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Flashcards in NINJA AUD 3 Deck (30):
1

An auditor usually obtains evidence of stockholders' equity transactions by reviewing the entity's:

A.
minutes of board of directors' meetings.

B.
transfer agents' records.

C.
canceled stock certificates.

D.
treasury stock certificate book.

The correct answer is A.


The minutes of the board of directors' meetings should document any changes in the company's equity, including the issuance of new stock, a new class of stock, purchase of treasury stock, stock options, splits or dividends, or the cancellation of stock certificates. Transfer agents' records, canceled stock certificates and the treasury stock book may give evidence relating to some equity transactions, but none of these items will show all equity transactions.

2

The primary source of information to be disclosed regarding litigation, claims, and assessments is:

A.
client's lawyer.

B.
court records.

C.
client's management.

D.
independent auditor.

The correct answer is C.


AU-C 501.A42 notes:




Quote


Management is the primary source of information about events or conditions considered in the financial accounting for, and reporting of, litigation, claims, and assessments because these matters are within the direct knowledge and, often, control of management. Accordingly, the auditor's procedures with respect to litigation, claims, and assessments include the following:
•Making inquiries of management as required by paragraph .16a, which may include a discussion about the policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments involving the entity that may give rise to a risk of material misstatement
•Obtaining written representations from management, in accordance with section 580, Written Representations, that all known actual or possible litigation, claims, and assessments whose effects should be considered when preparing the financial statements have been disclosed to the auditor and accounted for and disclosed in accordance with the applicable financial reporting framework


3

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

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

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

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

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

The correct answer is C.


It is permissible for an auditor to rely on internal controls tested in prior audits under certain circumstances. The auditor must determine if any changes have been made to the controls since they were last tested, and the auditor should perform audit procedures to establish the continuing relevance of audit evidence obtained in prior periods.

Certain factors would make relying on controls tested in prior audits not feasible. These factors could include:
•a weak control environment,
•weak monitoring controls,
•a significant manual element to relevant controls,
•personnel changes that significantly affect the application of the control,
•changing circumstances that indicate the need for changes in the control, and
•weak information technology (IT) controls.

If the CFO waived approvals on all checks to one vendor to expedite payment, the auditor should be deeply concerned about management override of controls and should not rely on the internal controls over disbursements that were relied on in prior years.

The elimination of the internal audit function would not be a concern for this year's audit, due to the timing of the event (after this year's balance sheet date).

The audit committee chairperson's resignation would not significantly affect any applications of controls. This occurrence may be a sign of other problems (such as a poor control environment or inherent risk), but it would not directly affect the operation and effectiveness of control activities.

Changing the frequency of accounts payable check runs would not change the internal controls over disbursements, as long as the control policies and procedures (approval, required vouchers attached to the bill, etc.) were still followed.

4

An auditor's program to examine long-term debt most likely would include steps that require:

A.
comparing the carrying amount of the debt to its year-end market value.

B.
correlating interest expense recorded for the period with outstanding debt.

C.
verifying the existence of the holders of the debt by direct confirmation.

D.
inspecting the accounts payable subsidiary ledger for unrecorded long-term debt

The correct answer is B.


Strong corroborating evidence verifying interest expense arises from multiplying the interest rate by the principal balance of long-term debt. The result should match the interest expense recorded for the debt. This correlation is essential in the audit of long-term debt.

5

When using classical variables sampling for estimation, an auditor normally evaluates the sampling results by calculating the possible error in either direction. This statistical concept is known as:

A.
precision.

B.
reliability.

C.
projected error.

D.
standard deviation.

The correct answer is A.


The possible error in either direction in variables sampling is calculated using the point estimate of the population and a formula involving the standard deviation and confidence level desired to derive a plus and minus interval from the point estimate. This interval is called a precision interval since it provides a range with some precision in which the true population value is likely to fall given a specified confidence level.

In statistical audit sampling, the precision is the allowance for sampling risk or sampling error, that is, the risk that when testing is restricted to a sample, the conclusion derived from the sample differs from the conclusion that would have been reached if the entire population had been tested. It is a measure of the difference between a sample estimate and the corresponding population characteristic at a specified sampling risk.

The precision is usually measured using a table or software and is based on sample size and sample results at the auditor's specified risk of assessing control risks too low. (Precision cannot be measured in nonstatistical sampling.)

6

In a probability-proportional-to-size sample with a sampling interval of $10,000, an auditor discovered that a selected account receivable with a recorded amount of $5,000 had an audited amount of $4,000. If this were the only misstatement discovered by the auditor, the projected misstatement of this sample would be:

A.
$1,000.

B.
$2,000.

C.
$5,000.

D.
$10,000.

You are correct, the answer is B.


In this question, one-half of the sample ($5,000 out of $10,000) has been audited. The misstatement is for $1,000 ($5,000 - $4,000). Projecting the same error rate for the unaudited half of the sample, the projected misstatement is for $2,000.

7

The following information pertains to Ali Corp. as of and for the year ended December 31, 20X1:

Liabilities $ 60,000
Stockholders' equity $500,000
Shares of common stock issued and outstanding 10,000
Net income $ 30,000
During 20X1, Ali's officers exercised stock options for 1,000 shares of stock at an option price of $8 per share. What was the effect of exercising the stock options?

A.
Debt-to-equity ratio decreased to 12%.

B.
Earnings per share increased by $0.33.

C.
Asset turnover increased to 5.4%.

D.
No ratios were affected.

The correct answer is A.


