated depreciation.

43

Which of the following circumstances most likely would cause an auditor to suspect an employee payroll fraud scheme?

a.

A separate payroll bank account is maintained on an imprest basis.

b.

Payroll checks are disbursed by the same employee each payday.

c.

There are significant unexplained variances between standard and actual labor cost.

d.

Employee time cards are approved by individual departmental supervisors.

Choice "c" is correct. Significant unexplained variances between standard and actual labor costs may cause the auditor to suspect an employee payroll fraud scheme.

Choice "b" is incorrect. Payroll checks generally are disbursed by the same person (or the same department) each payday, and this would not cause the auditor to suspect an employee payroll fraud scheme.

Choice "d" is incorrect. Time card approval by departmental supervisors is a standard practice, and would not raise an auditor's suspicions of a payroll fraud scheme.

Choice "a" is incorrect. Maintenance of a separate payroll bank account is a standard practice, and would not raise an auditor's suspicions of a payroll fraud scheme.

44

An auditor generally tests the segregation of duties related to inventory by:

a.

Test counts and cutoff procedures.

b.

Document inspection and reconciliation.

c.

Analytical procedures and invoice recomputation.

d.

Personal inquiry and observation.

Choice "d" is correct. The independent auditor's direct personal knowledge, based on personal inquiry and observation, are auditing procedures commonly used to test segregation of duties.

Choice "a" is incorrect. Test counts and cutoff procedures represent substantive tests, and they would not be used to test segregation of duties.

Choice "c" is incorrect. Analytical procedures and invoice recomputation represent substantive tests, and they would not be used to test segregation of duties.

Choice "b" is incorrect. Document inspection and reconciliation represent substantive tests, and they would not be used to test segregation of duties.

45

Tests designed to detect purchases made before the end of the year that have been recorded in the subsequent year most likely would provide assurance about management's assertion regarding:

a.

Accuracy.

b.

Obligations.

c.

Classification.

d.

Cutoff.

Choice "d" is correct. If purchases made before the end of the year have been recorded in the subsequent year, inventory will not be complete. The auditor uses cutoff tests to detect such situations and to determine that inventory quantities include all products, materials and supplies owned by the company. (Note that the cutoff assertion is closely related to the completeness and occurrence assertions.)

Choice "a" is incorrect. Assertions about accuracy deal with whether data related to recorded transactions has been included in the financial statements at appropriate amounts. Cutoff tests do not provide evidence related to the accuracy assertion for purchases.

Choice "b" is incorrect. Assertions about obligations deal with account balances, not with transactions and events.

Choice "c" is incorrect. Assertions about classification deal with whether particular components of the financial statements are properly presented, described, and disclosed. Cutoff tests would not provide evidence relevant to classification.

46

When an auditor does not receive replies to positive requests for year-end accounts receivable confirmations, the auditor most likely would:

a.

Increase the assessed level of detection risk for the valuation and completeness assertions.

b.

Increase the assessed level of inherent risk for the revenue cycle.

c.

Ask the client to contact the customers to request that the confirmations be returned.

d.

Inspect the allowance account to verify whether the accounts were subsequently written off.

Choice "c" is correct. When using positive confirmation requests, the auditor should generally follow up with a second and sometimes third request to those parties from whom replies have not been received. In addition, asking the client to contact its customers may encourage further responses.

Choice "d" is incorrect. Confirmations are designed to provide evidence of existence, so nonresponses would require alternative procedures focused on existence as well. Verification that the account was subsequently written off tests the valuation assertion, but does not provide evidence of existence.

Choice "a" is incorrect. The auditor sets detection risk based on the assessed levels of inherent risk and control risk, and would only increase the acceptable level of detection risk in response to a decrease in inherent or control risk. Failure to receive confirmations would not cause the auditor to make such a change.

Choice "b" is incorrect. Inherent risk assessments would not be affected by confirmation response rates, which are not subject to client control.

47

While observing a client's annual physical inventory, an auditor recorded test counts for several items and noticed that certain test counts were higher than the recorded quantities in the client's perpetual records. This situation could be the result of the client's failure to record:

a.

Sales returns.

b.

Purchase discounts.

c.

Sales.

d.

Purchase returns.

Choice "a" is correct. Failure to record sales returns would result in actual inventory quantities being greater than those recorded in the perpetual inventory records.

Choice "b" is incorrect. Failure to record purchase discounts would result in a difference in recorded costs, rather than recorded quantities.

Choice "d" is incorrect. Failure to record purchase returns would result in actual inventory quantities being less than those recorded in the perpetual inventory records.

Choice "c" is incorrect. Failure to record sales would result in actual inventory quantities being less than those recorded in the perpetual inventory records.

48

When control risk is assessed as low for assertions related to payroll, substantive tests of payroll balances most likely would be limited to applying analytical procedures and:

a.

Inspecting payroll tax returns.

b.

Observing the distribution of paychecks.

c.

Footing and crossfooting the payroll register.

d.

Recalculating payroll accruals.


Explanation

Choice "d" is correct. If the control risk is assessed as low, less substantive testing is necessary. In such an instance, substantive testing would normally be limited to analytical procedures and recalculating year-end accruals.

Choice "b" is incorrect. Observing distribution of paychecks is a test of controls, not a substantive test.

Choice "c" is incorrect. Footing and crossfooting the payroll register is an important substantive test, but it is limited in its effectiveness. Even if control risk is assessed as low, more effective substantive procedures should be performed.

Choice "a" is incorrect. Inspection of payroll tax returns is an extensive substantive test that would be performed if the control risk were assessed as high.

49

Which of the following questions would an auditor least likely include on an internal control questionnaire concerning the initiation and execution of equipment transactions?

a.

Are requests for purchases of equipment reviewed for consideration of soliciting competitive bids?

b.

Are requests for major repairs approved at a higher level than the department initiating the request?

c.

Are procedures in place to monitor and properly restrict access to equipment?

d.

Are prenumbered purchase orders used for equipment and periodically accounted for?

Choice "c" is correct. Questions relating to access controls for assets would not normally be a part of a questionnaire related to controls over the initiation and execution of equipment purchases.

Choice "b" is incorrect. Questions about controls related to the authorization of major repairs would likely be included on a questionnaire related to controls over the initiation and execution of equipment purchases.

Choice "d" is incorrect. Questions about the existence of prenumbered purchase orders would likely be included on the internal control questionnaire since prenumbering functions are an important control supporting the completeness assertion.

Choice "a" is incorrect. Questions about controls related to competitive bids would likely be included on a questionnaire related to controls over the initiation and execution of equipment purchases.

50

In establishing the existence and ownership of a long-term investment in the form of publicly-traded stock, an auditor should inspect the securities or:

a.

Inspect the audited financial statements of the investee company.

b.

Correspond with the investee company to verify the number of shares owned.

c.

Confirm the number of shares owned that are held by an independent custodian.

d.

Determine that the investment is carried at the lower of cost or market.

Choice "c" is correct. The auditor would confirm the number of shares held by an independent custodian to establish the existence and ownership of a long-term investment in publicly traded securities.

Choice "b" is incorrect. The investee company may not have timely information regarding the ownership of its stock.

Choice "a" is incorrect. Inspection of the audited financial statements of the investee company does not provide evidence about ownership of the securities.

Choice "d" is incorrect. Determination that the investment is carried at the proper market value provides assurance about valuation and about appropriate presentation and disclosure in the financial statements.

51

Determining that proper amounts of depreciation are expensed provides assurance about management's assertion of:

a.

Completeness, accuracy, and occurrence.

b.

Rights and obligations, and valuation.

c.

Valuation, allocation, and accuracy.

d.

Existence, completeness, and accuracy.

Choice "c" is correct. Determining that proper amounts of depreciation are expensed provides assurance with regard to valuation and allocation related to the asset, and accuracy in terms of financial statement presentation.

Choices "a", "b", and "d" are incorrect. Verifying depreciation computations does not provide evidence with respect to completeness, rights and obligations, existence, or occurrence.

52

In auditing accounts receivable the negative form of confirmation request most likely would be used when:

a.

The combined assessed level of inherent and control risk relative to accounts receivable is low.

b.

The auditor performs a dual purpose test that assesses control risk and obtains substantive evidence.

c.

Recipients are likely to return positive confirmation requests without verifying the accuracy of the information.

d.

A small number of accounts receivable are involved but a relatively large number of errors are expected.

Choice "a" is correct. Negative confirmations are used when the combined assessed level of inherent and control risk is low, a large number of small balances is involved, and the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration.

Choice "c" is incorrect. Blank positive confirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information.

Choice "d" is incorrect. If a small number of accounts are involved and a large number of errors are anticipated, positive confirmations should be used.

Choice "b" is incorrect. Confirmations are used exclusively as a substantive test, and are not used in the assessment of control risk.

53

When using confirmations to provide evidence about the completeness assertion for accounts payable, the appropriate population most likely would be:

a.

Invoices filed in the entity's open invoice file.

b.

Payees of checks drawn in the month after the year-end.

c.

Amounts recorded in the accounts payable subsidiary ledger.

d.

Vendors with whom the entity has previously done business.

Choice "d" is correct. When testing the completeness assertion for accounts payable, the appropriate population would be a list of vendors with whom the entity has previously done business.

Choice "c" is incorrect. Confirming amounts recorded would test the existence assertion, rather than completeness.

Choice "b" is incorrect. Checks drawn in the subsequent period represent only a subset of the client's vendor listing. (It would not include liabilities that have not yet been paid). In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected in the client's financial statements.

