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Flashcards in Evidence Deck (132):
1

An auditor would most likely review an entity's periodic accounting for the numerical sequence of shipping documents and invoices to support management's financial statement assertion of?

Completeness

  • Reviewing the use of and accounting for prenumbered shipping documents and invoices supports management's financial statement assertion of completeness. The numbering helps assure that transactions do not get lost and thus that all transactions are properly included.
  • Comparing shipping documents to related sales invoices (whether all items have been shipped)

2

Testing credit approval before shipping goods to customers tests Management's F/S Assertion of?

Valuation (Allocation)

Testing credit approval before shipping goods to customers tests the valuation assertion. This test addresses the collectibility of accounts receivable.

In general, the valuation/allocation assertion addresses whether the assets and/or liabilities have been included in the financial statements at appropriate amounts.

3

Management's FS Assertion of Rights (Obligations)

Rights and obligations refers to the entity's right to an asset or obligation for a liability.

4

There are 4 management FS assertions applicable to account balances at the period end: 

 

  1. Existence;
  2. Completeness;
  3. Rights or Obligations; and 
  4. Valuation and Allocation.

5

Management's Completeness FS Assertion on Long-term Investments

The completeness assertion for long-term investments addresses the proper inclusion of all long-term investments. An internal control satisfying the completeness assertion would compare the securities on hand with those recorded to ensure that all recorded securities held were actually held.

6

Audit Evidence Reliability

  • remember that the validity of audit evidence rests entirely within the Auditor's judgment

  1. Most reliable - evidence directly obtained by the Auditor.
  2. Evidence obtained from independent outside third party (even when obtained indirectly from the client!!!).
  3. Evidence directly obtained from client internally.
  4. Evidence in documention form is greater than verbal evidence.
  5. Original documentation is more persuasive and reliable than photocopies or faxes.

7

FS Assertion of Completeness - Cutoff Issues

Cutoff is often confusing as it addresses two assertions, Existence and Completeness.

Determining which of the two requires figuring out which transactions are being examined. In this item, the auditor is looking at transactions recorded in December which were not shipped until January. As a result, these transactions are really January sales, NOT December sales. The assertion being addressed is Existence as the auditor is verifying that December sales actually exist, i.e., they are valid sales. By proving that the supposed December sales were not shipped until January, the auditor has verified that the December sales do not exist.

8

Name the financial statement assertion with the below statement:

  1. There is such an asset
  2. The company legally owns all the assets
  3. All assets have been recorded
  4. Transactions are recorded in the correct accounting period
  5. Assets are recorded at proper amounts
  6. Assets are properly classified

 

  1. Existence and Occurrence
  2. Rights and obligations
  3. Completeness
  4. Cutoff
  5. Valuation (allocation)
  6. Presentation and disclosure

9

Name the type of audit procedure described in the statement below:

  1. Prepare a flowchart of internal control over sales
  2. Calculate the ratio of bad debt expense to credit sales
  3. Determine whether disbursements are properly approved
  4. Confirm accounts receivable
  5. Compare current financial information with comparable prior periods

  1. Risk assessment procedures (other than analytical procedures)
  2. Analytical procedures
  3. Test of Controls
  4. Test of Details of account balances, transactions, or disclosures
  5. Analytical procedures

10

Performing substantive analytical procedures at an interim date on ending balances has what impact on detection risk?

Detection risk increases because the balances audited in the interim are not as reliable as final year-end balances.  

The auditor would consider the difficulty in controlling the incremental audit risk, i.e., the risk that material misstatements will not be detected due to the early testing at interim. This difficulty would be impacted by the effectiveness of internal controls, the presence of rapidly changing business conditions or circumstances, and the availability of relevant information.

11

Audit Overall Review Stage

During the overall review stage, the auditor assesses the conclusions reached and the evaluation of the overall financial statement presentation. As part of that evaluation, he/she would consider whether the results of the audit procedures performed affect the risk of material misstatement due to fraud. The overall review would include considering the adequacy of the evidence gathered in response to unusual or unexpected balances and whether such balances reflected a misstatement due to fraud.

12

Before applying principal substantive tests to the details of accounts at an interim date prior to the balance sheet date, an auditor should?

  •  Assess control risk at below the maximum for the assertions embodied in the accounts selected for interim testing.
  • Determine that the accounts selected for interim testing are not material to the financial statements taken as a whole.
  • Consider whether the amounts of the year-end balances selected for interim testing are reasonably predictable.
  • Obtain written representations from management that all financial records and related data will be made available.

Consider whether the amounts of the year-end balances selected for interim testing are reasonably predictable.

  • The auditor's objective is to issue an opinion on the financial statements at the balance sheet date. The performance of substantive tests prior to the balance sheet date increases the risk that misstatements may occur at the balance sheet date that the auditor will not detect. As a result, the auditor must consider certain factors carefully before electing to perform such tests. The performance of substantive analytical procedures to address the roll-forward activity between the interim date and the year-end date would specifically consider whether the amounts of the year-end balances are reasonably predictable with respect to amount, significance, and composition.

13

List the common Audit Procedures performed

  1. Inspection
  2. Observation
  3. Inquiry
  4. External Confirmation
  5. Recalculation
  6. Reperformance
  7. Analytical Procedures

14

Permanent File vs. Current File

  • Permanent file = contains information that is referred to for more than one audit period
    • Flowcharts of internal control
    • schedule of ratios by year
    • Articles of incorporation or by-laws
    • Pension plan contract
    • Lease agreements, Bond indenture agreements
    • Analyses of capital stock and other owners' equity accounts
  • Current file = includes items relevant to the current year audit.
    • Working trial balance
    • Bank reconciliation 
    • Documentation indicating that the audit work was adequately planned and supervised.

15

Define Judgmental Misstatement

Management's unreasonable accounting estimates and/or inappropriate accounting policies.  

16

What impacts the quantity and content of an Auditor's documentation?

The quantity and content of an auditor's documentation would be affected by:

  • the nature of the engagement,
  • the nature of the auditor's report,
  • the nature of the financial statements, schedules, or other information on which the auditor is reporting,
  • the nature and condition of the client's records,
  • the assessed level of control risk,
  • and the needs in the particular circumstances for supervision and review of the work.

17

Working Trial Balance

The working trial balance is very similar to the worksheet.

  1. It begins with the balances per the client's trial balance,
  2. provides columns for audit adjustments and reclassifications,
  3. and ends up with the audited balances per the financial statements.

18

In order to use the negative form of accounts receivable confirmation, the following conditions must be met:

  1. a low risk of material misstatement; 
  2. a large number of small balances is involved;
  3. an expected very low exception rate; and
  4. the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration.

19

Confirmation Types

Remember that generally:

  • Positive = large balances
  • Negative = many small balances
  • The auditor should consider the best way to encourage the most responses, i.e. including client prepared schedules that detail the account balance, etc.

  1. Blank (strongest evidence) - provides more assurance but usually with a price (lower response rate than positive confirmations.  The recipient is asked to fill in the amount on the blank confirmation.
    • It is more likely to be used when the auditor is concerned that recipients will not devote proper attention to the confirmations.
  2. Positive (good evidence but not as strong as blank) - requests a response whether or not the recipient agrees with the amount on the confirmation.
  3. Negative (weak evidence) - requires response only if the recipient disagrees with the amount.
    • typically used if auditor is inclined to accept a higher detection risk and that the inherent risk and control risks are below maximum.   

20

Management's Significant Accounting Estimates

AICPA Professional Standards indicate that the auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the applicable financial reporting framework.

In evaluating the reasonableness of an accounting estimate, an auditor concentrates on key factors and assumptions that are:

  1. significant to the accounting estimate;
  2. sensitive to variations;
  3. deviations from historical patterns; and
  4. subjective and susceptible to misstatement and bias.

21

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?

  1. Inquire about the existence of related party transactions.
  2. Determine whether accounting estimates deviate from historical patterns.
  3. Confirm inventories at locations outside the entity.
  4. Review the lawyer's letter for information about litigation.

Review the lawyer's letter for information about litigation. 

If the auditor is concerned about identifying all material accounting estimates, the auditor is seeking to discover unrecorded estimates. The auditor is most likely to review the lawyer's letter for information about litigation. Litigation losses is an area that commonly requires estimates and one in which estimates could be material to the financial statements.

It is also an area that falls outside of the normal financial reporting process and, thus, is more likely to be missed.

22

Test of Controls - Timing

Tests of controls and substantive tests can be conducted at various times.  The timing of tests of controls is very flexible; they are often performed at an interim period, and subsequently updated through year-end.

