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Flashcards in A4-3 Deck (35)
1

Which of the following best describes the auditor's responsibility with respect to fair values?

a.

The auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.

b.

The auditor should assess the risk of material misstatement of fair value measurements.

c.

The auditor should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.

d.

The auditor should determine whether management has the intent and ability to carry out courses of action that may affect fair values.

Choice "a" is correct. The auditor's overall responsibility is to obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.

Choice "d" is incorrect. While it is true that the auditor should determine whether management has the intent and ability to carry out courses of action that may affect fair values, this is just one part of evaluating fair value measurements and not the best description of the auditor's overall responsibility.

Choice "b" is incorrect. While it is true that the auditor should assess the risk of material misstatement of fair value measurements, this is done to determine the nature, timing, and extent of audit procedures. It is not the best representation of the auditor's overall responsibility.

Choice "c" is incorrect. Management (and not the auditor) should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.

2

Which of the following would an auditor least likely consider with respect to fair values?

a.

The role of information technology in determining fair value measurements and disclosures.

b.

Whether the valuation methods used are appropriate in relation to the industry in which the entity operates.

c.

The effect on fair value measurement and disclosures of information available subsequent to the audit.

d.

Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to those transactions.

Choice "c" is correct. The auditor would consider subsequent events and transactions occurring before the completion of the audit, not after. The auditor is not responsible for predicting the future, and would not be expected to evaluate the effect of conditions arising subsequent to the audit, that, if known at the time of the audit, might have affected fair value measurements and disclosures.

Choice "d" is incorrect. The auditor is responsible for understanding relevant controls. Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to those transactions is a relevant control.

Choice "a" is incorrect. The auditor is responsible for understanding the entity's process for determining fair value measurements and disclosures. Considering the role of information technology in determining fair value measurements and disclosures is part of understanding this process.

Choice "b" is incorrect. The auditor should evaluate whether the valuation model is appropriate given the entity's circumstances. As part of this evaluation, the auditor should consider whether the valuation method is appropriate in relation to the business, industry, and environment in which the entity operates.

3

Which of the following procedures most likely would assist an auditor in determining whether management has identified all accounting estimates that could be material to the financial statements?

a.

Determine whether accounting estimates deviate from historical patterns.

b.

Review the lawyer's letter for information about litigation.

c.

Inquire about the existence of related party transactions.

d.

Confirm inventories at locations outside the entity

Choice "b" is correct. The auditor should inquire of management concerning pending or threatened litigation, and should obtain a letter from the client's lawyer to corroborate this information. Included in this letter is either an identification of the omission of any pending or threatened litigation, claims, and assessments, or a statement that the list of such matters (as provided by management) is complete.

Choice "c" is incorrect. Accounting estimates generally are not associated with the existence of related party transactions.

Choice "a" is incorrect. Evaluating deviations from historical patterns assists an auditor in determining if a recorded estimate is reasonable, but it does not provide assurance that management has identified all material accounting estimates.

Choice "d" is incorrect. Accounting estimates generally are not associated with the existence of inventories at locations outside the entity.

4

In evaluating the reasonableness of an entity's accounting estimates, an auditor normally would be concerned about assumptions that are:

a.

Similar to industry guidelines.

b.

Susceptible to bias.

c.

Insensitive to variations.

d.

Consistent with prior periods.

Choice "b" is correct. An auditor would be concerned about assumptions that are susceptible to bias because it is more likely that estimates based on such assumptions will be misstated.

Choice "d" is incorrect. The auditor would not normally be concerned about assumptions that are consistent with prior periods, as estimates based on such assumptions are less likely to be misstated.

Choice "c" is incorrect. The auditor would not normally be concerned about assumptions that are insensitive to variation, as estimates based on such assumptions are less likely to be misstated.

Choice "a" is incorrect. The auditor would not normally be concerned about assumptions that are similar to industry guidelines, as estimates based on such assumptions are less likely to be misstated.

5

The refusal of a client's attorney to provide information requested in an inquiry letter generally is considered:

a.

Reason to withdraw from the engagement.

b.

Equivalent to a significant deficiency in internal control.

c.

A limitation on the scope of the audit.

d.

Grounds for an adverse opinion.