Choice "a" is incorrect. The invoices filed in the entity's open invoice file would provide only a subset of the client's vendor listing. (It would not include liabilities for which the invoice had not yet been received.) In obtaining information about the completeness assertion, the auditor is concerned with determining whether liabilities exist which are not reflected in the client's financial statements.

54

In auditing long-term bonds payable, an auditor most likely would:

a.

Perform analytical procedures on the bond premium and discount accounts.

b.

Compare interest expense with the bond payable amount for reasonableness.

c.

Examine documentation of assets purchased with bond proceeds for liens.

d.

Confirm the existence of individual bondholders at year-end.

Choice "b" is correct. Comparing interest expense with the bond payable amount for reasonableness provides evidence that all interest expense was included and that the outstanding balance of the bonds payable is reasonable, as well as providing limited evidence concerning the amortization of bond discounts or premiums.

Choice "a" is incorrect. The auditor would recalculate bond premiums and discounts, rather than use an analytical procedure.

Choice "c" is incorrect. The auditor would normally examine documentation of the bond instruments rather than of assets purchased to determine the existence of any liens on the assets.

Choice "d" is incorrect. The auditor would confirm the outstanding bonds payable balance, not the existence of individual bondholders.

55

In performing tests concerning the granting of stock options, an auditor should:

a.

Verify the existence of option holders in the entity's payroll records or stock ledgers.

b.

Confirm the transaction with the Secretary of State in the state of incorporation.

c.

Determine that sufficient treasury stock is available to cover any new stock issued.

d.

Trace the authorization for the transaction to a vote of the board of directors.

Choice "d" is correct. In auditing the granting of stock options, the auditor would normally trace the transactions to approval by the board of directors.

Choice "b" is incorrect. The Secretary of State would not be able to confirm the granting of stock options.

Choice "a" is incorrect. Verifying the existence of option holders provides little evidence to support management's financial statement assertions.

Choice "c" is incorrect. Converted stock options may be distributed from authorized common shares rather than treasury stock.

56

Which of the following internal controls most likely would prevent direct labor hours from being charged to manufacturing overhead?

a.

Use of time tickets to record actual labor worked on production orders.

b.

Periodic independent counts of work-in-process for comparison to recorded amounts.

c.

Comparison of daily journal entries with approved production orders.

d.

Reconciliation of work-in-process inventory with periodic cost budgets.

Choice "a" is correct. The use of time tickets to record actual labor worked on production orders is the best way to prevent direct labor from being charged to manufacturing overhead.

Choice "b" is incorrect. The work-in-process inventory contains not only labor, but also materials and overhead.

Choice "c" is incorrect. Daily journal entries are made to record the use of labor and materials. Reconciliation of the amount of daily labor to approved production orders would not prevent direct labor from being charged to manufacturing overhead.

Choice "d" is incorrect. The work-in-process inventory contains not only labor, but also materials and overhead.

57

When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud most likely would be reduced if the:

a.

Trust company has no direct contact with the entity employees responsible for maintaining investment accounting records.

b.

Trust company places the securities in a bank safe-deposit vault under the custodian's exclusive control.

c.

Interest and dividend checks are mailed directly to an entity employee who is authorized to sell securities.

d.

Securities are registered in the name of the trust company, rather than the entity itself.

Choice "a" is correct. When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud would be reduced if the trust company deals only with the person reconciling the accounts, and not with the employees responsible for maintaining investment records.

Choice "d" is incorrect. The securities should be in the entity's name, and not the trust company's.

Choice "c" is incorrect. If interest and dividend checks are mailed directly (custody of the asset) to the employee authorized to sell the securities (authorization), incompatible duties would result which may result in fraud being concealed.

Choice "b" is incorrect. Limiting access to the assets would reduce the possibility of theft, but would not reduce the possibility of concealing fraud.

58

An auditor scans a client's investment records for the period just before and just after the year-end to determine that any transfers between categories of investments have been properly recorded. The primary purpose of this procedure is to obtain evidence about management's financial statement assertions of:

a.

Rights and obligations, and existence.

b.

Valuation and accuracy, and rights and obligations.

c.

Existence, and understandability and classification.

d.

Understandability and classification, and valuation and accuracy.

Choice "d" is correct. Investments may be classified as trading, available-for-sale, or held-to-maturity. The classification of each investment into one of these three categories determines how it will be shown on the balance sheet (understandability and classification) and whether it will be valued at market or at amortized cost (valuation and accuracy).

Choices "a", "b", and "c" are incorrect. Reviewing transfers of investments between categories will not provide evidence regarding rights and obligations or existence. Rights and obligations and existence would be concerned with whether the securities actually exist and are owned by the client.

59

Which of the following procedures represents a weakness in internal controls for payroll?

a.

The payroll clerk distributes signed payroll checks. Undistributed checks are returned to the payroll department.

b.

The accounting department wires transfers funds to the payroll bank account. The transfer is based on totals from the payroll department summary.

c.

The payroll department prepares checks. The chief financial officer signs the payroll checks.

d.

The payroll department prepares checks using a signature plate. The treasurer supervises the process before payroll checks are distributed.


Explanation

Choice "a" is correct. Unclaimed payroll checks should be returned to an independent party for follow up. Returning such checks (assets) to the payroll department (recordkeeping) represents an inadequate segregation of duties.

Choice "b" is incorrect. It is acceptable for the accounting department to set up the transfer of funds into the payroll account, since the accounting department does not have access to the actual funds.

Choice "d" is incorrect. The treasurer's supervision is crucial in this choice, serving to separate the recordkeeping function (payroll department) from the custodial function (the treasurer).

Choice "c" is incorrect. It is an appropriate segregation of duties for the payroll department to prepare the checks, while the chief financial officer signs them. This separates the recordkeeping function from the custodial function.

60

In auditing a manufacturing entity, which of the following procedures would an auditor least likely perform to determine whether slow-moving, defective, and obsolete items included in inventory are properly identified?

a.

Test the computation of standard overhead rates.

b.

Tour the manufacturing plant or production facility.

c.

Review inventory experience and trends.

d.

Compare inventory balances to anticipated sales volume.

Choice "a" is correct. Testing the computation of standard overhead rates relates to the accumulation of costs during the manufacturing process, and not to whether the inventory is slow-moving, defective, or obsolete after manufacture.

Choice "b" is incorrect. During a tour of the manufacturing plant or production facility, the auditor should be alert for items that appear to be old, obsolete, or defective.

Choice "d" is incorrect. Comparisons of inventory balances with anticipated sales volume might indicate higher inventory levels than would be expected, perhaps due to slow-moving, defective, or obsolete inventory items.

Choice "c" is incorrect. Review of inventory experience and trends may indicate slow-moving, defective, or obsolete inventory items. For example, the auditor may notice a particular item that is building up in inventory, or a trend toward reduced sales of that item.

61

When a company's stock record books are maintained by an outside registrar or transfer agent, the auditor should obtain confirmation from the registrar or transfer agent concerning the:

a.

Amount of dividends paid to related parties.

b.

Proper authorization of stock rights and warrants.

c.

Expected proceeds from stock subscriptions receivable.

d.

Number of shares issued and outstanding.


Explanation

Choice "d" is correct. If a client uses a stock transfer agent, confirmations should be used to provide evidence of shares authorized, issued, and outstanding, as well as to provide evidence of the individual transactions.

Choice "a" is incorrect. It is the auditor's responsibility to identify, examine, and evaluate the disclosure of related party transactions. The stock transfer agent would not necessarily know which parties are related to the client.

Choice "c" is incorrect. The auditor should recalculate, or should review management's calculations of, stock subscriptions receivable. Confirmation from the stock transfer agent would not be necessary to review this information.

Choice "b" is incorrect. Proper authorization of stock rights and warrants would best be verified by reviewing the minutes of Board of Director meetings. Confirmation from the stock transfer agent would not be necessary to review this information.

62

When a client engages in transactions involving derivatives, the auditor should:

a.

Develop an understanding of the economic substance of each derivative.

b.

Add an explanatory paragraph to the auditor's report describing the risks associated with each derivative.

c.

Notify those charged with governance about the risks involved in derivative transactions.

d.

Confirm with the client's broker whether the derivatives are for trading purposes.

Choice "a" is correct. In auditing investments in securities and derivatives, the auditor must assess the reasonableness and appropriateness of assumptions, market variables, and valuation models. In order to do this, the auditor must consider whether the substance of transactions or events differs materially from their form. Remember that generally accepted accounting principles require transactions and events to be reported in accordance with their economic substance, even if this differs from their form.

Choice "d" is incorrect. While the auditor might confirm settled and unsettled transactions with the broker, whether a security is held for trading purposes is based on management intent and would not be confirmed with the broker.

Choice "c" is incorrect. There is no requirement that the auditor notify those charged with governance about the risks involved in derivative transactions.

Choice "b" is incorrect. There is no requirement that the auditor add an explanatory paragraph to the auditor's report describing the risks associated with each derivative.

63

An auditor usually determines whether dividend income from publicly-held investments is reasonable by computing the amounts that should have been received by referring to:

a.

Annual audited financial statements of investee companies.

b.

Dividend records on file with the SEC.

c.

Stock ledgers maintained by independent registrars.

d.

Records produced by investment services.

Choice "d" is correct. Investment income from dividends is generally recalculated by comparing recorded income with dividend record books produced by investment advisory services such as "Moody's Dividend Record." These books state the dividend that was declared and paid by the investee.