23

Substantive Procedures - Timing / Issues

  • Remember that performing procedures at interim date increases Audit Risk

Auditors also have a certain amount of flexibility in planning the timing of substantive tests. These aspects should be considered:

  1. Factors to be considered before applying tests at an interim date before year-end
  2. Auditing procedures to be followed for the remaining period (the period after the interim date through year-end)
  3. Coordination of the timing of audit procedures

Before applying procedures at an interim date, an auditor should consider the incremental audit risk involved as well as whether performance of such interim procedures is likely to be cost-effective. As an illustration of a substantive test applied at an interim date, consider the confirmation of receivables as of November 30, one month prior to the client’s year-end.

Appropriate auditing procedures must be applied to provide a reasonable basis for extending November 30 interim date results to the remaining period(December 1-31). When control risk is assessed at a level below the maximum, the auditor might be able to perform only limited substantive tests during the remaining period to obtain the assurance needed as of the balance sheet date.

24

Auditor's evaluation of long-term debt

  1. Inquire of management concerning pledging of assets related to debt.
  2. Review debt agreements for details on pledged assets and for events which may result in default on the loan.
  3. Confirm long-term debt with payees or appropriate third parties.
  4. Obtain and inspect copies of debt agreements to verify whether provisions have been met and disclosed.

25

Attorney's Letters Interpretation

Remember about the dates of the AL and the Audit Report.  If the attorney's letter is dated significantly after the planned Audit Report date, the AR date should be changed.  Likewise, if the AL is dated significantly premature to the Audit Report date, the AL should be modified.  

The expectation is that the Attorney Letters and the Audit Report have dates that are very close to each other or the same.  

26

Key Co. plans to present comparative financial statements for the years ended December 31, 2005, and 2006, respectively. Smith, CPA, audited Key's financial statements for both years and plans to report on the comparative financial statements on May 1, 2007. Key's current management team was not present until January 1, 2006. What period of time should be covered by Key's management representation letter?

  1. January l, 2005, through December 31, 2006.
  2. January 1, 2005, through May 1, 2007.
  3. January 1, 2006, through December 31, 2006.
  4. January 1, 2006, through May 1, 2007.

January 1, 2005, through May 1, 2007.

The management representation letter should address all periods covered by the auditor's report. Key's management representation letter, therefore, should cover the two periods being audited up through the date of the report, i.e., from January 1, 2005, through May 1, 2007. This requirement exists even if management was not present during all periods covered by the auditor's report.

27

Analytical Procedures During Each Stage of the Audit

  • Remember GAAS requires the use of AP during the Risk Assessment and Nearing the End of the Audit stages, but AP's are NOT required to be used as substantive procedures.  

  • Risk assessment (also referred to as analytical procedures used to plan the audit) —Identify aspects of the entity of which the auditor was unaware and assist in assessing the risks of material misstatement. As such these tests help the auditor to determine the nature, timing, and extent of tests. 
  • Substantive procedures —Obtain relevant and reliable audit evidence to substantiate accounts for which overall comparisons are helpful. 
  • Near the end of the audit —Assist the auditor when forming an overall conclusions about whether the financial statements are consistent with the auditor's understanding of the entity. 


NOTE: GAAS requires the use of analytical procedures during the risk assessment and near the end of the audit. Analytical procedures are not a required substantive test. 

28

Lawyer Letters and Loss Contingencies

  • Remember, refusal of the lawyer to reply is a scope limitation which may affect the audit report.

The client’s lawyer is the primary source for corroboration of information obtained from the client concerning loss contingencies

Therefore, the client prepares a list and describes:

  • claims,
  • litigation,
  • assessments, and
  • unasserted claims pending against the firm. 

This information is sent by the auditor to the attorney who is to review it and provide additional input, if possible.

29

After an audit report is issued, an auditor discovers that an important audit procedure was not performed. Which of the following procedures is acceptable in this situation?

 

  1. No further action is necessary if the audit report can still be supported.
  2. Let the current report stand and correct material errors on the next audit report.
  3. Immediately notify known users of the omitted audit procedure.
  4. Require that the client notify financial statement users of the omitted procedures.
     

No further action is necessary if the audit report can still be supported.

Subsequent to issuance of an audit report, an auditor may realize that one or more necessary procedures were omitted from the audit. When this occurs, the auditor should first assess its importance. If omission is considered important (i.e., it affects present ability to support the previously expressed opinion) and if the auditor believes individuals are relying or are likely to rely on the financial statements, the procedures or alternate procedures should be promptly applied.

30

Which of the following is required documentation in an audit in accordance with generally accepted auditing standards?

  1. A signed engagement letter formalizing the level of service to be rendered.
  2. A flowchart depicting the segregation of duties and authorization of transactions.
  3. A written audit plan describing the necessary procedures to be performed.
  4. A memorandum setting forth the scope of the audit.

A written audit plan describing the necessary procedures to be performed.

  • WRT the EL, the auditor is required to have a written understanding with the client, it does not have to be signed. 

31

An examination of the balance in the accounts payable account as a part of a financial statement audit is ordinarily not designed to

  1. Detect accounts payable which are substantially past due.
  2. Verify that accounts payable were properly authorized.
  3. Ascertain the reasonableness of recorded liabilities.
  4. Determine that all existing liabilities at the balance sheet date have been recorded.

Verify that accounts payable were properly authorized.

This answer is correct because proper authorization is an internal control principle that an auditor examines by testing controls. Proper authorization only suggests that related account balances are more likely to be correct. Based on this reliance the auditor adjusts his/her substantive tests of account balances accordingly. Additionally, account balances may be correct whether they are properly authorized or not.

32

An auditor issued an audit report that was dual dated for a subsequent event occurring after the audit report date but before release of the auditor's report.

The auditor's responsibility for events occurring subsequent to the audit report date was?

Limited to the specific event referenced.

When a subsequent event disclosed in the financial statements occurs after audit report date but before release of the report, the auditor may elect to dual date his/her report. In doing so, the auditor is limiting responsibility for events occurring subsequent to the audit report date to the specific event referenced.

 

33

Subsequent Event Impact on the Audit Report Date

The Professional Standards indicate that, "The auditor's report should not be dated earlier than the date on which the auditor has obtained sufficient appropriate audit evidence to support the opinion. When a subsequent event occurs requiring adjustment of the financial statements but no disclosure is made, the report will still be dated when sufficient appropriate audit evidence had been obtained.

34

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?

 

  • Customers with credit balances.
  • Small account balances.
  • Individual overdue balances.
  • Individual invoices.

Individual Invoices

The auditor should consider the type of information respondents will most easily confirm when determining the sampling unit for the current year's audit. Some accounting systems may track transactions by invoice, rather than by account balance.

When there are "many differences" at the account-balance level for accounts receivable (particularly when those do not involve misstatements), the auditor may choose to focus on specific transactions represented by individual invoices for audit sampling purposes. That may make it easier for customers to respond accurately.

35

Directional Testing - Inventory

  • Existence
  • Completeness
  • Valuation
  • RIghts and obligations

Existence Testing - The auditor should select items from the client's (final) inventory listing, which is essentially the subsidiary ledger for the adjusted general ledger balance. The auditor should agree those selected items to the underlying inventory count tags (and the auditor's own count sheets) that serve as source documents.

Completeness Testing - the direction of the test is just the opposite. The auditor should select items from the underlying inventory count tags (including the auditor's own count sheets) and agree those to the client's inventory listing to establish that there were no omissions from the client's inventory listing.

Valuation Testing -

  1. Inv. Turnover evaluation, is is slow-moving?
  2. Price tests - regarding unit costs (not selling prices!!!)
  3. Test extensions - recalculate product of quantity x cost/unit

Rights and Obligations - is any inventory being used as collaterial for debt?

36

Directional Testing - Cash

  • Existence
  • Completeness

Existence Testing - Request a cut-off bank statement approximately 10 days after year-end to test the reconciling items on the year-end bank reconciliation. This request must come from management to the entity's financial institution to provide information directly to the entity's auditors.

  • Deposits in-transit - Verify that items listed as deposits in transit on the bank reconciliation have been processed as deposits on the cutoff bank statement (testing for "existence/occurrence" regarding the validity of those reconciling items); these should appear in chronological order on the cutoff bank statement.
  • Confirm cash balances directly with the bank.

Completeness Testing - 

  • Outstanding checksLook for checks processed with the cutoff bank statement and having a date prior to year-end; trace those items to the client's list of outstanding checks for "completeness."
  • Confirm liabilities directly with the bank

37

Issue when a client has multiple bank accounts with regard to Cash

Kiting is an overstatement of the true cash balance at year-end caused by recording the receipt, while failing to record the disbursement, associated with a transfer between cash accounts.