Choice "c" is correct. A lawyer's refusal to furnish the information requested in an inquiry letter would be a limitation on the scope of the audit sufficient to preclude an unmodified opinion.

Choice "d" is incorrect. An adverse opinion states that the financial statements do not present fairly the financial position or the results of operations or cash flows in conformity with generally accepted accounting principles. A lawyer's refusal to furnish the information requested in an inquiry letter does not necessarily mean that the financial statements are not fairly presented in conformity with GAAP.

Choice "a" is incorrect. A lawyer's refusal to furnish the information requested in an inquiry letter is not a reason to withdraw from the engagement, as long as the lawyer's refusal is not based on the client's request.

Choice "b" is incorrect. A lawyer's refusal to furnish the information requested in an inquiry letter is not considered to be a significant deficiency in internal control.

6

A client's lawyer is unable to form a conclusion about the likelihood of an unfavorable outcome of pending litigation because of inherent uncertainties. If the litigation's effect on the client's financial statements could be material but it is properly disclosed in the financial statements, the auditor most likely would:

a.

Withdraw from the engagement because of the lack of information furnished by the lawyer.

b.

Issue an unmodified opinion.

c.

Issue a qualified opinion in the auditor's report because of the lawyer's scope limitation.

d.

Disclaim an opinion on the financial statements because of the materiality of the litigation's effect.

Choice "b" is correct. A lawyer may be unable to respond concerning the likelihood of an unfavorable outcome of litigation, claims, and assessments or the amount or range of potential loss, because of inherent uncertainties. Even if the effect of the matter on the financial statements could be material, if it is properly disclosed (and supported by available evidence), the auditor will ordinarily issue an unmodified opinion.

Choice "c" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in a qualification.

Choice "a" is incorrect. The auditor should consider withdrawing from the engagement only if the lawyer withholds information per the client's request. Given the fact pattern, there is no need for the auditor to withdraw from the engagement.

Choice "d" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in a disclaimer of opinion.

7

When auditing related party transactions, an auditor places primary emphasis on:

a.

Confirming the existence of the related parties.

b.

Evaluating the disclosure of the related party transactions.

c.

Verifying the valuation of the related party transactions.

d.

Ascertaining the rights and obligations of the related parties.

Choice "b" is correct. The auditor should view related party transactions within the framework of existing pronouncements, placing primary emphasis on the adequacy of disclosure.

Choice "d" is incorrect. Since related party transactions are (by definition) not considered to be at arm's-length, the auditor generally does not ascertain the rights and obligations of the related parties.

Choice "a" is incorrect. The auditor generally does not confirm the existence of the related parties.

Choice "c" is incorrect. Since related party transactions are (by definition) not considered to be at arm's-length, the auditor generally does not verify the valuation of the related party transactions.

8

Which of the following procedures would an auditor ordinarily perform first in evaluating management's accounting estimates for reasonableness?

a.

Obtain an understanding of how management developed its estimates.

b.

Develop independent expectations of management's estimates.

c.

Test the calculations used by management in developing the estimates.

d.

Consider the appropriateness of the key factors or assumptions used in preparing the estimates.

Choice "a" is correct. In evaluating the reasonableness of an accounting estimate, the auditor should first obtain an understanding of how management developed its estimate.

Choice "b" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditor should use one or a combination of the following approaches: a) review and test the process used by management to develop the estimate, b) develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate, or c) review subsequent events.

Choice "d" is incorrect. After having first obtained an understanding of how management developed its estimate, the auditor should consider testing management's process by assessing the appropriateness of the key factors or assumptions used in preparing the estimate.

Choice "c" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditor should use one or a combination of the following approaches: a) review and test the process used by management to develop the estimate, b) develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate, or c) review subsequent events.

9

In evaluating the reasonableness of an accounting estimate, an auditor most likely would concentrate on key factors and assumptions that are:

a.

Objective and not susceptible to bias.

b.

Consistent with prior periods.

c.

Similar to industry guidelines.

d.

Deviations from historical patterns.

Choice "d" is correct. In evaluating the reasonableness of an estimate, an auditor would normally concentrate on key factors and assumptions that are (1) significant to the accounting estimate, (2) sensitive to variations, (3) deviations from historical patterns, or (4) subjective and susceptible to misstatements and bias.