Choice "c" is incorrect. Stock ledgers maintained by independent registrars indicate how many shares of stock are issued and outstanding, and identify the shareholders of record, but they do not contain information concerning dividends.

Choice "b" is incorrect. Dividend records on file with the SEC would probably include appropriate information, but it is more efficient to use a single source (such as "Moody's") than it is to obtain and review SEC records for each investee.

Choice "a" is incorrect. Annual audited financial statements of the investee companies give the total dividends paid, but there may not be enough information to determine exactly how much went to each type of stock and hence to each stockholder. In addition, it is more efficient to use a single source (such as "Moody's") than it is to obtain and review the financial statements of each investee.

64

An auditor's inquiries of management disclosed that the entity recently invested in a series of energy derivatives to hedge against the risks associated with fluctuating oil prices. Under these circumstances, the auditor should:

a.

Perform analytical procedures to determine if the derivatives are properly valued.

b.

Examine the contracts for possible risk exposure and the need to recognize losses.

c.

Document the derivatives in the auditor's communication with those charged with governance.

d.

Confirm the marketability of the derivatives with a commodity specialist.


Explanation

Choice "b" is correct. Generally accepted accounting principles specify that, in order to qualify for hedge treatment, the entity must demonstrate and disclose a number of transaction features including risk exposure. The auditor would therefore need to examine the contracts to evaluate the character of the hedge and the degree to which losses should be recognized in the determination of income, as well as the character of any disclosures.

Choice "a" is incorrect. Generally accepted accounting principles require this derivative to be valued at fair value. While the auditor does need to test management's assertions about fair value, analytical procedures are not the most likely way to do this. More likely, the auditor would obtain quoted market prices from financial publications, the exchanges, the National Association of Securities Dealers Automated Quotations System (NASDAQ), or pricing services. If quoted market prices were not available, estimates based on valuation models would be used.

Choice "d" is incorrect. The auditor would not generally confirm marketability with a commodity specialist, but rather would test the valuation of such securities by reference to quoted market prices, by using pricing services, or based on a valuation model.

Choice "c" is incorrect. There is no requirement that investments in derivatives be communicated to those charged with governance.

65

An auditor's principal objective in analyzing repairs and maintenance expense accounts is to:

a.

Determine that all obsolete plant and equipment assets were written off before the year-end.

b.

Identify plant and equipment assets that cannot be repaired and should be written off.

c.

Discover expenditures that were expensed but should have been capitalized.

d.

Verify that all recorded plant and equipment assets actually exist.

Choice "c" is correct. The auditor reviews repair and maintenance expense accounts to test for completeness of asset additions (i.e., the auditor is looking for items recorded as repairs or maintenance that would more properly have been capitalized as betterment of an asset).

Choice "a" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about obsolete assets. The auditor might review asset records for old assets, or observe assets that are not being used, in an effort to determine whether obsolete plant and equipment assets were written off before year-end.

Choice "d" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about the existence of assets. The auditor might select recorded plant and equipment assets, and then physically locate and observe them, in order to verify existence.

Choice "b" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about assets that cannot be repaired. The auditor might review asset records for old assets, or observe assets that are not being used, in an effort to determine whether assets that cannot be repaired have been properly written off.

66

An analysis of which of the following accounts would best aid in verifying that all fixed assets have been capitalized?

a.

Property tax expense.

b.

Depreciation expense.

c.

Repairs and maintenance.

d.

Cash.

Choice "c" is correct. An analysis of the repairs and maintenance account would best aid the auditor in verifying that all fixed assets have been capitalized. This account is generally analyzed to test for completeness of asset additions (i.e., the auditor is looking for items recorded as repairs or maintenance that would more properly have been capitalized as betterment of an asset).

Choice "d" is incorrect. An analysis of cash would not identify fixed assets that were not properly capitalized, since cash would be paid for the purchase regardless of whether the item were expensed or capitalized.

Choice "b" is incorrect. An analysis of depreciation expense would not identify fixed assets that were not properly capitalized, since no depreciation would be included for items not already classified as assets.

Choice "a" is incorrect. An analysis of property tax expense would not identify fixed assets that were not properly capitalized, since no property tax would be included for items not already classified as assets.

67

Which of the following strategies most likely could improve the response rate of the confirmations of accounts receivable?

a.

Restrict the selection of accounts to be confirmed to those customers with large balances.

b.

Explain to customers that discrepancies will be investigated by an independent third party.

c.

Include a list of items or invoices that constitute the customers' account balances.

d.

Ask customers to respond to the confirmation requests directly to the auditor by fax.

Choice "c" is correct. The auditor should consider the types of information respondents will be readily able to confirm. For instance, some accounting systems facilitate the confirmation of single transactions rather than entire balances. In such cases, the auditor might consider including a client-prepared statement of account showing details of the customer's account balance being confirmed. By making it easier for customers to determine which items are included in the balance being confirmed, the auditor also makes it more likely that those customers will respond.

Choice "a" is incorrect. Restricting the selection of accounts to be confirmed to those customers with large balances doesn't improve response rates, as customers with large balances are not necessarily more likely to respond than customers with small balances.

Choice "b" is incorrect. Explaining to customers that discrepancies will be investigated by an independent third party would not necessarily encourage them to respond, as they might be reluctant to set off this investigation.

Choice "d" is incorrect. Responses received by fax should be verified by calling the senders and requesting that the original confirmations be mailed back. Asking customers to respond by fax might actually reduce the response rate for receiving the original confirmation, since customers may decide that since they already sent the fax, they don't need to send the original back as well.

68

In establishing the existence and ownership of long-term investments in the form of publicly-traded stock, an auditor most likely would inspect the securities or:

a.

Confirm the number of shares owned that are held by an independent custodian.

b.

Correspond with the investee company to verify the number of shares owned.

c.

Apply analytical procedures to the dividend income and investments accounts.

d.

Inspect the cash receipts journal for amounts that could represent the sale of securities.

Choice "a" is correct. Confirmations should be requested from the custodian for securities that are in the possession of third parties.

Choice "b" is incorrect. The investee company may not have timely information regarding the ownership of its stock, nor would an investee typically want to correspond with all of its shareholders in this manner.

Choice "c" is incorrect. Analytical procedures might be used to test the reasonableness of dividend income, but this would not provide evidence about the existence and ownership of the investments.

Choice "d" is incorrect. Inspecting the cash receipts journal for amounts that could represent the sale of securities might provide evidence regarding sales (and gains or losses on sales), but would not provide evidence about the existence and ownership of the investments.

69

An auditor is testing the reasonableness of dividend income from investments in publicly-held companies. The auditor most likely would compute the amount that should have been received and recorded by the client by:

a.

Examining the details of the client's most recent cutoff bank statement.

b.

Electronically accessing the details of dividend records on the Internet.

c.

Confirming the details with the investee companies' registrars.

d.

Reading the details of the board of directors' meetings.

Choice "b" is correct. Electronically accessing the details of dividend records on the Internet is an efficient means of verifying dividend rates for multiple investments in a short amount of time. 

Choice "d" is incorrect. Board of directors' meetings would not necessarily include discussion of each and every dividend received, so this would not be a very effective method of testing dividend income.

Choice "c" is incorrect. If the client owns many dividend-bearing investments, confirming the details with each investee company's registrar would be time-consuming and inefficient.

Choice "a" is incorrect. Examining the details of the client's most recent cutoff bank statement might provide evidence regarding dividends received near the year-end date, but it would not provide evidence of dividend income throughout the year.

Choice "b" is correct. Electronically accessing the details of dividend records on the Internet is an efficient means of verifying dividend rates for multiple investments in a short amount of time. 

Choice "d" is incorrect. Board of directors' meetings would not necessarily include discussion of each and every dividend received, so this would not be a very effective method of testing dividend income.

Choice "c" is incorrect. If the client owns many dividend-bearing investments, confirming the details with each investee company's registrar would be time-consuming and inefficient.

Choice "a" is incorrect. Examining the details of the client's most recent cutoff bank statement might provide evidence regarding dividends received near the year-end date, but it would not provide evidence of dividend income throughout the year.

70

In auditing an entity's computerized payroll transactions, an auditor would be least likely to use test data to test controls concerning:

a.

Overpayment of employees for hours not worked.

b.

Missing employee identification numbers.

c.

Withholding of taxes and Social Security contributions.

d.

Control and distribution of unclaimed checks.

Choice "d" is correct. In auditing an entity's computerized payroll transactions, an auditor would be least likely to use test data to test controls concerning control and distribution of unclaimed checks, since these sorts of controls are typically not automated. Controls surrounding unclaimed checks typically rely on proper segregation of duties, which is best evaluated through the auditor's direct observation.

Choice "a" is incorrect. In auditing an entity's computerized payroll transactions, an auditor might use test data to test controls concerning overpayment of employees for hours not worked. For example, the auditor might input fictitious additional hours to determine whether any controls identify the problem.

Choice "c" is incorrect. In auditing an entity's computerized payroll transactions, an auditor might use test data to test controls concerning withholding of taxes and Social Security contributions. For example, the auditor might input fictitious amounts, or attempt to change the current amounts, to determine whether any controls identify the problem. 

Choice "b" is incorrect. In auditing an entity's computerized payroll transactions, an auditor might use test data to test controls concerning missing employee identification numbers. For example, the auditor might try to input employee payroll data without an appropriate identification number, to determine whether any controls identify the problem.

