Chapter 12 -- Evidence -- The Purchases, Inventory, Payroll, and Other Cycles

Question 1

Section 12.1: Substantive Testing of Accounts Payable and Purchases

When should an auditor do to confirm accounts payable?

Answer 1

• Documentary evidence is lacking
• Individual creditors have relatively large balances
• The client has made a major purchase from the creditor regardless of the size of the balance
• Unusual transactions are involved
• The account is secured

Question 2

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is the primary audit procedure to determine whether accounts payable is measured properly?

Answer 2

Vouching accounts payable to supporting documentation

Question 3

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is one way for an auditor to determine whether all merchandise for which the client was billed was received?

Answer 3

Review the vendor invoices and trace these them to the related receiving reports to confirm:
* Items purchased
* The amounts due
* The payment terms

Question 4

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is the auditor’s primary concern regarding procurement of liabilities?

Answer 4

• That accounts payable are not materially understated on the balance sheet
• The auditor should guard against management’s tendency both to inflate earnings and to exaggerate the financial strength of the firm through understatement of liabilities and expenses or overstatement of assets and revenues.
• The auditor’s primary focus will be on the completeness assertion

Question 5

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is most important for an auditor who is auditing a public warehouse?

Answer 5

• Inspection of receiving and issuing procedures in order to disclose for unrecorded liabilities
• Shipping orders and receiving reports that are not reflected in the records suggest that transactions are not being properly recorded.

Question 6

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is the best procedure for an auditor to test whether any checks have been issued without vouchers, purchase orders, and receiving reports?

Answer 6

• Trace cancelled checks to the related supporting documentation
• The checks should not have been written before the dates on the receiving reports.

Question 7

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What documentation does the auditor use to verify that the recieved merchandise has been recorded?

Answer 7

The auditor should review the receiving report since an accounts payable record should be included in the report.

Question 8

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is the appropriate population that an auditor should use when sending accounts payable confirmations?

Answer 8

The auditor should send confirmations to the vendors that have done previous business with the entity, regardless if there is a balance due.

Question 9

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What steps should an auditor do when testing for unrecorded liabilities?

Answer 9

• Examining cash disbursements made after the balance sheet date and comparing them with the accounts payable trial balance
• Sending confirmations to vendors with small and zero balances
• Reconciling payable balances with vendors’ documentation
• Vouch a sample of cash disbursements recorded just after year end to receiving reports and vendor invoices
• Trace subsequent payments to recorded payables is a primary procedure to match payments (checks issued) after year end with the related payables

Question 10

Section 12.1: Substantive Testing of Accounts Payable and Purchases

What is the purpose of an auditor reviewing the renewal of a note payable shortly after the balance sheet date?

Answer 10

• To test for the classification assertion
• The auditor should determine that the renewal had essentially the same terms and conditions as the recorded debt at year end
• A significant change may affect the classification of notes payable (e.g., as current or noncurrent).

Question 11

Section 12.1: Substantive Testing of Accounts Payable and Purchases

Why are audit procedures used to verify accrued liabilities differ from those employed for the verification of accounts payable?

Answer 11

Because accrued liabilities usually pertain to services that were paid for in the current year, but continue to the next reporting year, where as accounts payable report completed transactions.

Question 12

Section 12.2: Substantive Testing of Inventory

What is the auditor most interested in examining when verifying debits to perpetual inventory records?

Answer 12

Vendor invoices to confirm:
* The items purchased
* The amount due
* The payment terms
* Document inventory cost when compared with purchase orders and receiving reports

Question 13

Section 12.2: Substantive Testing of Inventory

What does an auditor test for the presentation assertion of inventory?

Answer 13

• Aggregation or disaggregation of balances
• Clarity of their descriptions
• Relevance and understandability of financial statement disclosures to test the presentation assertion.
• Confirmation of pledged inventory
• Inquire of management about consigned goods
• Inquire of management about major purchase commitments
• Inquire of management about pledging of inventory
• Inquire of management about other significant transactions or events.