Choice "b" is incorrect. The auditor need not concentrate on key factors or assumptions that are consistent with those of prior periods, since estimates based on such assumptions are less likely to be misstated.

Choice "c" is incorrect. The auditor need not concentrate on key factors or assumptions that are similar to industry guidelines, since estimates based on such assumptions are less likely to be misstated.

Choice "a" is incorrect. The auditor need not focus on factors that are objective and not susceptible to bias, since estimates based on such assumptions are less likely to be misstated.

10

The primary reason an auditor requests letters of inquiry be sent to a client's attorneys is to provide the auditor with:

a.

Corroboration of the information furnished by management about litigation, claims, and assessments.

b.

The probable outcome of asserted claims and pending or threatened litigation.

c.

A description and evaluation of litigation, claims, and assessments that existed at the balance sheet date.

d.

The attorneys' opinions of the client's historical experiences in recent similar litigation.

Choice "a" is correct. A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished by management concerning litigation, claims, and assessments.

Choice "b" is incorrect. While the attorney is requested to provide the auditor with the likelihood of an unfavorable outcome, the primary source of this information is management.

Choice "d" is incorrect. The attorney's opinion of historical experiences may provide some information to the auditor, but it is not the primary goal of audit inquiry letters.

Choice "c" is incorrect. While the attorney is asked to comment on management's description and evaluation of litigation, claims, and assessments that existed at the balance sheet date, the primary source of this information is management.

11

After determining that a related party transaction has, in fact, occurred, an auditor should:

a.

Obtain an understanding of the business purpose of the transaction.

b.

Substantiate that the transaction was consummated on terms equivalent to an arm's-length transaction.

c.

Add a separate paragraph to the auditor's standard report to explain the transaction.

d.

Perform analytical procedures to verify whether similar transactions occurred, but were not recorded.

Choice "a" is correct. After identifying the occurrence of a related party transaction, the auditor should apply the procedures considered necessary to obtain satisfaction concerning the purpose and nature of the transaction and its effect on the financial statements.

Choice "c" is incorrect. While an extra paragraph may be added to emphasize a matter, there is no requirement that related party transactions be disclosed via explanatory language added to the auditor's report.

Choice "d" is incorrect. Analytical procedures are generally not effective in the identification of related party transactions.

Choice "b" is incorrect. It will generally not be possible to substantiate representations that the transaction was consummated on terms equivalent to those that would have prevailed in an arm's-length transaction.

12

Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions?

a.

Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date.

b.

Retesting ineffective internal controls previously reported to those charged with governance.

c.

Inspecting communications with law firms for evidence of unreported contingent liabilities.

d.

Sending second requests for unanswered positive confirmations of accounts receivable.

Choice "a" is correct. Unusual nonrecurring transactions near year-end are characteristic of related party transactions. Since related party transactions are not at arm's-length, management may use such transactions to bolster sales or assets.

Choice "b" is incorrect. Retesting ineffective controls would not assist the auditor in identifying related party transactions.

Choice "d" is incorrect. Confirmation of accounts receivable would not assist the auditor in identifying related party transactions.

Choice "c" is incorrect. Finding unrecorded contingent liabilities would not assist the auditor in identifying related party transactions.

13

Which of the following factors most likely would cause a CPA not to accept a new audit engagement?

a.

The indications that management has not investigated employees in key positions before hiring them.

b.

The prospective client's unwillingness to permit inquiry of its legal counsel.

c.

The CPA's lack of understanding of the prospective client's operations and industry.

d.

The inability to review the predecessor auditor's working papers.

Choice "b" is correct. A direct letter of inquiry to the entity's legal counsel is required, and a client's refusal to permit such inquiry generally will result in a disclaimer of opinion. It is unlikely that a CPA would accept a new audit engagement under such circumstances.

Choice "d" is incorrect. Inability to review the predecessor auditor's working papers would not cause a CPA to decline a new audit engagement. The CPA would simply need to perform an appropriate level of work to substantiate the opening financial statement balances.

Choice "c" is incorrect. The CPA need not have an understanding of the prospective client's operations and industry before accepting a new audit engagement. Such an understanding may be obtained after acceptance, during the planning phase of the engagement.