71

The blank form of accounts receivable confirmations may be less efficient than the positive form because:

a.

Shipping documents need to be inspected.

b.

Subsequent cash receipts need to be verified.

c.

Recipients may sign the forms without proper investigation.

d.

More nonresponses to the requests are likely to occur.

Choice "d" is correct. Blank forms may result in lower response rates because a greater effort is required for response.

Choice "a" is incorrect. Using the blank form of confirmation does not imply that shipping documents need to be inspected. Inspection of shipping documents often occurs when confirmation responses are not received, regardless of which type of confirmation was initially sent.

Choice "c" is incorrect. Since blank forms do not include a balance, recipients cannot simply sign off on them without determining the balance.

Choice "b" is incorrect. Using the blank form of confirmation does not imply that subsequent cash receipts need to be verified. Verification of subsequent cash receipts often occurs when confirmation responses are not received, regardless of which type of confirmation was initially sent.

72

A test of a payroll system involved comparing an individual's number of overtime hours a week with an average of weekly overtime during a similar period in a prior year and evaluating the results. This is an example of what type of test?

a.

Range test.

b.

Category test.

c.

Reasonableness test.

d.

Detail test.

Choice "c" is correct. In a reasonableness test, data in two or more fields are checked for consistency. Comparing overtime hours in the current period to a prior period is one type of reasonableness test. 

Choice "a" is incorrect. A range test identifies amounts that fall outside a predetermined range.

Choice "d" is incorrect. A test of details is one in which specific details are evaluated, whereas in a reasonableness test, two different fields are compared. A test of details with respect to overtime hours might involve looking at time sheets for that week, for example.

Choice "b" is incorrect. A category test is not a commonly used term when discussing application controls.

73

An auditor confirmed accounts receivable as of an interim date, and all confirmations were returned and appeared reasonable. Which of the following additional procedures most likely should be performed at year-end?

a.

Resend confirmations for any significant customer balances remaining at year-end.

b.

Review supporting documents for new large balances occurring after the interim date, and evaluate any significant changes in balances at year-end.

c.

Review cash collections subsequent to the interim date and the year-end.

d.

Send confirmations for all new customer balances incurred from the interim date to year-end.

Choice "b" is correct. When auditing procedures are performed before year-end, additional procedures should be performed to extend the interim conclusions to year-end. Large balances would be tested by reviewing supporting evidence, and significant changes in the balance would also be investigated.

Choice "d" is incorrect. The auditor would not send confirmations for all new customer balances, but instead would focus on those that appear material.

Choice "a" is incorrect. The purpose of performing tests at interim is to minimize the amount of work that needs to be performed at year end, to improve efficiency. If confirmations were sent at interim, and the auditor was satisfied with the results of that testing, there would be no reason to send additional confirmations. Rather, interim conclusions would be extended by focusing on any material changes in the account, including new, large balances.

Choice "c" is incorrect. Review of subsequent cash collections is a means of supporting a receivables balance when no confirmation response has been received. This procedure generally would not be performed as a means of extending interim conclusions to year-end.

74

Which of the following procedures would an auditor least likely perform before the balance sheet date?

a.

Assessment of the risk of material misstatement.

b.

Confirmation of accounts payable.

c.

Observation of merchandise inventory.

d.

Identification of related parties.

Choice "b" is correct. The auditor should consider whether the year-end balances of the particular asset or liability accounts that might be selected for interim examination are reasonably predictable with respect to amount, relative significance, and composition. Accounts payable is relatively difficult to predict because it may fluctuate at management's discretion.

Choice "c" is incorrect. The auditor should consider whether the year-end balances of the particular asset or liability accounts that might be selected for interim examination are reasonably predictable with respect to amount, relative significance, and composition. Inventory is relatively predictable with respect to amount, composition and relative significance.

Choice "a" is incorrect. During planning, the auditor is required to obtain an understanding of the entity and its environment, including its internal control, and to assess risk. Such preliminary planning is often conducted prior to the balance sheet date.

Choice "d" is incorrect. Audit testing at interim dates may permit early consideration of significant matters affecting the year-end financial statements, such as the identification of related parties.

75

The most reliable procedure for an auditor to use to test the existence of a client's inventory at an outside location would be to:

a.

Trace the total on the inventory listing to the general ledger inventory account.

b.

Observe physical counts of the inventory items.

c.

Obtain a confirmation from the client indicating inventory ownership.

d.

Analytically compare the current-year inventory balance to the prior-year balance

Choice "b" is correct. The auditor's personal observation is generally one of the most reliable forms of evidence. Observing physical inventory counts provides reliable evidence that the inventory actually exists.

Choice "a" is incorrect. Tracing totals from the inventory listing to the general ledger inventory account provides evidence of completeness, not existence.

Choice "c" is incorrect. A confirmation from the client indicating ownership provides some evidence regarding rights and obligations, but does not provide evidence of existence.

Choice "d" is incorrect. Analytical comparisons of current year to prior year inventory balances might provide some evidence regarding completeness, existence, and valuation, but this is not as reliable a procedure for verifying existence as is the auditor's direct personal observation.

76

As part of the process of observing a client's physical inventories, an auditor should be alert to:

a.

Any change in the method of pricing from prior years.

b.

The inclusion of any obsolete or damaged goods.

c.

The existence of outstanding purchase commitments.

d.

The verification of inventory values assigned to goods in process.

Choice "b" is correct. As part of the process of observing a client's physical inventories, an auditor should be alert to the inclusion of any obsolete or damaged goods, which may need to be written down or written off.

Choice "a" is incorrect. An auditor cannot determine whether there have been changes in pricing methods simply by observing a client's physical inventories.

Choice "c" is incorrect. An auditor cannot determine whether outstanding purchase commitments exist simply by observing a client's physical inventories.

Choice "d" is incorrect. An auditor cannot determine what inventory values are assigned to goods in process simply by observing a client's physical inventories.

77

The auditor's inventory observation test counts are traced to the client's inventory listing to test for which of the following financial statement assertions?

a.

Rights and obligations.

b.

Understandability and classification.

c.

Allocation and valuation.

d.

Completeness.

Choice "d" is correct. The auditor should test the physical inventory report by tracing test counts taken by the auditor to the report, thereby verifying its completeness.

Choice "a" is incorrect. Tracing from test counts to the client's inventory listing does not test rights and obligations. Rights and obligations might be tested by examining paid vendors' invoices, inspecting consignment agreements and contracts, or by confirming inventory held at outside locations.

Choice "c" is incorrect. Tracing from test counts to the client's inventory listing does not test allocation and valuation. Allocation and valuation might be tested by examining paid vendors' invoices, evaluating direct labor rates, recalculating overhead rates, or examining an analysis of inventory turnover.

Choice "b" is incorrect. Tracing from test counts to the client's inventory listing does not test understandability and classification. Understandability and classification might be tested by confirming inventories pledged under loan agreements, examining drafts of the financial statements for appropriate balance sheet classification, etc.

78

An auditor is confirming accounts receivable using positive confirmations. The auditor decides to leave the accounts receivable amount blank rather than stating the amount owed. The auditor should be aware that the blank form may be less efficient because:

a.

Statistical sampling may not be used.

b.

Subsequent cash receipts need to be verified.

c.

A higher assessed level of detection risk is required.

d.

More nonresponses are likely to occur.

Choice "d" is correct. Blank forms may result in lower response rates because a greater effort is required for response.

Choice "b" is incorrect. Use of the blank form does not necessarily imply that subsequent cash receipts will need to be verified. This is an alternative procedure that might be used to follow up on nonresponses.

Choice "a" is incorrect. The decision regarding whether or not to use statistical sampling is independent of the decision regarding what form of accounts receivable confirmation to use.

Choice "c" is incorrect. Blank forms provide a greater degree of assurance, since the recipient cannot simply sign off without checking the balance. A greater degree of assurance results in a lower assessed level of detection risk.

79

Choice "d" is correct. Blank forms may result in lower response rates because a greater effort is required for response.

Choice "b" is incorrect. Use of the blank form does not necessarily imply that subsequent cash receipts will need to be verified. This is an alternative procedure that might be used to follow up on nonresponses.

Choice "a" is incorrect. The decision regarding whether or not to use statistical sampling is independent of the decision regarding what form of accounts receivable confirmation to use.

Choice "c" is incorrect. Blank forms provide a greater degree of assurance, since the recipient cannot simply sign off without checking the balance. A greater degree of assurance results in a lower assessed level of detection risk.

Choice "d" is correct. By vouching to time card data, the auditor is testing the occurrence assertion for hours worked.

Choice "c" is incorrect. Vouching to approved clock card data would provide evidence about hours worked, not pay rates. Pay rates would be tested by comparing to personnel records.

Choice "b" is incorrect. Vouching to approved clock card data does not provide evidence about segregation of duties.

Choice "a" is incorrect. Vouching to approved clock card data does not provide evidence about internal controls related to unclaimed paychecks. The auditor would need to observe a payroll distribution to evaluate these controls.

80

To gain assurance that all inventory items in a client's inventory listing schedule are valid, an auditor most likely would trace:

a.

Items listed in receiving reports and vendors' invoices to the inventory-listing schedule.

b.

Inventory tags noted during the auditor's observation to items listed in the inventory-listing schedule.

c.

Items listed in the inventory-listing schedule to inventory tags and the auditor's recorded count sheets.

d.

Inventory tags noted during the auditor's observation to items listed in receiving reports and vendors' invoices.