Question 14

Section 12.2: Substantive Testing of Inventory

How can an auditor determine if there isn’t a distinction between consigned goods and regular sales?

Answer 14

If there are large debits to accounts receivables and small periodic credits.

Question 15

Section 12.2: Substantive Testing of Inventory

What is included in the safeguarding of inventory?

Answer 15

Periodic reconciliation of detailed inventory records with the actual inventory on hand by taking a physical count.

Question 16

Section 12.2: Substantive Testing of Inventory

How does the auditor verify the accuracy, valuation and allocation assertion for inventory?

Answer 16

Make inquiries of production and sales personnel regarding obsolete and slow-moving inventory

Question 17

Section 12.2: Substantive Testing of Inventory

How does the auditor verify the completeness assertion for inventory?

Answer 17

• Tracing a sample of tags to the physical inventory listing to ensure that the tagged items are included in the listing
• Tracing the details of test counts to the final inventory schedule

Question 18

Section 12.2: Substantive Testing of Inventory

What is the process if statistical sampling methods are used instead of taking physical inventory?

Answer 18

• The auditor should become satisfied by performing alternative audit procedures.
• Attending a year-end inventory count is obviously impractical when the entity measures its inventory using statistical methods.
• The auditor is required to attend and observe at least some counts and should evaluate whether the methods applied and results are appropriate.

Question 19

Section 12.2: Substantive Testing of Inventory

How does the auditor verify the existence assertion for inventory?

Answer 19

• Send confirmations to vendors
• Tracing from the schedule to the inventory tags and ultimately to the auditor’s count sheet.
• Items listed in the inventory listing schedule to inventory tags and the auditor’s recorded count sheets.

Question 20

Section 12.2: Substantive Testing of Inventory

What is the most reliable procedure for an auditor to use to test the existence of a client’s inventory at an outside location?

Answer 20

• Observing physical counts (This is the most reliable as it provide direct personal knowledge)
• Confirming inventories at outside locations
• Testing transactions between a preliminary physical inventory date and the balance sheet date.

Question 21

Section 12.2: Substantive Testing of Inventory

What is the most appropriate for testing the completeness assertion for inventory?

Answer 21

• Performing cutoff procedures for shipping and receiving
• The terms, FOB shipping point versus FOB destination, should be evaluated to assure that the goods were recorded in the proper period.

Question 22

Section 12.2: Substantive Testing of Inventory

What areas should an auditor consider when testing the completeness assertion at the end of the year?

Answer 22

• Vertical Analysis
• Non-financial information (i.e. volume of goods)
• The inventory turnover ratio

Question 23

Section 12.3: Substantive Testing of Property, Plant, and Equipment

What is the most convincing evidence an auditor can obtain in verifying the amount of goodwill?

Answer 23

Fair values received from independent appraisals

Question 24

Section 12.3: Substantive Testing of Property, Plant, and Equipment

How does an auditor test for the existence assertion for PPE?

Answer 24

Select equipment recorded in the accounting records and locate them on the floor.

Question 25

Section 12.3: Substantive Testing of Property, Plant, and Equipment

How does an auditor test for the completeness assertion for PPE?

Answer 25

Trace the serial numbers on equipment to a nonissuer’s sub-ledger.

Question 26

Section 12.3: Substantive Testing of Property, Plant, and Equipment

How does an auditor test for the Allocation, valuation and accuracy assertion for PPE?

Answer 26

• Particular components of the financial statements are included at appropriate amounts
• Allocation adjustments are appropriately recorded
• Disclosures are appropriately measured and described.

Question 27

Section 12.3: Substantive Testing of Property, Plant, and Equipment

What does an auditor do when few property and equipment transactions occur during the year?

Answer 27

• Perform extensive tests of current year property and equipment transactions
• The auditor also may not rely on controls after obtaining an understanding of internal control

Question 28

Section 12.3: Substantive Testing of Property, Plant, and Equipment

What ways can an auditor learn of retirements of equipment?