Choice "a" is incorrect. Indications that management has not investigated employees in key positions before hiring them is a fraud risk factor that the auditor would need to consider in planning the audit, but it would not cause the CPA to decline the engagement.

14

Which of the following procedures most likely could assist an auditor in identifying related party transactions?

a.

Scanning the accounting records for recurring transactions.

b.

Evaluating the reasonableness of management's accounting estimates.

c.

Performing tests of controls concerning the segregation of duties.

d.

Reviewing confirmations of compensating balance arrangements.

Choice "d" is correct. Compensating balance arrangements may be maintained by or for related parties.

Choice "c" is incorrect. Performing tests of controls concerning the segregation of duties relates to the allocation of responsibilities among company employees; related party transactions typically relate to transactions with affiliates, owners, or management.

Choice "b" is incorrect. Evaluating the reasonableness of management's accounting estimates would not provide any evidence of transactions with affiliates, owners, or management.

Choice "a" is incorrect. Related party transactions are more likely to be nonrecurring than recurring.

15

In connection with an audit of our financial statements, management has prepared, and furnished to our auditors a description and evaluation of certain contingencies."

The foregoing passage most likely is from a(an):

a.

Audit inquiry letter to legal counsel.

b.

Financial statement footnote disclosure.

c.

Management representation letter.

d.

Audit committee's communication to the auditor.

Choice "a" is correct. Legal counsel is best able to corroborate the description and evaluation of contingencies provided by management.

Choice "c" is incorrect. The management representation letter serves to confirm, in writing, representations provided to the auditor. It does not include a statement indicating that management has prepared and furnished a list of contingencies.

Choice "d" is incorrect. The audit committee would not communicate to the auditor regarding the list of contingencies prepared by management.

Choice "b" is incorrect. It would be inappropriate to indicate in the footnotes whether specific information was provided by management to the auditor.

16

Which of the following procedures would an auditor ordinarily perform first in evaluating the reasonableness of management's accounting estimates?

a.

Obtain an understanding of how management developed its estimates.

b.

Review transactions occurring prior to the completion of field work that indicate variations from expectations.

c.

Compare independent expectations with recorded estimates to assess management's process.

d.

Analyze historical data used in developing assumptions to determine whether the process is consistent.

Choice "a" is correct. In evaluating the reasonableness of an estimate, the auditor must first obtain an understanding of how management developed its estimate.

Choices "b", "c", and "d" are incorrect. After obtaining an understanding of how management developed its estimate, the auditor would perform one or a combination of the following procedures:

Review subsequent events and transactions (occurring prior to completion of fieldwork) that corroborate the value of the estimate (choice "b").

Develop an independent estimate of the item for comparative purposes (choice "c").

Review and test the procedures used by management to develop the estimate (choice "d").

17

Which of the following parties should request inquiry of a client's lawyer?

a.

Client management.

b.

The stockholders.

c.

The auditor.

d.

The auditor's attorney.

Choice "a" is correct. The letter of inquiry to the client's attorneys is a request made by client management. Due to attorney-client privilege, the attorney would not be able to respond to such a request made by any other party. Note that management would request the attorney to respond directly to the auditor.

Choice "c" is incorrect. The auditor may request that the client include certain matters in the letter, but technically speaking, the request itself comes from client management.

Choice "b" is incorrect. The stockholders would not have any involvement in the letter of audit inquiry.

Choice "d" is incorrect. The auditor's attorney would not have any involvement in the letter of audit inquiry related to specific client engagements.

18

If a client will not permit inquiry of outside legal counsel, the auditor's report ordinarily will contain a(an):

a.

Adverse opinion.

b.

Disclaimer of opinion.

c.

Qualified opinion.

d.

Unmodified opinion with a separate explanatory paragraph.

Choice "b" is correct. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion.

Choice "a" is incorrect. Adverse opinions are used when there are very material departures from GAAP, which is not the case here.

Choice "d" is incorrect. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. An unmodified opinion with a separate explanatory paragraph would not be sufficient to address this situation.

Choice "c" is incorrect. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. A qualified opinion would not be sufficient to address this situation.

19

Which of the following statements extracted from a client's lawyer's letter concerning litigation, claims, and assessments most likely would cause the auditor to request clarification?

a.

"I believe that this action has only a remote chance in establishing any liability."

b.