Choice "c" is correct. Tracing from the inventory schedule to the inventory tags and the auditor's recorded count sheets verifies the validity (existence) of the items. Note that the correct term for the directional test for existence is "vouch." However, in practice (and on the CPA Exam), the term trace is sometime used interchangeably with the term vouch. 

Choice "b" is incorrect. Tracing from inventory tags to the inventory listing schedule verifies the completeness of the schedule, not the existence (or validity) of the items.

Choice "d" is incorrect. Tracing to receiving reports and to vendors' invoices from the inventory tags might be used to verify completeness of purchases or payables.

Choice "a" is incorrect. Tracing from receiving reports and vendors' invoices to the inventory listing are cutoff procedures used to verify completeness of the inventory listing.

81

An auditor suspects that certain client employees are ordering merchandise for themselves over the Internet without recording the purchase or receipt of the merchandise. When vendors' invoices arrive, one of the employees approves the invoices for payment. After the invoices are paid, the employee destroys the invoices and the related vouchers. In gathering evidence regarding the fraud, the auditor most likely would select items for testing from the file of all:

a.

Vendors' invoices.

b.

Approved vouchers.

c.

Cash disbursements.

d.

Receiving reports.

Choice "c" is correct. Because the employee is destroying the invoices and related vouchers, the most obvious documentation remaining would be the file of all cash disbursements. The auditor would select items from this file and then attempt to trace from specific cash disbursements to the related invoices and approved vouchers. Missing documentation might be indicative of fraud.

Choices "b" and "a" are incorrect. Because the employee destroys the related invoices and vouchers, selecting items from the file of remaining invoices and vouchers would never identify the fraud.

Choice "d" is incorrect. Selecting items from the file of receiving reports will not identify fraudulent purchases that are shipped directly to the employees' home addresses.

82

In performing a search for unrecorded retirements of fixed assets, an auditor most likely would:

a.

Tour the client's facilities, and then inspect the property ledger and the insurance and tax records.

b.

Tour the client's facilities, and then analyze the repair and maintenance account.

c.

Inspect the property ledger and the insurance and tax records, and then tour the client's facilities.

d.

Analyze the repair and maintenance account, and then tour the client's facilities.

Choice "c" is correct. In a search for unrecorded disposals, the auditor would vouch a sample of assets on the property ledger to those on hand in the client's facility.

Choice "a" is incorrect. By touring the facility first, and then comparing assets found to those recorded on the property ledger, the auditor is testing the completeness of the property ledger, a procedure used to search for unrecorded additions.

Choice "d" is incorrect. Analysis of the repair and maintenance account is useful in identifying transactions that should have been capitalized versus expensed (i.e., unrecorded additions).

Choice "b" is incorrect. Analysis of the repair and maintenance account is useful in identifying transactions that should have been capitalized versus expensed (i.e., unrecorded additions).

83

Upon receipt of customers' checks in the mailroom, a responsible employee should prepare a remittance listing that is forwarded to the cashier. A copy of the listing should be sent to the:

a.

Accounts receivable bookkeeper to update the subsidiary accounts receivable records.

b.

Internal auditor to investigate the listing for unusual transactions.

c.

Entity's bank to compare the listing with the cashier's deposit slip.

d.

Treasurer to compare the listing with the monthly bank statement.

Choice "a" is correct. A copy of the remittance listing is sent to the accounts receivable clerk and used to update the subsidiary accounts receivable records. 

Choice "b" is incorrect. A copy of each remittance listing would not be sent to the internal audit staff.

Choice "d" is incorrect. The bank statement is typically reconciled by an employee having no part in authorizing or recording cash transactions, not by the treasurer.

Choice "c" is incorrect. The bank only receives a copy of the deposit slip, not the remittance listing.

84

An auditor suspects that a client's cashier is misappropriating cash receipts for personal use by lapping customer checks received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the:

a.

Daily cash summaries with the sums of the cash receipts journal entries.

b.

Dates uncollectible accounts are authorized to be written off with the dates the write-offs are actually recorded.

c.

Individual bank deposit slips with the details of the monthly bank statements.

d.

Dates checks are deposited per bank statements with the dates remittance credits are recorded.

Choice "d" is correct. When lapping occurs, an employee uses current remittances to conceal remittances that have been stolen previously. Thus, a lag will exist from the time that this current payment is deposited until the current customer's account is actually credited. (The current payment is applied to the previous customer's account).

Choice "a" is incorrect. The total of daily cash summaries will still agree with the total amount entered in the cash receipts journal if lapping is occurring (because the employee does not record as received the amount of cash stolen).

Choice "c" is incorrect. Individual deposit slips will still agree with the bank statements if lapping is occurring. 

Choice "b" is incorrect. The date that write-offs are approved and actually occur will not be affected by a lapping scheme.

85

Which of the following payroll control activities would most effectively ensure that payment is made only for work performed?

a.

Require employees to have their direct supervisors approve their time cards.

b.

Require all employees to record arrival and departure by using the time clock.

c.

Require all employees to sign their time cards.

d.

Have a payroll clerk recalculate all time cards.

Choice "a" is correct. A direct supervisor's approval of the time cards most effectively ensures that payment is paid for work performed as the supervisor observes the employees and determines whether employees are present and working.

Choice "b" is incorrect. All employees recording arrival and departure by using the time clock does not ensure that the employees were actually present and/or working during the recorded time.

Choice "d" is incorrect. Having a payroll clerk recalculate all time cards provides assurance as to mathematical accuracy but this does not ensure that the employees actually were present and/or working.

Choice "c" is incorrect. Requiring all employees to sign their time cards does not ensure that employees actually worked or were present. An unscrupulous employee would claim that he/she worked by signing the time card when in fact he/she did not work.

86

An auditor's analytical procedures indicate a lower than expected return on an equity method investment. This situation most likely could have been caused by:

a.

The investee's decision to reduce cash dividends declared per share of its common stock.

b.

A substantial fluctuation in the price of the investee's common stock on a national stock exchange.

c.

An error in recording amortization of the excess of the investor's cost over the investment's underlying book value.

d.

An error in recording the unrealized gain from an increase in the fair value of available-for sale securities in the income account for trading securities.

Choice "c" is correct. Under equity method accounting, the amortization of the excess of the investor's cost over the investment's underlying book value reduces the investor's income from the equity method investment. If amortization is calculated incorrectly (i.e., the amortization is too high), this could lower the return on the investment.

Choice "a" is incorrect. Under equity method accounting, dividends are recorded as a reduction of the investor's investment in the balance sheet, not as income on the income statement. Therefore, the lower dividend should not reduce the calculated return on the equity method investment.

Choice "d" is incorrect. Equity method investments are accounted for separate from investments classified as trading or available-for-sale. Therefore, an error in the accounting for trading and available-for-sale securities should have no impact on the calculated return on an equity method investment.

Choice "b" is incorrect. Equity method investments are not reported at fair value. Therefore, a substantial fluctuation in the price of the investee's common stock would have no impact on the investor's return on the equity method investment.

NOTE to students: The answer to this question (and your ability to perform a successful audit) depends on your knowledge of financial accounting concepts. If you are unfamiliar with equity method accounting, please consult the Financial 3 lecture in the Becker Financial materials.

87

Under which of the following conditions may an auditor's observation procedure for inventory be performed during or after the end of the period under audit?

a.

When well-kept perpetual inventory records are checked by the client periodically by comparisons with physical counts.

b.

When total inventory has not varied more than 5% in the last five years.

c.

When the auditor finds minimal variations in client records and test counts in prior periods.

d.

When the client maintains periodic inventory records.

Choice "a" is correct. Interim testing is permitted when the risk of material misstatement is low. An entity has strong internal control over inventory and therefore low risk of material misstatement if the entity has well kept perpetual inventory records that are checked periodically by comparisons with physical counts. In this situation, the auditor could elect to perform the inventory observation at an interim date during the period under audit, or after year-end. If the inventory observation is performed at an interim date, the perpetual inventory records would allow the auditor to gather evidence regarding changes to inventory between the interim date and year-end.

Choice "d" is incorrect. Interim testing is generally not appropriate when an entity maintains periodic inventory records because periodic inventory records are only updated on the date when a physical inventory is taken and the books are adjusted to actual. Subsequent transactions to inventory (purchases and sales) are not recorded in the inventory account. If the inventory observation was performed at an interim date, periodic inventory records would not allow the auditor to gather evidence regarding changes to inventory between the interim date and year-end.

Choice "c" is incorrect. The auditor cannot rely upon the results of substantive procedures performed in prior years when conducting an audit in the current year.

Choice "b" is incorrect. Whether or not total inventory has not varied more than 5% in the last five years is irrelevant to whether the auditor's observation procedure for inventory be performed during or after the end of the period under audit.

88

Which of the following procedures would be most appropriate for testing the completeness assertion as it applies to inventory?

a.

Examining paid vendor invoices.

b.

Performing cutoff procedures for shipping and receiving.

c.

Scanning perpetual inventory, production, and purchasing records.

d.

Tracing inventory items from the tag listing back to the physical inventory quantities.

Choice "b" is correct. Performing cutoff procedures provides assurance that goods in transit (shipped or received) are appropriately included or excluded from inventory and this procedure is most appropriate for testing the completeness assertion.

Choice "c" is incorrect. Scanning perpetual inventory, production, and purchasing records would only include transactions that have been recorded. The completeness assertion is focused on unrecorded transactions.