Kiting Testing - Prepare a schedule of interbank (or intercompany) transfers to verify that both sides of the transfer are properly accounted for (that is, verify that the cash receipts journal and the cash disbursements journal both reflect the transfer in the same proper period) and to detect any "kiting."

38

Directional Testing - Accounts Receivable

  • Existence
  • Completeness
  • Valuation
  • Rights & Obligations

Existence Testing - two steps 

  1. Verify that the subsidiary A/R ledger agrees or reconciles with the A/R general ledger (control) balance
  2. Confirm all accounts that are individually material and confirm select other accounts on a test basis.
    • Positive - respond either way
    • Negative - respond only if disagree

Completeness Testing - Perform a "cutoff" test of salesCompare shipping documents to sales invoices to assess whether the sales were recorded in the appropriate period.

Valuation Testing - review the client's aged trial balance of A/R. Inquire about any large or delinquent items.  Review receiving documents for unusual sales returns.

Rights and Obligations Testing - are any A/R pledged as collaterial for debt?

39

Proper cutoff procedures involve what two assertions?

  1. Existence 
  2. Completeness

Proper "cutoff" involves two assertions ("existence/occurrence" and "completeness"). Usually the auditor performs certain specific audit procedures directed at testing the validity of recorded transactions (i.e., existence/occurrence) but "completeness" is primarily addressed by these cutoff procedures (along with applicable analytical procedures).

40

If no response is received to a positive confirmation request, the auditor should:

 

  1. Send a second (follow-up) confirmation request, and
  2. Perform "alternate procedures" if still no response is received.
    • Subsequent cash receipts (the preferred alternate procedure)  --  Trace collections on the account subsequent to the date of the confirmation to the cash receipts journal and to the bank statement (suggests the balance was valid if it was subsequently collected).

    • Vouch to (inspect) the underlying documents (the last resort if the account has not been collected)  --  Examine the documents (customer's purchase order, client's sales invoice, and shipping documents) supporting the validity ("occurrence") of the transactions comprising the account balance.

41

When auditing inventories, an auditor would least likely verify that?

  1. The financial statement presentation of inventories is appropriate.
  2. Damaged goods and obsolete items have been properly accounted for.
  3. All inventory owned by the client is on hand at the time of the count.
  4. The client has used proper inventory pricing.

All inventory owned by the client is on hand at the time of the count.

In auditing inventories, an auditor must verify all relevant assertions. The auditor, therefore, should verify that the financial statement presentation is appropriate (presentation and disclosure), that damaged goods and obsolete items have been properly accounted for (valuation), and that proper inventory pricing has been used (valuation). It would not be necessary to verify that all inventory owned was on hand. Inventory may be owned and be in transit, on consignment, or in a public warehouse.

42

A 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?

  1. Observation
  2. Confirmation
  3. Calculation
  4. Inspection

Confirmation

When inventory is held in a public warehouse, the auditor would ordinarily obtain direct confirmation from the custodian.

Auditors typically confirm consigned inventory and inventory in warehouses. Some companies store inventory items in public warehouses. In such a situation, the auditor should confirm in writing with the custodian that the goods are being held. Additionally, if such holdings are significant, the auditor should apply one or more of the following procedures: 

  • Review the client's control procedures relating to the warehouseman.
  • Obtain a CPA's report on the warehouseman's internal control.
  • Observe physical counts of the goods.
  • If warehouse receipts have been pledged as collateral, confirm with lenders details of the pledged receipts.

43

Which of the following accounts should be reviewed by the auditor to gain reasonable assurance that additions to property, plant, and equipment are not understated?

  1. Depreciation
  2. Accounts Payable
  3. Cash
  4. Repairs

Repairs and Maintenance

The repairs expense account may include additions that have been erroneously expensed. Thus, the auditor’s review of the repairs account would reveal a possible understatement of additions to property, plant, and equipment.

A number of CPA questions address this area.  A PP&E acquisition may improperly be recorded in the repair and maintenance expense account.  Therefore, an analysis of repairs and maintenance may detect understatements of PP&E.  Alternatively, an analysis of PP&E may disclose repairs and maintenance that have improperly been capitalized, thereby resulting in overstatements of PP&E.

44

Clarified SAS vs. Preceding Standards

Remember the clarified standards are more principle's based and are not so focused on U.S. GAAP, but rather to the "applicable reporting framework." This is considered a more neutral approach.    

45

Directional Testing - Investment Securities

  • Existence
  • Completeness

Remember when auditing investments and derivatives, the main focus is on Valuation (see separate card) and the valuation is based on the investee's financial results.

Existence Testing - auditor uses inspection and confirmation

  1. Physically inspect any securities in the possession of the client entity.
  2. Confirm any stocks and bonds held by an independent custodian.

Completeness Testing - the auditor primarily uses analytical procedures to address the risk of omissions.

  1. Evaluate investment income or loss accounts:
    • Verify revenue through confirmation when investments are held by an independent custodian;
    • May trace cash receipts to a bank statement; and
    • May recalculate the interest income on debt instruments or dividends received on stock investments.
  2. Compare dividends, interest, or other investment income (loss) to prior year's working papers for reasonableness; dividends can be verified by consulting dividend record books produced by commercial investment advisory services.
  3. Review the minutes of the meetings of those charged with governance for approval of any large transactions.

 

46

Directional Testing - Investment Securities

  • Valuation
  • Rights and Obligations

Valuation Testing - 

  • Bonds -
    • verify interest earned by recalculating,
    • review amortization of any premium or discount,
    • inquire about management's intention to hold to maturity. 
  • Investments (in stocks or bonds) -
    • compare CV at BOY to prior year working papers,
    • verify the year-end fair value to outside source (WSJ, online indexes, etc.)
    • evaluate the adequacy of disclosure as required by the applicable accounting standards.
    • Inquire of management about any impairments that may be other than temporary.
  • Investments (equity method)
    • Examine the investee's current year's audited financial statements to verify the investor's percentage share of income (loss) and any dividend distributions.

Rights and Obligations - document management's intent in the mgmt. representation letter.  remember the basic rules for Fair Value:

  • Trading Securities - Balance Sheet at FV, Unrealized G/L's directly to income statement
  • AFS - BS at FV, Unrealized G/L to OCI
  • HTM - BS recorded at amortized cost basis, NO recognition to Income Statement for fluctuations in FMV.  

47

Directional Testing - Fixed Assets

  • Existence
  • Completeness
  • R&O
  • Valuation

Existence Testing - 

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

Completeness Testing - 

  • Tracing the serial numbers on equipment to the entity's accounting records establishes that, in fact, the assets have not been omitted.

Rights & Obligations Testing - collateral inquiry of mgmt. & document mgmt's responses

Valuation Testing -

  •  Determining that proper amounts of depreciation are expensed (provides assurance that depreciation expense and accumulated depreciation are properly presented and that the resulting net asset valuation is consistent with the requirements of GAAP)

48

What is the purpose of auditing the Repairs and Maintenance account?

Analysis of repairs and maintenance accounts is primarily performed to identify capitalizable expenditures erroneously charged to expense.

Debits that appear in repairs and maintenance expense have not been capitalized. A careful analysis of those charges will enable the auditor to identify major repairs and other expenditures that should have been capitalized.

49

The retirement of plant assets results in?

The retirement of plant assets would result in a debit to accumulated depreciation, along with a credit to the plant assets account for the acquisition cost.

50

Existence Assertion

Start with and go from the Accounting Records (i.e. subsidiary ledger, etc.) and trace to the source document (purchase order, etc.)

Accounting Records -------------> Source Document = Existence Test

  • Observe the client’s distribution of payroll checks.
  • Confirm a sample of recorded receivables by direct communication with the debtors.
  • Review standard bank confirmations for indications of kiting.

51

Income Statement Elements are Primarily Tested by what?

Analytical Procedures (which would also include recalculating the payroll accrual, i.e. high level AP oriented tasks)

  • typically test of details (TOD) will be performed only when the analytical procedures suggest that a RMM exists and that a more detailed investigation is necessary.  

52

List the 5 Assertions Related to Classes of Transactions and Events During the Period (i.e. Income Statement Assertions)

  1. Occurrence - validity of recorded items on the IS
  2. Completeness - has something been omitted?
  3. Cutoff - proper period (this is typically addressed with Occurrence and Completeness and isn't individually tested)
  4. Accuracy - as to reasonableness of dollar amount
  5. Classification - proper account

53

Directional Testing - Current Liabilities (Accounts/Vouchers Payable)

  • Unlike Assets (Existence), the Aud's focus for Liabilities is on Completeness
    • ​remember if question asks about Vouchers Payable, payables are tracked by individual transaction and not grouped, thus they would need to be confirmed by the Aud by individual transaction.
  • Also - see separate card on "Other Current Liabilities"

Completeness Testing - search for unrecorded liabilities

  1. review cash disbursments subsequent to year-end and agree to related vendor invoices and receiving documents to identfy transactions that should have been reported as liabilities at year-end.  
  2. examine any unpaid invoices with related receiving documents to identify transactions that should have been recorded as liabilities at year-end.  
  3. Inquiry of mgmt. about knowledge of unrecorded liabilities

Existence & Valuation Testing - 

  1. Verify the mathematical accuracy of payables by comparing the general ledger balance to the supporting detailed listing of payables.
  2. Vouch selected items to the underlying vendor's invoices.
  3. Could "confirm" selected payables, but usually do not
  4. Valuation is generally not significant issue because there is presumption by Aud that the client will pay 100% of what is owed.  