"I believe that the plaintiff's case against the company is without merit."

c.

"I believe that the plaintiff will have problems establishing any liability."

d.

"I believe that the company will be able to defend this action successfully."

Choice "c" is correct. The lawyer's comment that the plaintiff "will have problems establishing any liability" is vague…it does not provide an evaluation of the likelihood of an unfavorable outcome. Does "will have problems" mean a loss is probable, reasonably possible, or remote? The auditor would likely want to request clarification to ensure that the situation has been properly accounted for and disclosed.

Choice "a" is incorrect. When a lawyer asserts that a contingent liability is improbable ("remote chance"), it is unlikely that the auditor would require further clarification.

Choice "b" is incorrect. When a lawyer asserts that a contingent liability is improbable ("without merit"), it is unlikely that the auditor would require further clarification.

Choice "d" is incorrect. When a lawyer asserts that a contingent liability is improbable ("able to defend this action successfully"), it is unlikely that the auditor would require further clarification.

20

Which of the following events most likely would indicate the existence of related parties?

a.

High turnover of senior management and members of the board of directors.

b.

Selling real estate at a price significantly different from appraised value.

c.

Granting stock options to key executives at favorable prices.

d.

Failure to correct internal control weaknesses on a timely basis.

Choice "b" is correct. Transactions based on terms that are significantly different from those that would be expected in an arm's length transaction, such as selling real estate at a price significantly different from appraised value, may be indicative of related party involvement.

Choice "c" is incorrect. Executives are considered to be related parties regardless of whether or not stock options at favorable prices are granted.

Choice "a" is incorrect. High turnover of management and/or board members may be caused by any number of circumstances, but is unlikely to be related to the existence of related parties.

Choice "d" is incorrect. Failure to correct internal control weaknesses on a timely basis is a management decision that is unlikely to be related to the existence of related parties.

21

Which of the following procedures most likely would assist an auditor to identify litigation, claims, and assessments?

a.

Inspect checks included with the client's cutoff bank statement.

b.

Obtain a letter of representations from the client's underwriter of securities.

c.

Read the file of correspondence from taxing authorities.

d.

Apply ratio analysis on the current-year's liability accounts.

Choice "c" is correct. In identifying litigation, claims, and assessments, the auditor should review correspondence from taxing authorities, which may indicate an existing tax liability.

Choice "a" is incorrect. Inspecting checks included with the client's cutoff bank statement is not likely to assist an auditor in indentifying litigation, claims, and assessments. Checks included with the cutoff statement would simply provide some indication of monies paid near the year-end date.

Choice "b" is incorrect. The client's underwriter of securities is not likely to provide information regarding litigation, claims, and assessments.

Choice "d" is incorrect. Ratio analysis of liability accounts will not provide evidence of pending or threatened litigation, claims, and assessments.

22

Which of the following events least likely would indicate the existence of related party transactions?

a.

Borrowing funds at an interest rate significantly below prevailing market rates.

b.

Writing off obsolete inventory to net realizable value just before year end.

c.

Making a loan with no scheduled date for the funds to be repaid.

d.

Maintaining compensating balance arrangements for the benefit of principal stockholders.

Choice "b" is correct. Writing off obsolete inventory to net realizable value just before year end is not indicative of the existence of related party transactions.

Choice "c" is incorrect. Making a loan with no scheduled date for the funds to be repaid differs significantly from market terms, and would therefore be indicative of the existence of related party transactions.

Choice "d" is incorrect. Maintaining compensating balance arrangements for the benefit of principal stockholders is indicative of the existence of related party transactions.

Choice "a" is incorrect. Borrowing funds at an interest rate significantly below prevailing market rates is indicative of the existence of related party transactions.

23

Which of the following procedures would an auditor most likely perform regarding litigation?

a.

Discuss with management its policies and procedures for identifying and evaluating litigation.

b.

Confirm the details of pending litigation with the client's adversaries' legal representatives.

c.

Inspect the legal documents in the client's lawyer's possession regarding pending litigation.

d.

Confirm directly with the clerk of the court that the client's litigation is properly disclosed.

Choice "a" is correct. The auditor should discuss with management the controls adopted to identify, evaluate, and account for litigation.

Choice "d" is incorrect. The clerk of the court would not have any information regarding whether or not litigation is properly disclosed in the financial statements.