Choice "a" is incorrect. Examining paid vendor invoices would exclude invoices from vendors for goods received but not yet billed by the vendor.

Choice "d" is incorrect. Tracing items from the tag listing back to the physical inventory quantities is a test for the existence of the inventory on the tag listing. For the completeness assertion, the auditor should trace from the physical inventory quantities to the tag listing.

89

Which of the following activities performed by a department supervisor most likely would help in the prevention or detection of a payroll fraud?

a.

Approving a summary of hours each employee worked during the pay period.

b.

Hiring employees and authorizing them to be added to payroll.

c.

Setting the pay rate for departmental employees.

d.

Distributing paychecks directly to department employees.

Choice "a" is correct. The approval of a summary of hours for each employee is performed by the department supervisor as the department supervisor observes whether the amount of each employee's reported hours is correct and whether the employee is being compensated for time actually worked.

Choice "d" is incorrect. The departmental supervisor approves payroll. If the departmental supervisor distributed paychecks directly to departmental employees, then this would be incompatible functions - the departmental supervisor would have access to assets (distributing paychecks) and also authorization of the transaction (approval of payroll). The departmental supervisor could dismiss an employee and not notify human resources, keep the dismissed employee's paycheck, and forge an endorsement on the employee's check.

Choice "c" is incorrect. The pay rate is established by the human resource department. If the departmental supervisor set the pay rates, then he/she could be in collusion with the employee and obtain a kickback for paying an employee more than an established rate for a certain pay grade.

Choice "b" is incorrect. Hiring employees and authorizing them to be added to the payroll is performed by the human resources department. If the departmental supervisor could hire employees, then he/she could hire someone not qualified for the position and be in collusion with the employee and obtain a kickback from the employee. A fictitious employee could also be "hired."

90

During the confirmation of accounts receivable, an auditor receives a confirmation via the client's fax machine. Which of the following actions should an auditor take?

a.

Not accept the confirmation and treat it as an exception.

b.

Accept the confirmation and file it in the working papers.

c.

Accept the confirmation but verify the source and content through a telephone call to the respondent.

d.

Not accept the confirmation and select another customer's balance to confirm.

Choice "c" is correct. To restrict the risks associated with facsimile responses and treat the confirmations as valid audit evidence, the auditor should consider taking certain precautions, such as verifying the source and contents of a facsimile response in a telephone call to the purported sender.

Choice "d" is incorrect. The auditor could accept the confirmation and not select another customer's balance to confirm provided certain additional procedures are performed, as described above.

Choice "a" is incorrect. The auditor could accept the confirmation and not treat it as an exception provided certain additional procedures are performed, as described above.

Choice "b" is incorrect. The auditor would need to perform additional procedures before accepting the confirmation.

91

Which of the following tests of details most likely would help an auditor determine whether accounts payable have been misstated?

a.

Reviewing bank transfers recorded as cash received from customers.

b.

Examining vendor statements for amounts not reported as purchases.

c.

Examining reported purchase returns that appear too low.

d.

Searching for customer-returned goods that were not reported as returns.

Choice "b" is correct. Examining vendor invoices for amounts not reported as purchases is a procedure to determine if accounts payable have been understated (completeness assertion). Accounts payable would be understated for the amounts of purchases that were not reported.

Choice "c" is incorrect. Examining reported purchase returns that appear too low means that the transactions have been recorded. The auditor would be more interested in purchase returns that have not been reported.

Choice "d" is incorrect. Searching for customer-returned goods that were not reported as returns would have an impact on accounts receivable and sales returns accounts, not accounts payable.

Choice "a" is incorrect. Reviewing bank transfers recorded as cash received from customers has an impact on accounts receivable, not accounts payable.

92

An auditor most likely would analyze inventory turnover rates to obtain evidence concerning management's assertions about:

a.

Understandability and classification.

b.

Existence.

c.

Rights and obligations.

d.

Valuation and allocation.

Choice "d" is correct. An auditor most likely would analyze inventory turnover rates to obtain evidence concerning management's assertions about valuation and allocation (i.e., if the inventory is becoming older, an obsolescence reserve might be required).

Choice "b" is incorrect. The existence assertion addresses whether assets, liabilities, and equity interests exist. Analysis of inventory turnover would not provide evidence concerning this assertion.

Choice "c" is incorrect. Rights and obligations pertain to ownership of assets and liabilities. Analysis of inventory turnover would not provide evidence concerning this assertion.

Choice "a" is incorrect. Understandability and classification deal with whether the components of the financial statements are properly presented, described, and disclosed. Analysis of inventory turnover would not provide evidence concerning this assertion.

93

During an audit of an entity's stockholders' equity accounts, the auditor determines whether there are restrictions on retained earnings resulting from loans, agreements, or state law. This audit procedure most likely is intended to verify management's assertions related to:

a.

Valuation and allocation.

b.

Existence.

c.

Classification and understandability.

d.

Completeness.

Choice "c" is correct. Restrictions on retained earnings are for contractual or legal appropriation of retained earnings. The purpose is to restrict dividends, and such restrictions should be disclosed in the financial statements.

Choice "b" is incorrect. Restrictions on retained earnings have no effect on the existence of retained earnings.

Choice "d" is incorrect. Completeness refers to the inclusion of all transactions and balances. Restrictions on retained earnings will not affect completeness.

Choice "a" is incorrect. Assertions about valuation and allocation deal with whether assets, liabilities, and equity interests have been included in the financial statements at appropriate amounts. Restrictions on retained earnings do not affect valuation and allocation.

94

An insignificant portion of a client's inventory is in public warehouses. Evidence of the existence of this merchandise can most efficiently be acquired through which of the following methods?

a.

Observation.

b.

Confirmation.

c.

Inspection.

d.

Calculation.

Choice "b" is correct. The auditor should observe the physical inventory count of goods held in public warehouses if the inventory held therein is significant; otherwise, confirmation of such inventory is sufficient.

Choice "a" is incorrect. Although observation would provide the more effective evidence of existence, it would generally not be the most efficient and should only be done if the inventory is significant.

Choice "d" is incorrect. Calculation is generally not a step performed to determine existence of inventory.

Choice "c" is incorrect. Inspection of inventory, like observation, would provide the more effective evidence of existence; it would generally not be the most efficient method and should only be done if the inventory is significant.

95

The purpose of tracing a sample of inventory tags to a client's computerized listing of inventory items is to determine whether the inventory items:

a.

Represented by tags were reduced to the lower of cost or market.

b.

Included on the listing were properly counted.

c.

Included in the listing were properly valued.

d.

Represented by tags were included on the listing.

Choice "d" is correct. The directional test of tracing is generally used to test completeness. In this case, tracing the inventory tags to the computerized list of inventory items is a test of the completeness of the inventory list.

Choice "b" is incorrect. Recalculation would be the step that would help to determine whether items included on the listing were properly counted.

Choice "a" is incorrect. Tracing is not relevant to the valuation determination of whether the lower of cost or market adjustment was properly applied.

Choice "c" is incorrect. Tracing is not relevant to any valuation determinations.

96

When an auditor decides to confirm accounts receivable balances rather than individual invoices, it most likely would be beneficial to include with the confirmations:

a.

Lists of the customers' recent payments that the client has already recorded.

b.

Copies of the customers' purchase orders that support the account balances.

c.

Client-prepared statements of account that show the details of the account balances.

d.

Copies of the client's shipping documents that support the account balances

Choice "c" is correct. When confirming the total accounts receivable balance, it is beneficial to include a client-prepared statement of account that shows the details of the account balances so that the confirmation recipients can more easily verify the receivable balance.

Choice "d" is incorrect. The client's shipping documents would not generally be helpful to allow a respondent to be able to confirm an existing balance.

Choice "a" is incorrect. Listing client payments that had already been recorded would generally not be relevant in confirming unpaid invoices.

Choice "b" is incorrect. The customer's purchase orders would not generally be helpful to allow a respondent to be able to confirm an existing balance.

97

Who should be responsible for preparing a purchase order, matching the receiving report and invoice with the purchase order, and paying for the related purchase?

a.

The manager of the department requesting the goods is responsible for preparing the purchase order, the purchasing department is responsible for matching goods, and the accounts payable department is responsible for making payment.

b.

The purchasing department is responsible for preparing the purchase order, but the treasurer is responsible for matching documents and making payment.

c.

The purchasing department is responsible for preparing the purchase order, the receiving department is responsible for matching documents, and the accounts payable department is responsible for making payment.

d.

The purchasing department is responsible for preparing the purchase order, the accounts payable department is responsible for matching documents, and the treasurer is responsible for making payment.


Explanation

Choice "d" is correct. In order to have an appropriate segregation of duties, the purchasing department should prepare the purchase order, the accounts payable department should match the purchase order, receiving report, and vendor invoice, and the treasurer should actually make the payment.

Choice "b" is incorrect. The accounts payable department (not the treasurer) matches the purchase order, receiving report, and vendor invoice before approving the voucher for payment.

Choice "c" is incorrect. The receiving department prepares a receiving report, but does not match it with the purchase order and the invoice. Matching these documents should be done by the accounts payable department. In addition, the treasurer, and not the accounts payable department, should make the payment.

Choice "a" is incorrect. The manager of the department requesting the goods is responsible for preparing a purchase requisition, not a purchase order. The purchasing department then prepares the purchase order. The accounts payable department should match the documents, but should not make the payment. Payment should be made by the treasurer.

98

Which is true about the auditor's observation of physical inventory counts?