Rights and Obligations - 

  1. inspect specific terms of payables for related party transactions

54

Directional Testing - Other Current Liabilities

Remember, the auditor uses analytical procedures (i.e. high level) extensively to evaluate other miscellaneous payables:

  • Wages and salaries payable - the auditor can compute the estimated accrual, in view of the number of days to be accrued relative to a whole pay period.
  • Dividends payable - the auditor can compute, in view of the declared dividends/share (per the minutes of meetings of those charged with governance) times the number of shares outstanding.
  • Interest payable (and the related interest expense) - the auditor can compute an estimate of accrued interest for the time period involved, based on the interest rate (and payment dates) specified in the underlying debt agreements.

55

Directional Testing - Long-term Liabilities

  • Completeness
  • Existence
  • Valuation
  • Rights & Obligations

Completeness Testing - use substantive tests of transactions (to address decreases in debt):

  1. Verify due dates for payments in the loan agreements.
  2. Trace cash disbursements from the accounting records to the bank statement.
  3. Examine canceled notes if paid in full.
  4. Could confirm year-end balances, but confirmations are most applicable to establishing the validity of recorded items (that is, existence).

Existence Testing - use substantive tests of transactions (to address increases in debt):

  1. Obtain copies of new loan agreements for the auditor's review and documentation.
  2. Verify authorization of new debt in minutes of meetings of those charged with governance.
  3. Trace receipts from the accounting records to the bank statement.

Valuation Testing - there are few measurement issues associated with most liabilities, but long-term liabilities should be based on present values:

  1. Trace related cash receipts and disbursements from the accounting records to the bank statements.
  2. Examine the underlying loan contracts related to the stated dollar amounts.
  3. Recalculate the amortization of any premium or discount using the effective interest method.
  4. Apply analytical procedures to the related expense accounts (e.g., interest) -- Note that the balance sheet item and the related income statement item are usually addressed on the same audit documentation (working paper).

Rights and Obligations Testing - make inquiries of management and inspect loan documents for debt covenants and collateral issues.  

56

Lapping of Trade Account Receivables

Lapping of trade accounts receivable involves an abstraction of funds and subsequent delay in crediting receipts to accounts receivable (similar concept to Kiting). If customers send payments directly to a depository bank, there is no opportunity for abstraction of funds or subsequent misapplication.

Lapping slows down the recording of customers’ payments. Therefore, confirmations may detect lapping when an auditor receives replies in which customers state that they have paid the receivable well before year-end.

57

One of the auditor’s objectives in observing the actual distribution of payroll checks is to determine that every name on the payroll is that of a bona fide employee. The payroll observation is an auditing procedure that is generally performed for which of the following reasons?

  1. The professional standards that are generally accepted require the auditor to perform the payroll observation.
  2. The various phases of payroll work are not sufficiently segregated to afford effective internal control.
  3. The independent auditor uses personal judgement and decides to observe the payroll distribution on a particular audit.
  4. The standards that are generally accepted by the profession are interpreted to mean that payroll observation is expected on an audit unless circumstances dictate otherwise.

The various phases of payroll work are not sufficiently segregated to afford effective internal control.

  • A typical problem in the payroll area is the apparent existence of fictitious employees which may arise due to inadequate segregation in the payroll area. The observation of a payroll distribution should detect any such irregularity.

58

Once a CPA has determined that accounts receivable have increased due to slow collections in a "tight money" environment, the CPA would be likely to?

  • evaluate going concern impact
  • expand tests of collectability
  • Increase the balance in the allowance for bad debts account
  • Review the credit and collection policy

Expand tests of collectability

  • This answer is correct because during a period of slow collections caused by "tight money," the primary problem is to ascertain that the account is properly valued. Expanding the tests of collectability would allow the auditor to determine if the accounts are collectible.

59

To satisfy the valuation assertion when auditing an investment accounted for by the equity method, an auditor most likely would?

Examine the audited financial statements of the investee company.

Examination of the audited financial statements of the investee company will reveal the investee’s operating and financing results and will allow the auditor to test whether changes in the account have been properly reflected.

60

As one of the year-end audit procedures, the auditor instructed the client’s personnel to prepare a standard bank confirmation request for a bank account that had been closed during the year.  After the client’s treasurer had signed the request, it was mailed by the assistant treasurer. What is the major flaw in this audit procedure?

  1. The confirmation request was signed by the treasurer.
  2. Sending the request was meaningless because the account was closed before the year-end.
  3. The request was mailed by the assistant treasurer.
  4. The CPA did not sign the confirmation request before it was mailed.

The request was mailed by the assistant treasurer.

  • This answer is correct because allowing the client to mail the confirmation directly violated the requirement that the confirmations remain under the auditor’s control. The auditor is unable to ascertain whether the confirmation reached the proper party.

Things to remember with confirmations...

  1. The auditor must maintain control of mailing the confirmations
  2. The confirmations must always be signed by the Treasurer or the appropriate client rep. (NOT signed by the auditor!!!)

61

Which of the following material events occurring subsequent to the December 31, 20X5 balance sheet would not ordinarily result in an adjustment to the financial statements before they are issued on March 2, 20X6?

  1. Write-off of a receivable from a debtor who had suffered from deteriorating financial condition for the past 6 years. The debtor filed for bankruptcy on January 23, 20X6.
  2. Acquisition of a subsidiary on January 23, 20X6. Negotiations had begun in December of 20X5.
  3. Settlement of extended litigation on January 23, 20X6, in excess of the recorded year-end liability.
  4. A 3-for-5 reverse stock split consummated on January 23, 20X6.

Acquisition of a subsidiary on January 23, 20X6. Negotiations had begun in December of 20X5.

  • the condition (acquisition of a subsidiary) did not arise until after year-end. Footnote disclosure of this transaction, however, is necessary.

The other answers are incorrect because:

  • the debtor’s deteriorating financial condition was in existence at year-end. Therefore, an adjustment to the financial statements is appropriate.
  • the condition giving rise to the litigation existed at the balance sheet date. Therefore, settlement of the litigation would require an adjustment to the financial statements.
  • GAAP requires retroactive adjustment for such stock splits.

62

IT Evidence-Gathering Procedures

  • Audit Software (focus is on substantive procedures)

Generalized software  --  Canned audit programs to access and test client's files; initially expensive to develop, but can be efficient if used on numerous engagements.

Customized software  --  Programs specifically written to access the files of a particular client; may be cheaper in the short run, but more expensive in the long run if such costs are incurred for many clients.

Data mining software  --  Commercially available software (such as ACL or Idea) can be easily used to access client's electronic data and perform a broad range of substantive audit tasks (such as performing analytical procedures and sampling for confirmation work).

63

IT Evidence-Gathering Procedures

  • Test of Controls (when IT related controls are internal and unobservable)

  1. Test Data - Introducing "dummy" transactions under the auditor's control
  2. Integrated Test Facility (ITF) - Create a fictitious division or department within the client and process the "dummy" data along with the client's "live" data; again, be careful not to contaminate the client's actual files
  3. Parallel Simulation -  Processing the client's actual data on the auditor's software and then comparing auditor's output to client's output for agreement.
  4. Tagging - specific client transactions and tracing them through the client's system
  5. Embedded Audit Modules - (and audit hooks) - Systems that don't have a permanent audit trail require that any "auditing" occurs while processing take place.

64

A number of audit procedures are involved in completing the audit. These procedures, completed on or near the last day of fieldwork, include

A number of audit procedures are involved in completing the audit. These procedures, completed on or near the last day of fieldwork, include:

  • Search for unrecorded liabilities
  • Review of minutes of meetings of shareholders, board of directors, and the audit committee
  • Perform analytical procedures
  • Perform procedures, including the inquiry of client’s lawyers, to identify loss contingencies
  • Perform review for subsequent events
  • Obtain representation letter
  • Evaluate audit findings
  • Review adequacy of disclosures using a disclosure checklist that lists all specific disclosures required by GAAP and the SEC, if appropriate
  • Review of working papers performed by manager, partner, and possibly a second partner review performed by a partner who is not otherwise involved in the engagement but to provide an independent review of the work performed.  The review process helps provide assurance that audit risk is an appropriately low level, working paper documentation is adequate, and that the evidence supports the opinion being rendered
  • Communicate with the audit committee

65

Analytical Procedures (when performed as substantive procedures)

  • remember this is not required by GAAS, only for planning and the end of the audit stages

An auditor may decide to reduce tests of details for a particular objective if analytical procedures performed as substantive procedures reveal no likely misstatements.