Choice "c" is incorrect. The auditor does not generally inspect documents held by the client's lawyer, but rather relies on the lawyer's written response to the audit inquiry letter.

Choice "b" is incorrect. It would be inappropriate for the auditor to contact the legal representatives of the client's adversaries.

24

A client is a defendant in a patent infringement lawsuit against a major competitor. Which of the following items would least likely be included in the attorney's response to the auditor's letter of inquiry?

a.

A discussion of case progress and the strategy currently in place by client management to resolve the lawsuit.

b.

An evaluation of the ability of the client to continue as a going concern if the verdict is unfavorable and maximum damages are awarded.

c.

A description of potential litigation in other matters or related to an unfavorable verdict in the patent infringement lawsuit.

d.

An evaluation of the probability of loss and a statement of the amount or range of loss if an unfavorable outcome is reasonably possible.

Choice "b" is correct. It is the auditor's responsibility to evaluate the ability of the client to continue as a going concern. The attorney would not make such an evaluation.

Choice "c" is incorrect. An audit inquiry letter should include inquiry regarding all significant matters that may result in litigation, and the attorney would likely respond to all such matters, not just one specific matter. In addition, an audit inquiry letter should include inquiry regarding an estimate of potential loss, so this too would likely be addressed in the attorney's response.

Choice "a" is incorrect. An audit inquiry letter should include inquiry regarding the progress of the case to date and management's intended response, and the attorney would likely address these issues in his/her response.

Choice "d" is incorrect. An audit inquiry letter should include inquiry regarding the degree of probability of an unfavorable outcome, and the amount or estimate of potential loss. The attorney would likely address these issues in his/her response.

25

An auditor requests a client to send letters of audit inquiry to attorneys who have been consulted concerning litigation, claims, and assessments. The primary reason for this request is to obtain:

a.

Corroboration of the information furnished by management concerning litigation, claims, and assessments.

b.

The attorneys' assurance that litigation, claims, and assessments that are probable of assertion are properly accounted for.

c.

The opinion of an expert whether any loss contingencies are possible, probable, or remote.

d.

A description of litigation, claims, and assessments that have a reasonable possibility of unfavorable outcomes.

Choice "a" is correct. An external inquiry of the entity's attorney is the auditor's primary means of obtaining verification of management information pertaining to litigation, claims, and assessments.

Choice "b" is incorrect. The attorney is an expert in litigation, claims, and assessment, and can provide information about the nature of the matter, progress of the case, degree of probability of an unfavorable outcome, and estimate of potential loss. However, the attorney is not an expert in accounting and would not provide assurance regarding the accounting for such matters.

Choice "d" is incorrect. Although the attorney does provide a description of litigation, claims, and assessments that have a reasonable possibility of unfavorable outcomes, this is only a portion of what the attorney provides, and is not the primary reason for the request. The primary reason for the request is to obtain verification of management information pertaining to litigation, claims, and assessments.

Choice "c" is incorrect. The attorney does provide information regarding the degree of probability of an unfavorable outcome, but evaluating whether loss contingencies are possible, probable, or remote is not the primary reason for the request. The primary reason for the request is to obtain verification of management information pertaining to litigation, claims, and assessments.

26

Which of the following procedures should an auditor perform concerning litigation, claims, and assessments?

a.

Discuss with the client's lawyer its philosophy of defending litigation, claims, and assessments that have a high probability of being resolved unfavorably.

b.

Inspect legal documents in the possession of the client's lawyer that are relevant to pending litigation and unasserted claims and assessments.

c.

Confirm directly with the client's lawyer that all litigation, claims, and assessments have been properly recorded in the financial statements.

d.

Obtain assurance from management that it has disclosed all unasserted claims that its lawyer has advised are probable of assertion.

Choice "d" is correct. The auditor should obtain assurance from management that it has disclosed all unasserted claims that its lawyer has advised are probable of assertion.

Choice "b" is incorrect. The auditor should examine documents in the client'spossession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers. The auditor does not generally examine documents held by the client's lawyer.

Choice "a" is incorrect. If the lawyer has indicated that there is a high probability of a litigation, claim, or assessment being resolved unfavorably, the auditor would use this information, together with an estimate of the range of potential loss (if available), to evaluate management's financial statement presentation. The auditor would not generally discuss with the client's lawyer its defense philosophy regarding such matters.