I.

It can provide evidence supporting the existence assertion.

II.

It can provide evidence supporting the completeness assertion.

a.

Both I and II.

b.

I only.

c.

II only.

d.

Neither I nor II are true.

Choice "a" is correct. Observation of physical inventory counts provides evidence about both existence and completeness. Observing the inventory provides evidence that it physically exists; observing the actual count provides evidence regarding completeness (i.e., does it appear that the client is doing a careful, accurate, and complete job of counting all of the inventory?).

Choices "b", "c", and "d" are incorrect, based on the above explanation.

99

Which of the following does not demonstrate an inappropriate segregation of duties?

a.

The purchasing manager approves vendor invoices for payment.

b.

A billing clerk prepares invoices and records the resulting increase in accounts receivable.

c.

The cashier performs the monthly bank reconciliation.

d.

An accounting clerk receives customer payments and records the resulting reduction in accounts receivable.

Choice "b" is correct. Preparing invoices and recording the related receivables are both recordkeeping functions that would not be inconsistent with each other.

Choice "d" is incorrect. This would allow the clerk to misappropriate cash while still reducing the receivable, such as in a lapping scheme.

Choice "c" is incorrect. The purpose of a bank reconciliation is to uncover unexplained discrepancies between the bank balance and the cash on hand. If the reconciliation is not performed by someone independent, the cashier may be able to misappropriate cash and conceal the theft.

Choice "a" is incorrect. This would allow the purchasing manager to purchase and pay for unauthorized goods with little oversight from others.

100

Which audit procedure is most likely related to the classification and understandability of the financial statements with respect to inventory?

a.

Analyzing inventory turnover.

b.

Examining consignment agreements.

c.

Confirming inventories pledged under loan agreements.

d.

Obtaining quotations for the current market value of inventory.

Choice "c" is correct. The pledge or assignment of any inventories should be appropriately disclosed in the financial statements.

Choice "d" is incorrect. Inventories should be reduced, when appropriate, to replacement cost or net realizable value, but this is more closely related to the valuation of inventory.

Choice "b" is incorrect. Consignment agreements should be examined to ensure that the entity has ownership rights to the inventory (and does not include inventory owned by others), but this relates to the rights and obligations assertion, not to classification and understandability assertions.

Choice "a" is incorrect. Inventory turnover is analyzed as a means of identifying slow-moving, excess, defective, or obsolete items included in inventory, but this relates more closely to the valuation of inventory.

101

Generally accepted auditing procedures have not been followed in which of the following situations?

a.

The accounts receivable balance is immaterial, so the auditor decides not to send any receivables confirmations.

b.

The auditor receives several faxed and emailed confirmation responses indicating that the amount stated is correct. The auditor does not perform any additional procedures related to these electronic responses.

c.

An unusually large number of receivables confirmations are not returned, and the auditor decides to verify the related cash receipts rather than sending second requests.

d.

The auditor receives very few responses to negative confirmations sent. The auditor does not perform any additional procedures related to the non-responses.

Choice "b" is correct. Confirmation responses received electronically should be verified by calling the sender. It is possible for such responses to look like they came from the respondent when in fact they were actually generated by another party, such as the client.

Choice "a" is incorrect. Confirmations are not required if the balance of receivables is immaterial.

Choice "c" is incorrect. Verification of subsequent cash receipts provides excellent evidence about year-end receivables, and would be an appropriate alternative procedure when responses are not received.

Choice "d" is incorrect. Negative confirmations only request a response when the amount stated is incorrect, so there would be no need to perform additional procedures in this case.

102

An auditor is required to confirm accounts receivable if the accounts receivable balances are:

a.

Older than the prior year.

b.

Smaller than expected.

c.

Subject to valuation estimates.

d.

Material to the financial statements.

Choice "d" is correct.  The use of audit confirmations for an entity's accounts receivables is a required GAAP procedure if the accounts receivable balances are deemed material to the balance sheet.

Choice "a" is incorrect. While the age of the accounts receivable account may indicate the potential lack of collectability, it is not a reason for confirmations to be required under GAAP.

Choice "b" is incorrect. Confirmations are not required for accounts receivables that are immaterial or small.

Choice "c" is incorrect. All accounts receivable are subject to valuation estimates (the estimate of the allowance for uncollectible accounts). The need for an allowance is not a criteria used to assess whether accounts receivable confirmations are required.

103

Which of the following controls should prevent an invoice for the purchase of merchandise from being paid twice?

a.

The check signer reviews and cancels the voucher packets.

b.

An individual independent of cash operations prepares a bank reconciliation.

c.

The check signer accounts for the numerical sequence of receiving reports used in support of each payment.

d.

Two check signers are required for all checks over a specified amount.

Choice "a" is correct. Having the check signer review and cancel the voucher packet is a preventive control to ensure the same voucher is not presented and paid a second time. Additionally, because this control is implemented prior to processing (paying for) the original invoice, it functions as a preventive control of avoiding duplicate payments.

Choice "c" is incorrect. This control helps ensure that payment is made for actual goods received (documented), but canceling the voucher packets to avoid duplication of payments is a preventive control.

Choice "b" is incorrect. This is not a preventive control because the bank reconciliation may detect multiple payments for the same invoice after the payments already happened.

Choice "d" is incorrect. Having two check signers for material invoices is not a preventive control here. An effective preventive control is canceling the voucher packets regardless of the dollar amount of the invoices.

104

In confirming a client's accounts receivable in prior years, an auditor discovered many differences between recorded account balances and confirmation replies.  These differences were resolved and were not misstatements.  In defining the sampling unit for the current year's audit, the auditor most likely would choose:

a.

Individual invoices.

b.

Customers with credit balances.

c.

Small account balances.

d.

Individual overdue balances.

Choice "a" is correct. Because of the significant discrepancies on past confirmations, the auditor would most likely choose to use individual invoices in the current year's audit. Depending on the client's accounting system, these invoices could provide more confirmation detail including individual transactions instead of a balance at a point in time. By confirming individual transaction detail on the individual invoices, there should be fewer discrepancies than confirmations sent out to customers in years past.

Choice "b" is incorrect. An auditor is unlikely to focus the confirmation process on customers with credit balances because credit balance accounts receivable are unlikely to be overstated. Confirmation is primarily a test of existence, or overstatement.

Choice "c" is incorrect. When confirming accounts receivable, the auditor is unlikely to focus on confirming small account balances because misstatements in accounts with small balances are unlikely to be material and because the confirmation process is primarily a test of existence, or overstatement.

Choice "d" is incorrect. The confirmation process typically does not focus on overdue balances because confirmation is primarily a test of existence and not valuation.

105

A company employs three accounts payable clerks and one treasurer.  Their responsibilities are as follows:

Employee

Responsibility

Clerk 1   Reviews vendor invoices for proper signature approval.

Clerk 2  Enters vendor invoices into the accounting system and verifies payment terms.

Clerk 3  Posts entered vendor invoices to the accounts payable ledger for payment and mails checks.

Treasurer  Reviews the vendor invoices and signs each check.

Which of the following would indicate a weakness in the company's internal control?

a.

Clerk 2 reconciles the accounts payable ledger with the general ledger monthly.

b.

Clerk 3 mails the checks and remittances after they have been signed.

c.

The treasurer uses a stamp for signing checks.

d.

Clerk 1 opens all of the incoming mail.

Choice "b" is correct. Clerk 3 responsibilities indicate a weakness in internal control as the accounts payable clerk has both the recordkeeping and custody functions. To mitigate this control weakness, clerk 3 can have responsibility for posting invoices to the ledger, but the Treasurer should be the person that mails the checks, which is part of the custody function.

Choice "d" is incorrect. The functions assigned to clerk 1 do not indicate an internal control weakness.

Choice "a" is incorrect. There is no internal control weakness for clerk 2 based on the recordkeeping functions assigned.

Choice "c" is incorrect. Using a stamp to sign checks is not an internal control weakness (especially in a high transaction environment) as long as the Treasurer has custody of his or her signature stamp.

106

Which of the following management assertions is an auditor most likely testing if the audit objective states that all inventory on hand is reflected in the ending inventory balance?

a.

Inventory is complete.

b.

Inventory is properly valued.

c.

The entity has rights to the inventory.

d.

Inventory is properly presented in the financial statements.

Choice "a" is correct. In order to determine whether the actual inventory on hand is reflected in the ending inventory balance by the client, the auditor would test the completeness of inventory. This is done in conjunction with inventory observation, through testing the physical inventory report by tracing test counts to the report to verify that reported inventory is complete.

Choice "c" is incorrect.  The verification of legal right to the inventory is not a test that would satisfy this audit objective.

Choice "b" is incorrect. Testing whether management properly valued its inventory would not satisfy the audit objective, but testing for completeness would.

Choice "d" is incorrect. Testing for this management assertion would not satisfy the audit objective because inventory can be properly presented in the financial statements without the inventory amounts being accurate.

107

Which of the following explanations most likely would satisfy an auditor who questions management about significant debits to accumulated depreciation accounts in the current year?

a.

Current year's depreciation expense was erroneously understated.

b.

The estimated remaining useful lives of plant assets were revised upward.

c.

Plant assets were retired during the current year.

d.

Prior years' depreciation expenses were erroneously understated.

Choice "c" is correct. The explanation that plant assets were retired during the year would most likely satisfy an auditor who questions management about significant debits to accumulated depreciation accounts made during the year. The journal entry to retire an asset includes a debit to accumulated depreciation and a credit to the asset account.