66

Related Party Transactions

Primary emphasis is placed on the adequacy of the disclosure of the related-party transactions.

Auditors should obtain an understanding of related party relationships sufficient to conclude, based on the audit evidence obtained, whether the financial statements, insofar as they are affected by those relationships and transactions, achieve fair presentation.

67

In performing tests of controls, the auditor will normally find that:

  • The level of risk is directly proportionate to the rate of error.
  • The rate of deviations in the sample exceeds the rate of error in the accounting records.
  • The rate of error in the sample exceeds the rate of deviations.
  • All unexamined items result in errors in the accounting records.

The rate of deviations in the sample exceeds the rate of error in the accounting records.

Remember that because a deviation from a control procedure does not necessarily result in a misstatement (e.g., an unapproved invoice may still represent a valid business expenditure), the rate of misstatements is generally lower than the deviation rate.

This answer is correct because the existence of a deviation from a control activity may or may not indicate that an error exists in the accounting records. For example, an invoice which has not been footed to test mathematical accuracy may still be correctly totaled and properly recorded in the accounting records.

68

In performing a search for unrecorded retirements of fixed assets, an auditor normally would?

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

Look to discover what you need to look for (i.e. old assets in the records/data) and go see if the assets are still at the plant.  

69

How to tell the difference between tests of control and substantive tests.

  • TofC verifies the operating effectiveness of a control
    • look for approval signature, reperform, observation and inquiry
  • Substantive tests look for MM
    • Confirmation, inventory observation, cash counts, search for unrecorded liabilities

70

What would an auditor do to establish the proper valuation for PP&E?

Recalculate depreciation to establish proper valuation of PP&E.  In addition, the existence of recurring losses on retired assets may indicate that depreciation charges are generally insufficient.

71

The date of the management representation letter should coincide with the?

Date of the auditor's report.

  • The representation letter should be addressed to the auditor, in a letter dated no earlier than the date of the auditor’s report. 
  • The representation letter should be signed by the chief executive officer and the chief financial officer
  • Representations from management are not a substitute for the application of other necessary auditing procedures. 
  • Representations should be obtained for all periods being reported upon, even if management was not present during all of those periods. 
  • Management refusal to furnish written representations precludes an unmodified opinion, and ordinarily results in a disclaimer, although a qualified opinion may be appropriate in some circumstances.

72

Audit Evidence Reliability

  • Obtained from knowledgeable independent sources outside the client company rather than nonindependent sources
  • Generated internally through a system of effective controls rather than ineffective controls
  • Obtained directly by the auditor rather than indirectly or by inference (e.g., observation of application of a control is more reliable than an inquiry to the client concerning the control)
  • Documentary in form (paper, electronic, or other) rather than an oral representation
  • Provided by original documents rather than copies or facsimiles

73

Subsequent Event Disclosure Examples

Rule of thumb is does the event have an impact on the financial statements?  

Generally would disclose:

  1. Sale of the bond or capital lease
  2. Loss of PP&E due to fire or flood
  3. Settlement of litigation (even if event giving rise to lawsuit occurred after balance sheet date)

Generally would not disclose:

  1. Major drop in quoted market price of entity's stock

74

Auditing Unrecorded Liabilities

  • What is the best audit procedure for determining existence of UL's?

Examine a sample of cash disbursements in the period subsequent to year-end.

The search for unrecorded liabilities is performed near the completion of the audit to determine that proper cutoffs have been made and to give the auditor additional information in his/her evaluations of account balances as of the balance sheet date. One of the principal procedures used to accomplish this objective is the examination of a sample of cash disbursements in the period subsequent to year-end. This examination will allow the auditor to see if any cash disbursements are made for liabilities which were unrecorded in the previous year.

75

A cash shortage may be concealed by transporting funds from one location to another or by converting negotiable assets to cash.  Because of this, which of the following is vital?

  1. Simultaneous confirmations.
  2. Simultaneous bank reconciliations.
  3. Simultaneous verification.
  4. Simultaneous surprise cash count.

Simultaneous verification. 

By simultaneously verifying cash, securities, and other related items, any concealment of cash shortages will be exposed. If a transfer from another account is made to conceal a cash shortage, a shortage in the transferred item will result and this will be identified.

Because of the liquid nature of securities, the auditor’s inspection is generally performed at year-end simultaneously with the audit of cash, bank loans (e.g., a revolving credit agreement), and other related items.

76

When a contingency is resolved immediately subsequent to the issuance of a report which was qualified with respect to the contingency, the auditor should

  1. Insist that the client issue revised financial statements.
  2. Inform the audit committee that the report cannot be relied upon.
  3. Take no action regarding the event.
  4. Inform the appropriate authorities that the report cannot be relied upon.

Take no action regarding the event.

When a contingency is resolved immediately subsequent to the issuance of a report which was qualified with respect to the contingency, the auditor is not required to take any action regarding the event. Resolution of the contingency after the issuance of the report is not subsequent discovery of facts existing at the date of the auditor’s report. Because the contingency did result in a qualified report, the auditor was aware of the facts existing at the date of the auditor’s report. Also, the auditor’s responsibility for continuing inquiry is precluded by AU 561.

77

Dual Dating the Auditor's Report

Dual dating the report extends the auditor’s responsibilities. If the auditor becomes aware of a subsequent event that has occurred after the completion of fieldwork, but before the issuance of the report (which should be disclosed), the auditor may dual date the report. Additionally, the auditor may date the report as of the date of the subsequent event and extend the procedures for review of subsequent events to that date. Thus, the decision whether or not to dual date the report is based upon the auditor’s willingness to extend audit procedures.

78

When counting cash on hand the auditor must exercise control over all cash and other negotiable assets to prevent

  1. Theft.
  2. Irregular endorsements.
  3. Substitution.
  4. Deposits-in-transit.

Substitution. the liquidity of these assets makes substitution (changing the form of the assets and thereby double counting them) possible.

This relates to the issue of simultaneous verification.  Because of the liquid nature of securities, the auditor’s inspection is generally performed at year-end simultaneously with the audit of cash, bank loans (e.g., a revolving credit agreement), and other related items.

79

In verifying the amount of goodwill recorded by a client, the most convincing evidence which an auditor can obtain is by comparing the recorded value of assets acquired with the?

 

  1. Assessed value as evidenced by tax bills.
  2. Seller’s book value as evidenced by financial statements.
  3. Insured value as evidenced by insurance policies.
  4. Appraised value as evidenced by independent appraisals.
     

Appraised value as evidenced by independent appraisals.

Identifiable assets acquired in a "purchase" business combination should be recorded at their appraised values.

80

An inventory turnover analysis is useful to the auditor because it may detect

  1. Inadequacies in inventory pricing.
  2. Methods of avoiding cyclical holding costs.
  3. The optimum automatic reorder points.
  4. The existence of obsolete merchandise.

The existence of obsolete merchandise.

Inventory turnover analysis may be useful to the auditor in detecting the existence of obsolete merchandise. As the proportion of obsolete merchandise to total inventory grows, the inventory turnover would decrease.

The inventory pricing answer is incorrect because the price impact would have to be significantly material to have any impact on inventory turnover.  

81

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

  1. Inspect legal documents in the possession of the client’s lawyer that are relevant to pending litigation and unasserted claims and assessments.
  2. Discuss with the client’s lawyer its philosophy of defending litigation, claims, and assessments that have a high probability of being resolved unfavorably.
  3. Confirm directly with the client’s lawyer that all litigation, claims, and assessments have been properly recorded in the financial statements.
  4. Obtain assurance from management that it has disclosed all unasserted claims that its lawyer has advised are probable of assertion.

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

The lawyer is ordinarily required to inform management of such unasserted claims, but the lawyer is not required to inform the auditor; thus, it is particularly important for the auditors to obtain assurance from management that such unasserted claims have been disclosed.

82

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

  1. Adverse opinion.
  2. Disclaimer of opinion.
  3. Unmodified opinion with a separate explanatory paragraph.
  4. Unmodified (unqualified) opinion.

Disclaimer of opinion. The client’s refusal is a client-imposed scope limitation, and such scope limitations ordinarily result in a disclaimer of opinion.