Choice "c" is incorrect. It is the auditor's responsibility (not the lawyer's) to determine whether litigation, claims, and assessments have been adequately recorded or disclosed in the financial statements.

27

Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions?

a.

Vouching accounting records for recurring transactions recorded just after the balance sheet date.

b.

Reviewing confirmations of loans receivable and payable for indications of guarantees.

c.

Performing analytical procedures for indications of possible financial difficulties.

d.

Inspecting correspondence with lawyers for evidence of unreported contingent liabilities.

Choice "b" is correct. Reviewing confirmations of loans receivable and payable is useful for determining the existence of related party transactions because guarantees are commonly provided by or for related parties.

Choice "d" is incorrect. Detection of unreported contingent liabilities is not a procedure that would assist the auditor in identifying related party transactions.

Choice "a" is incorrect. Recurring transactions after year-end are a usual business occurrence. Related party transactions would most likely be nonrecurring.

Choice "c" is incorrect. While financial difficulties may be associated with related party transactions, it is unlikely that analytical procedures would assist the auditor in identifying such transactions.

28

Which of the following is an audit procedure that an auditor would most likely perform concerning litigation, claims, and assessments?

a.

Confirm directly with the client's lawyer that all litigation, claims, and assessments have been recorded or disclosed in the financial statements.

b.

Discuss with management the controls adopted for evaluating and accounting for litigation, claims, and assessments.

c.

Examine the legal documents in the client's lawyer's possession concerning litigation, claims, and assessments to which the lawyer has devoted substantial attention.

d.

Request the client's lawyer to evaluate whether the client's pending litigation, claims, and assessments indicate a going concern problem.

Choice "b" is correct. The independent auditor's procedures with respect to litigation, claims, and assessments should include discussing with management the controls adopted for identifying, evaluating, and accounting for litigation, claims, and assessments.

Choice "d" is incorrect. The evaluation of going concern issues is the auditor's responsibility.

Choice "c" is incorrect. The auditor should examine documents in the client's possession concerning litigation, claims, and assessments, including correspondence and invoices from lawyers. The auditor does not generally examine documents held by the client's lawyer.

Choice "a" is incorrect. The client's lawyer would only know about matters that he or she has been engaged to handle, which might not include all litigation, claims, and assessments. In addition, it is the auditor's responsibility (not the lawyer's) to determine whether litigation, claims, and assessments have been adequately recorded or disclosed in the financial statements.

29

Which of the following procedures would an auditor most likely perform to assist in the evaluation of loss contingencies?

a.

Performing appropriate analytical procedures.

b.

Reading the financial statements, including footnotes.

c.

Checking arithmetic accuracy of the accounting records.

d.

Obtaining a letter of audit inquiry from the client's lawyer.

Choice "d" is correct. Obtaining a letter of audit inquiry from the client's lawyer may aid the auditor in evaluating loss contingencies.

Choice "c" is incorrect. Checking the arithmetic accuracy of accounting records would not be likely to provide information regarding loss contingencies.

Choice "a" is incorrect. Performing appropriate analytical procedures would not be likely to provide information regarding loss contingencies.

Choice "b" is incorrect. Reading the financial statements, including footnotes, would not be likely to provide information regarding loss contingencies.

30

Which of the following steps should an auditor perform first to determine the existence of related parties?

a.

Request a list of related parties from management.

b.

Review the company's business structure.

c.

Review proxy and other materials filed with the SEC.

d.

Examine invoices, contracts, and purchasing orders.

Choice "a" is correct. In order to determine the existence of related parties, the auditor must first request that management provide a list of related parties. 

Choice "d" is incorrect. Before an auditor examines invoices, contracts, and purchasing orders for evidence of related party transactions, the auditor must first inquire of management regarding the identity of related parties.

Choice "b" is incorrect. Reviewing the company's business structure is unlikely to provide information regarding the existence of related parties. Business structure is occasionally deliberately designed to obscure related party transactions.

Choice "c" is incorrect. Proxy and other materials filed with the SEC may provide evidence of related party transactions. However, the auditor must first inquire of management regarding the identity of related parties.