Choice "d" is incorrect. If prior years' depreciation expense was erroneously understated, the auditor would expect a debit to retained earnings and a credit to accumulated depreciation for the error correction.

Choice "a" is incorrect. Typically, accumulated depreciation is debited when there is total and permanent impairment, and when an asset is sold, retired, or otherwise disposed of. If the current year's depreciation expense was erroneously understated, this would not typically result in debits to accumulated depreciation. Instead, the auditor would expect smaller amounts credited to accumulated depreciation.

Choice "b" is incorrect. A change in useful life is handled prospectively. An increase in the remaining useful lives of assets would result in smaller amounts of depreciation expense being credited to accumulated depreciation.

108

An auditor traces the serial numbers on equipment to a nonissuer's sub-ledger. Which of the following management assertions is supported by this test?

a.

Presentation and disclosure.

b.

Rights and obligations.

c.

Valuation and allocation.

d.

Completeness.

Choice "d" is correct. Completeness is the assertion supported by the auditor tracing the serial numbers on equipment (source) to a nonissuer's sub-ledger (book).

Choice "c" is incorrect. Valuation and allocation relate to whether the amounts have been recorded correctly. Reviewing serial numbers on equipment would not provide information about the proper value of the equipment.

Choice "b" is incorrect. Rights and obligations relate to whether the entity holds or controls the rights to the equipment. Inspecting supporting transactions or inspection of contracts would provide evidence of rights and obligations for equipment.

Choice "a" is incorrect. Assertions about presentation and disclosure relate to making sure components of the financial statements are properly presented, described, and disclosed. The auditor would need to review the financial statements, not the serial numbers on equipment, to support the presentation and disclosure assertion.

109

Which of the following procedures would an auditor most likely complete to test the existence assertion of property, plant, and equipment?

a.

Obtaining a detailed fixed-asset register and ensuring depreciation methods are applied consistently.

b.

Obtaining a detailed fixed-asset register and ensuring items are appropriately capitalized.

c.

Obtaining a listing of current-year additions and verifying that items are recorded in the proper period.

d.

Obtaining a listing of all current-year additions, vouching significant additions to original invoices, and determining that they have been placed in service.

Choice "d" is correct. Existence is verified by vouching from the records and statements back to the supporting documents. Therefore, to test the existence assertion of property, plant, and equipment, an auditor most likely would obtain a listing of all current-year additions (records), vouching significant additions to original invoices (source), and determining that they have been placed in service (source).

Choice "b" is incorrect. An auditor would typically review the related repair and maintenance expense accounts in order to locate items that should have been capitalized.

Choice "c" is incorrect. Obtaining a listing of current-year additions and verifying that items are recorded in the proper period is typically used to test the cutoff assertion.

Choice "a" is incorrect. Obtaining a detailed fixed-asset register and ensuring depreciation methods are applied consistently is typically used to test the valuation, allocation, and accuracy assertion.

110

Under which of the following circumstances would using the blank form of confirmation of accounts receivable most likely be preferable to other types of positive confirmations?

a.

Prior years' audits indicate a pattern of overstatement of account balances.

b.

Accounts receivable are immaterial to the entity's financial statements.

c.

Recipients are likely to sign other types of positive confirmations without careful investigation.

d.

The auditor's combined assessed level of control risk and inherent risk is low

Choice "c" is correct. Blank confirmations should be used if recipients are likely to sign confirmations without careful investigation. Blank confirmations require the recipient to fill in the balance, so the recipient cannot simply sign off without checking the balance.

Choice "d" is incorrect. When the auditor's combined assessed level of control risk and inherent risk are low, the auditor would most likely utilize positive confirmations that state the amount owed. Blank confirmations often result in a lower response rate due to the greater effort required for a response.

Choice "a" is incorrect. The auditor most likely would not prefer the blank form of confirmations over other types of positive confirmations when prior years' audits indicate a pattern of overstatement of account balances. The auditor most likely would prefer sending a positive confirmation stating the amount owed, since blank confirmations often result in a lower response rate due to the greater effort required for a response.

Choice "b" is incorrect. The auditor most likely would not prefer the blank form of confirmations over other types of positive confirmations when accounts receivable are immaterial to the entity's financial statements. Blank confirmations often result in a lower response rate due to the greater effort required for a response.

111

When performing an audit, a CPA notes that bad debt expense is unusually high relative to similar firms in the industry. The CPA should recommend which of the following controls?

a.

Require credit checks on all new customers.

b.

Send monthly statements of account to customers with outstanding balances.

c.

Reconcile accounts receivable in the general ledger with the subsidiary ledger.

d.

Use approved price lists for customer billing.

Choice "a" is correct. Credit checks help the company determine the likelihood of a debtor's ability to pay. Credit checks on new customers may result in the company extending less credit to customers who are unlikely to pay, which may result in a lower bad debt expense.

Choice "d" is incorrect. Using approved price lists for customer billing would help ensure that customers are charged the correct price; however, it is unlikely to decrease bad debt expense.

Choice "b" is incorrect. Sending monthly statements to customers with outstanding balances is an important procedure. However, customers who are unlikely or unable to pay probably would not be persuaded by receiving monthly statements.

Choice "c" is incorrect.  Reconciling accounts receivable in the general ledger with the subsidiary ledger is an important procedure to ensure accuracy of the financial statements; however, it is unlikely to decrease bad debt expense.

112

Which of the following procedures would an auditor most likely perform in searching for unrecorded payables?

a.

Compare cash payments made after the balance sheet date with the accounts payable trial balance.

b.

Review the responses of accounts receivable confirmations for indications of disputes with customers.

c.

Examine a sample of creditor balances to supporting invoices, receiving reports, and purchase orders.

d.

Reconcile receiving reports with related cash payments made just prior to the year-end.

Choice "a" is correct. An auditor most likely would compare cash payments made after the balance sheet date with the accounts payable trial balance in searching for unrecorded payables. The auditor is looking for items that should have been recorded as of the balance sheet date, but were not.

Choice "d" is incorrect. Reconciling receiving reports with related cash payments made just prior to year-end would not help the auditor search for unrecorded payables. Cash payments for items received should result in the payable being eliminated.

Choice "b" is incorrect. Reviewing the responses of accounts receivable confirmations for indications of disputes with customers is a substantive procedure related to the revenue cycle, not the expenditure cycle.

Choice "c" is incorrect. An auditor most likely would compare a sample of creditor balances to supporting invoices, receiving reports, and purchase orders to verify that the accounts payable exist. The search for unrecorded payables is primarily used to support the completeness assertion.

113

Which of the following strategies most likely could improve the response rate of the confirmation of accounts receivable?

a.

Notifying the recipients that second requests will be mailed if they fail to respond in a timely manner.

b.

Requesting customers to respond to the confirmation requests directly to the auditor by fax or email.

c.

Including a list of items or invoices that constitute the account balance.

d.

Restricting the selection of accounts to be confirmed to those customers with relatively large balances.

Choice "c" is correct. Positive accounts receivable confirmations require a recipient to respond and confirm their account balance. These confirmations may be blank or have the amount owed stated. A recipient is more likely to respond if it is easier for them to verify the balance. A listing of items or invoices that constitute an account balance would be easier to confirm than a confirmation that is blank or one that just shows the total balance owed. (If the total amount of the balance is shown, the recipient may have to take an additional step of adding up all the invoices owed.)

Choice "d" is incorrect. Restricting the selection to those customers with relatively large balances might not improve the response rate. For example, customers with large balances may have several invoices that they would have to review and total.

Choice "b" is incorrect. Requesting customers to respond to the confirmation requests directly to the auditor by fax or e-mail might not improve the response rate. Some customers may prefer to respond by mail. In addition, recipients that respond electronically should also be requested to mail the original confirmation to the auditor.

Choice "a" is incorrect. A recipient, who does not want to respond to a confirmation, probably would not be persuaded by a notification that second requests will be mailed if they fail to respond in a timely manner.

114

An auditor suspects that a client is fraudulently overstating revenue by recording fictitious sales. Which of the following audit procedures would most likely be used to identify this situation?

a.

Select a sample of sales invoices and trace into the sales journal.

b.

Select a sample of shipping documents and trace to the related sales invoices.

c.

Select a sample of sales invoices and trace to the related shipping documents.

d.

Select a sample of entries in the sales journal and trace to the related sales invoices.

Choice "c" is correct. In recording fictitious sales, the client will likely have created phony sales invoices, but no related shipment will have occurred.

Choice "b" is incorrect. This would test for completeness of sales, by identifying items that were shipped but not recorded.

Choices "a" and "d" are incorrect. The sales invoices and the sales journal are both internally created documents, and both would likely reflect the fictitious sale

115

An auditor tests an entity's control of obtaining credit approval before shipping goods to customers in support of management's financial statement assertion of:

a.

Rights and obligations.

b.

Existence.

c.

Completeness.

d.

Valuation and allocation.

Choice "d" is correct. By ensuring that credit approval is obtained before goods are shipped to customers, the auditor is testing management's assertion that accounts receivable are collectible (valuation or allocation).

Choice "c" is incorrect. Ensuring that credit approval is obtained before goods are shipped does not support the completeness assertion.

Choice "b" is incorrect. Ensuring that credit approval is obtained before goods are shipped does not support the existence assertion.

Choice "a" is incorrect. Ensuring that credit approval is obtained before goods are shipped does not support the rights and obligations assertion.