83

Each of the following is a type of a known misstatement, except

  1. An inaccuracy in processing data.
  2. The misapplication of accounting principles.
  3. Differences between management and the auditor's judgment regarding estimates.
  4. A difference between the classification of a reported financial statement element and the classification according to generally accepted accounting principles.

Differences between management and the auditor's judgment regarding estimates.  The professional standards consider differences in estimates as "other estimated misstatements," not "known misstatements."

84

The auditor can best verify a client’s bond sinking fund transactions and year-end balance by

  1. Confirmation with the bond trustee.
  2. Confirmation with individual holders of retired bonds.
  3. Recomputation of interest expense, interest payable, and amortization of bond discount or premium.
  4. Examination and count of the bonds retired during the year.

Confirmation with the bond trustee. The best verification of a client’s bond sinking fund transactions and year-end balance is confirmation with the bond trustee. The bond trustee is an independent party and accordingly can provide valid evidence.

85

Which of the following is ordinarily designed to detect possible material dollar misstatements in the financial statements?

  1. Tests of controls.
  2. Analytical procedures.
  3. Information technology controls.
  4. Post audit working paper review.

Analytical procedures. 

Substantive analytical procedures are substantive tests which can aid in the detection of material errors by identifying unexpected fluctuations or the absence of expected fluctuations in the relationships between data.

86

A lawyer’s response to an auditor’s request for information concerning litigation, claims, and assessments will ordinarily contain which of the following?

  1. An explanation regarding limitations on the scope of the response.
  2. A statement of concurrence with the client’s determination of which unasserted possible claims warrant specification.
  3. Confidential information which would be prejudicial to the client’s defense if publicized.
  4. An assertion that the list of unasserted possible claims identified by the client represents all such claims of which the lawyer may be aware.

An explanation regarding limitations on the scope of the response. 

A lawyer’s response will ordinarily contain an explanation of the limitations on the scope of the response. The lawyer will appropriately limit the response to matters which he has given substantive attention to, and to matters that are considered material to the financial statements. These limitations are not limitations on the scope of the auditor’s examination.

87

“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 forgoing passage most likely is from a(n)

  1. Audit inquiry letter to legal counsel.
  2. Management representation letter.
  3. Audit committee’s communication to the auditor.
  4. Financial statement footnote disclosure.

Audit inquiry letter to legal counsel. 

The client’s lawyer is the primary source for corroboration of information obtained from the client concerning loss contingencies.  Therefore, the client prepares a list and describes claims, litigation, assessments, and unasserted claims pending against the firm.  This information is sent by the auditor to the attorney who is to review it and provide additional input, if possible.

88

Audit Working Papers

  • Primary purpose?

The primary purposes of audit workpapers are to support the auditor’s opinion and to aid in conducting and supervising the audit engagement.

89

Which of the following analyses appearing in a predecessor’s working papers is the successor auditor least likely to be interested in reviewing?

  1. Analysis of noncurrent balance sheet accounts.
  2. Analysis of current balance sheet accounts.
  3. Analysis of contingencies.
  4. Analysis of income statement accounts.

Analysis of income statement accounts. The successor will normally review working papers of continuing accounting significance. Prior income statement accounts are less likely to have continuing significance than are balance sheet accounts and contingencies. Also, an auditor spends most of their time during an audit analyzing balance sheet accounts.

90

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?

  1. Customers with credit balances.
  2. Small account balances.
  3. Individual overdue balances.
  4. Individual invoices.

Individual invoices.  Sampling individual invoices may make it easier for customers to reply accurately (particularly when those customers use a voucher system in which liabilities are recorded by individual purchase).

91

To establish illegal "slush funds," corporations may divert cash received in normal business operations. An auditor would encounter the greatest difficulty in detecting the diversion of proceeds from

  1. Scrap sales.
  2. Dividends.
  3. Purchase returns.
  4. COD sales.

Scrap sales are generally irregular in nature and these sales often are inadequately controlled by the internal control. This lack of adequate internal control makes it difficult for the auditor to detect any irregularities.

92

Before applying substantive procedures to the details of asset accounts at an interim date, an auditor should assess

  1. Control risk at below the maximum level.
  2. Inherent risk at the maximum level.
  3. The difficulty in controlling the incremental audit risk.
  4. Materiality for the accounts tested as insignificant.

The difficulty in controlling the incremental audit risk.  Professional standards require that an auditor assess the difficulty in controlling the incremental audit risk. In addition, the auditor should consider the cost of the substantive tests that are necessary to appropriately examine the remaining period.

93

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

  1. Shipping documents need to be inspected.
  2. Recipients may sign the forms without proper investigation.
  3. More nonresponses to the requests are likely to occur.
  4. Subsequent cash receipts need to be verified.

More nonresponses to the requests are likely to occur.  Requiring respondents to supply such information may decrease the number of responses obtained and result in the need for additional audit procedures.

94

Under which of the following circumstances would an auditor be most likely to intensify an examination of a $500 imprest petty cash fund?

  1. Reimbursement vouchers are not prenumbered.
  2. Reimbursement occurs twice each week.
  3. The custodian occasionally uses the cash fund to cash employee checks.
  4. The custodian endorses reimbursement checks.

Reimbursement occurs twice each week.  A petty cash fund is most frequently used for small expenditures and one would not expect to find one in which the imprest amount of $500 was being reimbursed twice weekly. The auditor would be likely to intensify an examination of the petty cash fund if this situation occurred.

95

Some firms which dispose of only a small part of their total output by consignment shipments fail to make any distinction between consignment shipments and regular sales. Which of the following would suggest that goods have been shipped on consignment?

  1. Numerous shipments of small quantities.
  2. Numerous shipments of large quantities and few returns.
  3. Large debits to accounts receivable and small periodic credits.
  4. Large debits to accounts receivable and large periodic credits.
     

Large debits to accounts receivable and small periodic credits.  When consignment sales are shipped as regular sales, accounts receivable would be debited for large amounts. However, because the consignee is under no obligation to pay for the goods until they are sold, accounts receivable would be credited in small periodic amounts.

96

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

  1. Making a loan with no scheduled date for the funds to be repaid.
  2. Maintaining compensating balance arrangements for the benefit of principal stockholders.
  3. Borrowing funds at an interest rate significantly below prevailing market rates.
  4. Writing off obsolete inventory to net realizable value just before year-end.

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

Writing off of obsolete inventory in such a manner is an ordinary procedure that is required by GAAP and not directly related to whether related-party transactions exist. Related-party transactions often involve transactions with one or more characteristics that would not exist in "arm’s-length transactions."

97

Confirmation of individual accounts receivable balances directly with debtors will, of itself, normally provide evidence concerning the

  1. Collectability of the balances confirmed.
  2. Ownership of the balances confirmed.
  3. Existence of the balances confirmed.
  4. Internal control over balances confirmed.

Existence of the balances confirmed.  Confirmation does provide evidence as to the existence of the receivable since the debtor acknowledges it.  

Confirm accounts and notes receivable by direct communication with debtors to verify the existence and gross valuation of the accounts.

98

The audit working papers often include a client-prepared, aged trial balance of accounts receivable as of the balance sheet date.  This aging is bestused by the auditor to

  1. Evaluate internal control over credit sales.
  2. Test the accuracy of recorded charge sales.
  3. Estimate credit losses.
  4. Verify the validity of the recorded receivables.

Estimate credit losses. Aging accounts receivable evaluates the adequacy of the allowance for doubtful accounts (i.e., to estimate credit losses). 

An aging schedule is used to address the receivable valuation assertion. Such a schedule summarizes receivables by their age (e.g., 0-30 days since sale, 31-60 days since sale...).  Estimates of the likely amount of bad debts in each age group are then made (typically based on historical experience) to estimate whether the amount in the allowance for doubtful accounts is adequate at year-end.

99

Operational Auditing

Operational audits, generally performed by internal auditors, typically evaluate the effectiveness and efficiency of various operational processes.  As such they are similar to "performance audits" as presented in the Government Auditing Standards. In fact, the topic "operational auditing" was dropped from the AICPA Content Specification Outline when compliance auditing was added.

A typical objective of an operational audit is for the auditor to make recommendations for improving performance.

100

Which of the following circumstances would most likely cause an auditor to suspect that material fraud exists in a client’s financial statements?

  1. Property and equipment are usually sold at a loss before being fully depreciated.
  2. Significantly fewer responses to confirmation requests are received than expected.
  3. Monthly bank reconciliations usually include several in-transit items.
  4. Clerical errors are listed on a computer-generated exception report.

Significantly fewer responses to confirmation requests are received than expected.  Receiving significantly fewer responses to confirmation requests than were expected is considered a circumstance that should cause the auditor to consider whether material misstatements exist.