31

Which of the following statements extracted from a client's lawyer's letter concerning litigation, claims, and assessments most likely would cause the auditor to request clarification?

a.

"We believe that the company will be able to defend this action successfully."

b.

"We believe that the plaintiff's case against the company is without merit."

c.

"We believe that the possible liability to the company is nominal in amount."

d.

"We believe that the action can be settled for less than the damages claimed."

Choice "d" is correct. This statement seems to give some indication that the lawyer believes that there is at least some likelihood that there may be a known or estimable amount and that the case may actually result in a liability.

Choice "c" is incorrect. This statement does not indicate that an amount may be known that would allow the auditor to report anything on the financial statements.

Choice "b" is incorrect. This statement seems to indicate a remote likelihood of any liability arising from this case, thus no disclosure would be needed.

Choice "a" is incorrect. This statement seems to indicate a remote likelihood of any liability arising from this case, thus no disclosure would be needed.

32

In auditing contingent liabilities, which of the following procedures would an auditor most likely perform?

a.

Confirm the details of outstanding purchase orders.

b.

Read the minutes of the board of directors' meetings.

c.

Perform tests of controls on the cash disbursement activities.

d.

Apply analytical procedures to accounts payable.

Choice "b" is correct. In auditing contingent liabilities, an auditor would want to review the minutes of meetings of stockholders, board of directors, and other executive committees in order to find out about communication that may have been transmitted on such issues.

Choice "a" is incorrect. This step will not likely help to determine if any contingent liabilities exist.

Choice "d" is incorrect. This step will not likely help to determine if any contingent liabilities exist.

Choice "c" is incorrect. This step will not likely help to determine if any contingent liabilities exist.

33

An auditor becomes aware that a client has been threatened with litigation. The auditor would likely send an audit inquiry letter to the client's attorney regarding all of the following, except:

a.

An estimate of the potential loss that may be incurred due to the litigation.

b.

How likely it is that there will be an unfavorable outcome to the litigation.

c.

Management's intended response and the progress of the case to date.

d.

The appropriateness of management's financial statement disclosure.

Choice "d" is correct. The auditor would not inquire of the client's attorney regarding the appropriateness of management's financial statement disclosure, as this is an evaluation that should be performed by the auditor.

Choice "c" is incorrect. The auditor would inquire of the client's attorney regarding management's intended response and the progress of the case to date.

Choice "b" is incorrect. The auditor would inquire of the client's attorney regarding the likelihood of an unfavorable outcome.

Choice "a" is incorrect. The auditor would inquire of the client's attorney regarding the potential loss that might be incurred.

34

Which of the following is not a procedure the auditor would use in evaluating the reasonableness of an accounting estimate?

a.

Develop an independent estimate and compare it to management's estimate.

b.

Confirm via the management representation letter that management has disclosed all significant estimates.

c.

Determine how management developed their estimate and test the procedures they used.

d.

Use subsequent events to determine whether the estimate was reasonable.

Choice "b" is correct. While the auditor might obtain such a representation from management, confirmation that all significant estimates have been disclosed would not be enough to substantiate the reasonableness of the estimates.

Choices "c", "d", and "a" are incorrect. In evaluating the reasonableness of an estimate, the auditor may perform one or a combination of the following procedures: Review and test management's procedures, develop an independent estimate for comparative purposes, or review subsequent events and transactions (occurring prior to the completion of fieldwork) for corroborative purposes.

35

In auditing related party transactions, an auditor ordinarily places primary emphasis on:

a.

Verifying the valuation of the related party transactions.

b.

Confirming the existence of the related parties.

c.

The probability that related party transactions will recur.

d.

The adequacy of the disclosure of the related party transactions.

Choice "d" is correct. When auditing related party transactions, the auditor mustdetermine whether they are adequately disclosed in accordance with GAAP.

Choice "c" is incorrect. The auditor's emphasis is on reviewing actual related party transactions that have occurred and not on the probability that a related party transaction could recur in the future.

Choice "b" is incorrect. Confirming the existence of related parties would be an initial step (only) when auditing related party transactions.

Choice "a" is incorrect. While verification of the amounts associated with related party transactions may be part of the test process performed by an auditor, the primary emphasis is on determining whether the disclosure of the related party transactions are adequate.