Answer 28

• Review of depreciation
• Analysis of debits to the accumulated depreciation account
• Review if insurancy policy riders

Question 29

Section 12.3: Substantive Testing of Property, Plant, and Equipment

Why does an auditor analyzes repairs and maintenance accounts?

Answer 29

To obtain evidence that expenditures for property and equipment that should be capitalized are not charged to expense.

Question 30

Section 12.3: Substantive Testing of Property, Plant, and Equipment

What situations would cause debits to the accumulated depreciation account?

Answer 30

• Equipment that was sold or disposed of
• The life of an asset has been lengthened

Question 31

Section 12.3: Substantive Testing of Property, Plant, and Equipment

How does an auditor test for the presentaion assertion of equipment when it is classified as a finance lease?

Answer 31

The auditor will evaluate the propriety of the interest rate used in discounting the future lease payments.

Question 32

Section 12.4: Substantive Testing of Investments

What provides the best form of audit evidence pertaining to the annual measurement of the investment when an investor did not select the fair value option?

Answer 32

The audited financial statements of the investee

Question 33

Section 12.4: Substantive Testing of Investments

What should an auditor do when an entity holds an asset of another entity as security for an outstanding debt?

Answer 33

• The auditor should examine the collateral and estimate its fair value to determine the reasonableness of the arrangement.
• The auditor may refer to published data such as current market quotations to determine the value of securities.

Question 34

Section 12.4: Substantive Testing of Investments

How does an auditor test for existence and rights and obligations assertions for publicly traded stock?

Answer 34

• Inspection
• External confirmation by the issuer, custodian, or counterparty;
• External confirmation of unsettled transactions by the broker-dealer
• Reading partnership or similar agreements.
• Brokers, banks, agents, or others holding securities for the client should be requested by the client to respond directly in writing to the auditor’s confirmation requests.

Question 35

Section 12.4: Substantive Testing of Investments

How does an auditor test for the completeness assertion for investments?

Answer 35

Using analytical procedures to estimate the total investment income.

Question 36

Section 12.4: Substantive Testing of Investments

What procedures would an auditor perform on an audit of a prepaid insurance account?

Answer 36

The prepayments are:
* Properly valued according to the applicable reporting framework
* Apply to future periods
* Are expected to be realized (to provide future benefits)
* Are accurately classified.

Question 37

Section 12.4: Substantive Testing of Investments

When an auditor is performing analytical procedures on an equity method investment, what would cause the expected return on an equity method investment to be lower?

Answer 37

• An error in recording amortization of the excess of the investor’s cost over the investment’s underlying carrying amount.
• The transaction to record the amortization is a recurring entry that, if miscalculated, could result in a lower return than expected

Question 38

Section 12.4: Substantive Testing of Investments

In a manufacturing company, how does an auditor test for the existence assertion?

Answer 38

• Confirm with the broker-dealer
• Inspect and count stocks and bonds
• Vouching all changes during the year to the broker-dealer’s advices and statements

Question 39

Section 12.5: Substantive Testing of Noncurrent Debt

What steps does an auditor perform when auditing non-current debt?

Answer 39

• Analyze the interest expense recorded for th period with the outstanding debt
• The auditor verifies the amount of outstanding liabilities
• If interest expense is excessive in relation to noncurrent debt, unrecorded interest-bearing obligations may be outstanding

Question 40

Section 12.5: Substantive Testing of Noncurrent Debt

What steps does an auditor perform when auditing notes payable?

Answer 40

• Multiply the average outstanding loan balance by the interest rate and Compare the result to the interest expense recorded
• The debt-to-equity ratio, which equals total liabilities divided by total equity, also can be calculated and compared with previous periods

Question 41

Section 12.5: Substantive Testing of Noncurrent Debt

What is the bond trustee?

Answer 41

• The bond trustee is an outside, independent agent responsible for maintaining subsidiary ledgers and paying dividends
• They often keeps the sinking-fund accounts
• The auditor should verify bond sinking-fund transactions with this trustee

Question 42

Section 12.5: Substantive Testing of Noncurrent Debt

What should an auditor do when auditing a current issue of bonds payable?