101

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

  1. Unaudited information from internal quarterly reports.
  2. Various account assertions in the planning memorandum.
  3. Comments in the prior year’s management letter.
  4. The control risk assessment relating to specific financial assertions.

Unaudited information from internal quarterly reports.  Analytical procedures used in planning generally use data aggregated at a high level, data such as account balances from the prior year or from quarterly financial statements.

102

An auditor who is engaged to examine the financial statements of a business enterprise will request a cutoff bank statement primarily in order to

  1. Verify the cash balance reported on the bank confirmation inquiry form.
  2. Verify reconciling items on the client’s bank reconciliation.
  3. Detect lapping.
  4. Detect kiting.

Verify reconciling items on the client’s bank reconciliation.  A cutoff bank statement will include canceled checks and deposit slips for the period immediately following year-end. The auditor is, therefore, able to test whether the reconciling items at year-end have been handled properly.

Kiting is the wrong answer because a cutoff bank statement, by itself, will provide limited assistance in detecting kiting. Kiting is the overstatement of cash by recording a deposit without a corresponding withdrawal at year-end and is best detected through the use of a bank transfer schedule.

103

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

  1. Stock ledgers maintained by independent registrars.
  2. Dividend records on file with the SEC.
  3. Records produced by investment services.
  4. Minutes of the investee’s board of directors.

Records produced by investment services.  

Investment services maintain records of such dividend income and auditors use such records to compare with a client’s recorded dividend income.

Tricky Question...remember that the SEC does not keep dividend information as mentioned in one of the answers. 

104

Why should an auditor be alert for obsolete inventory when observing a client's physical inventories?

The auditor may observe such obsolete or damaged goods which should be written to lower values in the accounting records.  

The Auditor should examine inventory quality and condition to assess whether there may be evidence suggesting that it is in unsatisfactory condition.

105

In connection with the audit of a current issue of long-term bonds payable, the auditor should

  1. Determine whether bondholders are persons other than owners, directors, or officers of the company issuing the bond.
  2. Calculate the effective interest rate to see if it is substantially the same as the rates for similar issues.
  3. Decide whether the bond issue was made without violating state or local law.
  4. Ascertain that the client has obtained the opinion of counsel on the legality of the issue.

Ascertain that the client has obtained the opinion of counsel on the legality of the issue.  The auditor is concerned with the legality of an issue of bonds, and should obtain an opinion of legal counsel.

106

An auditor concludes that a substantive auditing procedure considered necessary during the prior period’s audit was omitted.  Which of the following factors would most likely cause the auditor promptly to apply the omitted procedure?

  1. There are no alternative procedures available to provide the same evidence as the omitted procedure.
  2. The omission of the procedure impairs the auditor’s present ability to support the previously expressed opinion.
  3. The source documents needed to perform the omitted procedure are still available.
  4. The auditor’s opinion on the prior period’s financial statements was unmodified (unqualified).

The omission of the procedure impairs the auditor’s present ability to support the previously expressed opinion.

If the auditor concludes that the omission of the procedure impairs his/her present ability to support a previously expressed opinion and the auditor believes that persons may be relying on the financial statements, the omitted procedure or alternative procedures should be applied to provide a satisfactory basis for the opinion.

107

Which of the following statements concerning analytical procedures is correct?

  1. Analytical procedures may be omitted entirely for some financial statement audits.
  2. Analytical procedures used during risk assessment of the audit should not use nonfinancial information.
  3. Analytical procedures usually are effective and efficient for tests of controls.
  4. Analytical procedures alone may provide the appropriate level of assurance for some assertions.

Analytical procedures alone may provide the appropriate level of assurance for some assertions

108

Which of the following most likely would cause an auditor to consider whether a client’s financial statements contain material misstatements?

  1. Management did not disclose to the auditor that it consulted with other accountants about significant accounting matters.
  2. The chief financial officer will not sign the management representation letter until the last day of the auditor’s fieldwork.
  3. Audit trails of computer-generated transactions exist only for a short time.
  4. The results of an analytical procedure disclose unexpected differences.

The results of an analytical procedure disclose unexpected differences.  

The typical approach is 

  1. Develop an expectation for the account balance
  2. Determine the amount of difference from the expectation that can be accepted without investigation
  3. Compare the company’s account balance (or ratio) with the expected account balance
  4. Investigate significant differences from the expected account balance

109

During the first part of the current fiscal year, the client company began dealing with certain customers on a consignment basis.  Which of the following audit procedures is least likely to bring this new fact to the auditor’s attention?

  1. Tracing of shipping documents to the sales journal.
  2. Test of cash receipts transactions.
  3. Confirmation of accounts receivable.
  4. Observation of physical inventory.

Observation of physical inventory.  Observation of physical inventory would not indicate that shipments have been made on a consignment basis. Irrespective of whether sales are on a regular basis or a consignment basis, the inventory would not be in the client’s possession.

110

Several years ago Conway, Inc. secured a conventional real estate mortgage loan.  Which of the following audit procedures would be least likely to be performed by an auditor examining the mortgage balance?

  1. Examine the current year’s canceled checks.
  2. Review the mortgage amortization schedule.
  3. Inspect public records of lien balances.
  4. Recompute mortgage interest expense.

Inspect public records of lien balances. It is unlikely that public records can provide relevant information about the current mortgage balance and, therefore, this procedure is the least likely to be performed by an auditor.

111

Which of the following is the most important consideration of an auditor when examining the stockholders’ equity section of a client’s balance sheet?

  1. Changes in the capital stock account are verified by an independent stock transfer agent.
  2. Stock dividends and/or stock splits during the year under audit were approved by the stockholders.
  3. Stock dividends are capitalized at par or stated value on the dividend declaration date.
  4. Entries in the capital stock account can be traced to a resolution in the minutes of the board of directors’ meetings.

Entries in the capital stock account can be traced to a resolution in the minutes of the board of directors’ meetings.  The auditor’s primary concern when examining the stockholders’ equity section of the balance sheet is that proper authorization exists for transactions affecting the capital stock account.

112

Which of the following areas would ordinarily be expected to require the most time when performing an audit of a continuing client?

  1. Accounts receivable.
  2. Common stock.
  3. Retained earnings.
  4. Salaries expense.

Accounts receivable!!!  Accounts receivable represents an account with many transactions and therefore would be expected to require significant audit time.  

Retained earnings is incorrect because it requires little audit time because few adjustments are expected into retained earnings.

113

Which of the following is the most reliable analytical procedure to verify the year-end financial statement balances of a wholesale business?

  1. Verify depreciation expense by multiplying the depreciable asset balances by one divided by the depreciation rate.
  2. Verify commission expense by multiplying sales revenue by the company’s standard commission rate.
  3. Verify interest expense, which includes imputed interest, by multiplying long-term debt balances by the year-end prevailing interest rate.
  4. Verify FICA tax liability by multiplying total payroll costs by the FICA contribution rate in effect during the year.

Verify commission expense by multiplying sales revenue by the company’s standard commission rate.  If the firm has a standard commission rate, the commission expense would be directly related to the sales revenue. Therefore, this would be a reliable analytical procedure.

When developing an expectation, the auditor must attempt to identify plausible relationships. These expectations may be derived from

  1. The information itself in prior periods
  2. Anticipated results such as budgets and forecasts
  3. Relationships among elements of financial information within the period
  4. Industry information
  5. Relevant nonfinancial information

114

When developing an expectation, the auditor must attempt to identify plausible relationships. These expectations may be derived from

  1.   (1) The information itself in prior periods
  2.   (2) Anticipated results such as budgets and forecasts
  3.   (3) Relationships among elements of financial information within the period
  4.   (4) Industry information
  5.   (5) Relevant nonfinancial information

Relationships differ in their predictability. Be familiar with the following principles:

  1. Relationships in a dynamic or unstable environment are less predictable than those in a stable environment.
  2. Relationships involving balance sheet accounts are less predictable than income statement accounts (because balance sheet accounts represent balances at one arbitrary point in time).
  3. Relationships involving management discretion are sometimes less predictable (e.g., decision to incur maintenance expense rather than replace plant).

115

Which of the following most likely would give the most assurance concerning the valuation assertion of accounts receivable?

  1. Tracing amounts in the subsidiary ledger to details on shipping documents.
  2. Comparing receivable turnover ratios to industry statistics for reasonableness.
  3. Inquiring about receivables pledged under loan agreements.
  4. Assessing the allowance for uncollectible accounts for reasonableness.

Assessing the allowance for uncollectible accounts for reasonableness addresses whether receivables are properly valued at their net realizable value.

116

For which of the following ledger accounts would the auditor be most likely to analyze the details?