Answer 42

The auditor therefore should determine that the client has obtained the opinion of a lawyer on the legality of the bond issue, which includes:
* Determine that all noncurrent debt has been recorded and constitutes bona fide liabilities
* Verify that federal and state laws relevant to financial reporting have been complied with
* Determine that premium, discount, interest payable, and interest expense are accurately recorded
* Monitor compliance with debt contracts
* Review proper presentation and disclosure in the financial statements.

Question 43

Section 12.6: Substantive Testing of Equity

What date is the auditor concerned with for establishing that dividends are paid to client corporation shareholders who hold stock?

Answer 43

The record date

Question 44

Section 12.6: Substantive Testing of Equity

What is an auditor’s primary concern when examining the shareholders’ equity section of a client’s balance sheet?

Answer 44

• That all capital stock transactions are properly authorized
• All entries in the capital stock account should be traced to the minutes of the board of directors’ meetings
• The articles of incorporation, by-laws, and minutes of shareholders’ meetings should also be reviewed

Question 45

Section 12.6: Substantive Testing of Equity

What is included in an audit of owners’ equity?

Answer 45

• Determining that dividend declarations have been in compliance with debt agreements
• Tracing the authorization of the dividend from the directors’ minutes
• Determining that the declared dividend amount was closed into retained earnings

Question 46

Section 12.6: Substantive Testing of Equity

How does an auditor test for the existence assertion for treasury stock?

Answer 46

Auditors can inspect their clients’ stock certificates to ensure that all recorded treasury stock actually exists and is in the possession of the company

Question 47

Section 12.6: Substantive Testing of Equity

How does an auditor test for the valuation assertion for treasury stock?

Answer 47

• The auditor should test closing entries to determine whether net income has been closed to retained earnings
• This assures that net income was properly closed to retained earnings will help an auditor determine whether retained earnings is valued correctly

Question 48

Section 12.7: Substantive Testing of Payroll

In testing for the completness and cut-off assertions when the RMM is assessed as low, what substantive tests of payroll balances would an auditor most likely perform?

Answer 48

• Apply analytical procedures
• Recalculate payroll accruals
• Compare payroll costs with entity standards or budgets

Question 49

Section 12.7: Substantive Testing of Payroll

How does an auditor test for the existence assertion for costs and expenses?

Answer 49

• Compare the current year’s expense with that of the prior year’s is an analytical procedure
• The objective of analytical procedures is to identify such things as the existence of unusual transactions and events, and amounts, ratios, and trends that might indicate matters that have financial statement and audit planning ramifications

Question 50

Section 12.7: Substantive Testing of Payroll

When would an auditor most likely would perform substantive tests of details on payroll transactions and balances?

Answer 50

• When analytical procedures indicate unusual fluctuations in recurring payroll entries
• An auditor should first inquire of management about the fluctuations.
• If management does not give a valid reason, then the auditor performs additional procedures to investigate the differences are necessary

Question 51

Section 12.7: Substantive Testing of Payroll

What steps does an auditor perform to check the accuracy of hours worked?

Answer 51

• Compare clock cards with shop job time tickets
• The job tickets, which contain the total hours worked on each job, should not vary significantly from the employee time cards used to compute payroll

Question 52

Section 12.7: Substantive Testing of Payroll

Why would auditor should consider observing a client’s distribution of regular payroll checks?

Answer 52

• Separation of payroll duties is not effective enough to reduce control risk
• The observation should establish whether payment is made only to bona fide employees

Question 53

Section 12.7: Substantive Testing of Payroll

What procedures in an audit most effectively tests that benefit payments to plan participants are paid in accordance with a nonissuer’s defined benefit pension plan plan document?

Answer 53

• Recalculating benefits for selected participants based on the plan provisions using relevant service and salary history to support the recorded benefits paid to the participants
• Inquiries of management about pension benefit agreements
• Comparison of general ledger and financial statement balances
• Recalculation of pension costs