  1. Service revenue.
  2. Sales.
  3. Repairs and maintenance expense.
  4. Sales salaries expense.

Repairs and maintenance expense.  Erroneously expensing capital acquisitions is a frequent accounting error.

Note: the other answers are wrong because they are frequently tested through analytical procedures and tests of controls.  

117

The objective of tests of details of transactions performed as substantive procedures is to

  1. Detect material misstatements in the financial statements.
  2. Evaluate whether management’s policies and procedures operated effectively.
  3. Identify specific financial statement assertions that satisfy the audit objectives.
  4. Verify that significant deficiencies in the accounting system are discovered.

Detect material misstatements in the financial statements.  

  • When evaluating evidence, the objective is to obtain an estimate of the total misstatement in the financial statements and to determine whether it exceeds a material amount.  The auditor estimates the likely error in the financial statements and attempts to determine whether an unacceptably high audit risk exists. Note here that in the evaluation of audit evidence, because of information obtained during the audit, the auditor may revise his/her preliminary estimate of materiality.

118

An auditor most likely would apply analytical procedures near the completion of the audit to

  1. Enhance the auditor’s understanding of subsequent events.
  2. Identify auditing procedures omitted by the staff accountants.
  3. Determine whether additional audit evidence may be needed.
  4. Evaluate the effectiveness of the internal control activities.

Determine whether additional audit evidence may be needed.  These analytical procedures will help the auditor in assessing the conclusions reached and in the evaluation of the overall financial statement presentation; accordingly, results of the overall review may indicate that additional evidence may be needed.

119

An independent auditor finds that a corporation occupies office space, at no charge, in an office building owned by a shareholder.  This finding indicates the existence of

  1. Management fraud.
  2. Related-party transactions.
  3. Window dressing.
  4. Weak internal control.

Related-party transactions.  Relationships with principal shareholders of this nature are considered related-party transactions.

120

In evaluating the reasonableness of an entity’s accounting estimates, an auditor most likely concentrates on key factors and assumptions that are:

  1. Stable and not sensitive to variation.
  2. Objective and not susceptible to bias.
  3. Deviations from historical patterns.
  4. Similar to industry guidelines.

Deviations from historical patterns will ordinarily be investigated since the deviation may be the result of an error or fraud.

121

Of the following, which is the least persuasive type of audit evidence?

  1. Documents mailed by outsiders to the auditor.
  2. Correspondence between auditor and vendors.
  3. Copies of sales invoices inspected by the auditor.
  4. Computations made by the auditor.

Copies of sales invoices inspected by the auditor.  Copies of sales invoices represent internally generated evidence, which is considered less reliable than externally generated evidence received directly by the auditor.

122

The audit procedure of analyzing the repairs and maintenance accounts is primarily designed to provide evidence in support of the audit proposition that all

  1. Expenditures for fixed assets have been recorded in the proper period.
  2. Capital expenditures have been properly authorized.
  3. Noncapitalizable expenditures have been properly expensed.
  4. Expenditures for fixed assets have been capitalized.

Expenditures for fixed assets have been capitalized.  examination of the expense account may disclose expenditures for fixed assets which have been improperly expensed. 

Relationship with repairs and maintenance.  A number of CPA questions address this area.  A PP&E acquisition may improperly be recorded in the repair and maintenance expense account.  Therefore, an analysis of repairs and maintenance may detect understatements of PP&E. Alternatively, an analysis of PP&E may disclose repairs and maintenance that have improperly been capitalized, thereby resulting in overstatements of PP&E.

123

An auditor plans to apply substantive tests to the details of asset and liability accounts as of an interim date rather than as of the balance sheet date. The auditor should be aware that this practice

  1. Eliminates the use of certain statistical sampling methods that would otherwise be available.
  2. Presumes that the auditor will reperform the tests as of the balance sheet date.
  3. Should be especially considered when there are rapidly changing economic conditions.
  4. Potentially increases the risk that errors that exist at the balance sheet date will not be detected.

Potentially increases the risk that errors that exist at the balance sheet date will not be detected.  interim testing increases detection risk since end-of-year balances will receive less testing.

124

In violation of company policy, Lowell Company erroneously capitalized the cost of painting its warehouse.  The auditor examining Lowell’s financial statements would most likely detect this when

  1. Discussing capitalization policies with Lowell’s controller.
  2. Examining maintenance expense accounts.
  3. Observing, during the physical inventory observation, that the warehouse had been painted.
  4. Examining the construction work orders supporting items capitalized during the year.

Examining the construction work orders supporting items capitalized during the year.  the cost which was erroneously capitalized will be included in the population of construction work orders which were capitalized during the year.

Vouch additions and retirements to PP&E to verify their existence, accuracy, and the client’s rights to them. Typically large PP&E transactions support will include original documents such as contracts, deeds, construction work orders, invoices, and authorization by the directors.  This procedure will also help to identify transactions that should be expensed rather than capitalized.

125

Which employees sign the management representations letter?

CEO and CFO.  Ordinarily the chief executive officer and the chief financial officers should sign the letter of representations. These are the individuals who the auditor believes are responsible for and knowledgeable about the matters covered by the representations.

126

The physical count of inventory of a retailer was higher than shown by perpetual records. Which of the following could explain the difference?

  1. Inventory items had been counted but the tags placed on the items had not been taken off the items and added to the inventory accumulation sheets.
  2. Credit memos for several items returned by customers had not been prepared.
  3. No journal entry had been made on the retailer’s books for several items returned to its suppliers.
  4. An item purchased "FOB shipping point" had not arrived at the date of inventory count and had not been reflected in the perpetual records.

Credit memos for several items returned by customers had not been prepared. if credit memos for items returned by customers to the client are not prepared, the perpetual records will not be adjusted to reflect the returned items. Thus, the physical inventory will be greater than indicated by the perpetual records.

127

An auditor’s purpose in reviewing the renewal of a note payable shortly after the balance sheet date most likely is to obtain evidence concerning management’s assertions about

  1. Existence or occurrence.
  2. Presentation and disclosure.
  3. Completeness.
  4. Valuation or allocation.

Presentation and disclosure. renewal of the note may provide an auditor with information on whether the note should be presented as a current or noncurrent liability.

128

On receiving the bank cutoff statement, the auditor should trace

  1. Deposits in transit on the year-end bank reconciliation to deposits in the cash receipts journal.
  2. Checks dated prior to year-end to the outstanding checks listed on the year-end bank reconciliation.
  3. Deposits listed on the cutoff statement to deposits in the cash receipts journal.
  4. Checks dated subsequent to year-end to the outstanding checks listed on the year-end bank reconciliation.

Checks dated prior to year-end to the outstanding checks listed on the year-end bank reconciliation. comparing checks returned with the cutoff statement which was dated prior to year-end with the list of outstanding checks on the bank reconciliation will provide evidence as to the completeness of the listing of outstanding checks on the bank reconciliation. This step facilitates a search for unrecorded liabilities.

129

Describe what's going on when performing the below tests.

Tracing sales transactions from the:

  1. Source documents to the accounting records.

  2. Accounting records to the source documents.

  1. Source to Records = will primarily address understatements of sales, i.e. completeness.
  2. Records to Source = tests for overstatements (the existence assertion)

130

An auditor would be least likely to use confirmations in connection with the examination of

  1. Inventories.
  2. Long-term debt.
  3. Property, plant, and equipment.
  4. Stockholders’ equity.

Property, plant, and equipment. an effective confirmation should be sent to parties who are likely to be able to respond meaningfully. In the case of property, plant, and equipment, those who supplied the item(s) may not have adequate records on historic sales and, therefore, will not be able to respond to the confirmation meaningfully.

Other answers are wrong because:

  • Inventories - consigned inventory
  • LTD - creditors records
  • SE - stock outstanding with registrar

131

Analytical procedures are most appropriate when testing which of the following types of transactions?

  1. Payroll and benefit liabilities.
  2. Acquisitions and disposals of fixed assets.
  3. Operating expense transactions.
  4. Long-term debt transactions.

Operating expense transactions. Professional standards indicate that analytical procedures are most effective when they are applied to plausible and predictable relationships, often involving income statement accounts.

132

“Subsequent events” for reporting purposes are defined as events which occur subsequent to the

  1. Balance sheet date.
  2. Date of the auditor’s report.
  3. Balance sheet date but prior to the date of the auditor’s report.
  4. Date of the auditor’s report and concern contingencies which are not reflected in the financial statements.

Balance sheet date but prior to the date of the auditor’s report.

subsequent events are those events or transactions which occur subsequent to the balance-sheet date, but prior to the issuance of the financial statements and the auditor’s report, that have a material effect on the financial statements and, therefore, require adjustment or disclosure in the statements.