During the year, the officers exercised stock options for 1,000 shares of stock at an option price of $8 per share. Stockholders' equity would increase by the following amount: $1,000 × $8 = $8,000.

Entry to record exercise of options:


Dr. Cash or Accrued liability - ESOP (1,000 x $8) $8,000
Cr. Stockholders' equity $8,000

The stockholders' equity is $500,000 on December 31, 20X1. This amount reflects the exercise of the stock options. Therefore, stockholders' equity before the exercise of the stock options would be $500,000 - $8,000 = $492,000.
•Debt/Equity ratio prior to exercise of options: $60,000 ÷ $492,000 = 0.122
•Debt/Equity ratio after exercise of options: $60,000 ÷ $500,000 = 0.12




Note


Insufficient information is available for calculating any of the other ratios/answers.


8

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

A.
presentation and disclosure.

B.
existence.

C.
both presentation and disclosure and existence.

D.
neither presentation and disclosure nor existence.

The correct answer is B.


Assertions tested by the auditor for classes of transactions and events for the period under audit:
•Occurrence—Transactions and events that have been recorded have occurred and pertain to the entity.
•Completeness—All transactions and events that should have been recorded have been recorded.
•Accuracy—Amounts and other data relating to recorded transactions and events have been recorded appropriately.
•Cutoff—Transactions and events have been recorded in the correct accounting period.
•Classification—Transactions and events have been recorded in the proper accounts.

Assertions tested by the auditor for account balances at period end:
•Existence—Assets, liabilities, and equity interests exist.
•Rights and obligations—The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
•Completeness—All assets, liabilities, and equity interests that should have been recorded have been recorded.
•Valuation and allocation—Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

If an auditor observes the mailing of monthly statements to customers and reviews evidence of follow-up errors, the auditor can determine if customer balances exist at the balance sheet date based on this evidence. The auditor can also determine that the billing transactions recorded in the sales and accounts receivable accounts occurred.

The question did not ask about whether the amounts were appropriately presented and clearly expressed (which would be an assertion associated with presentation and disclosure).

9

The auditor determines that effective internal controls exist for all relevant assertions related to a material class of transactions, account balance, and disclosure. As a result, the auditor can elect to perform which of the following tests?
I.Tests of controls
II.Substantive procedures
III.Analytical procedures

A.
I only

B.
III only

C.
Both I and II

D.
Either I or II

You are correct, the answer is C.


AU-C 330.18 states, “Irrespective of the assessed risks of material misstatement, the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure.” AU-C 330.A9 states, “Because effective internal controls generally reduce but do not eliminate the risk of material misstatement, tests of controls reduce but do not eliminate the need for substantive procedures.” While the auditor can elect to use only a substantive approach, if a test of controls is not efficient, the auditor cannot use only a test of controls approach. Therefore, “Either I or II” is not a correct answer. Analytical procedures are a form of substantive tests, but would not be used as the sole source of substantive testing in an audit.

10

In evaluating an entity's accounting estimates, one of an auditor's objectives is to determine whether the estimates are:

A.
not subject to bias.

B.
consistent with industry guidelines.

C.
based on objective assumptions.

D.
reasonable in the circumstances.

You are correct, the answer is D.


The auditor's objective in evaluating accounting estimates is to determine the reasonableness of the estimate in light of the circumstances. Estimates are potentially biased and based on subjective (and objective) assumptions. Industry guidelines may provide assistance in the calculation of the estimate.

11

As a result of sampling procedures applied as tests of controls, an auditor incorrectly assesses control risk higher than appropriate. The most likely explanation for this situation is that:

A.
the deviation rate in the auditor's sample is less than the tolerable rate, but the deviation rate in the population exceeds the tolerable rate.

B.
the deviation rate in the auditor's sample exceeds the tolerable rate, but the deviation rate in the population is less than the tolerable rate.

C.
the deviation rates of both the auditor's sample and the population exceed the tolerable rate.

D.
the deviation rates of both the auditor's sample and the population are less than the tolerable rate.

The correct answer is B.


An audit sample is a portion of the total. When a sample is drawn from a population, the items selected may or may not be representative of the population as a whole. “Sampling risk is the risk that the auditor's conclusion based on a sample may be different from the conclusion if the entire population were subjected to the same audit procedure.” (AU-C 530.05) (i.e., control risk may be assessed too high or too low).

If the deviation rate in the sample is higher than the tolerable rate, the auditor may assess a high level of control risk. However, if the deviation rate in the population does not exceed the tolerable rate, the auditor will have assessed the level of control risk for the sample as greater than the true operating effectiveness of the control.

12

An auditor who uses statistical sampling for attributes in testing internal controls should reduce the planned reliance on a prescribed control when the:

A.
sample rate of deviation plus the allowance for sampling risk equals the tolerable rate.

B.
sample rate of deviation is less than the expected rate of deviation used in planning the sample.

C.
tolerable rate less the allowance for sampling risk exceeds the sample rate of deviation.

D.
sample rate of deviation plus the allowance for sampling risk exceeds the tolerable rate.

The correct answer is D.


The maximum tolerable rate (MTR) on compliance deviations represents a critical value established so that the possibility of deviations in excess of that rate would cause the auditor to place less than full reliance (perhaps no reliance) on the control being evaluated. According to many CPA firms, MTR should not exceed 10% if some reliance is being placed on selected internal accounting control procedures. If substantial reliance is to be placed upon an internal accounting control, a MTR of 5% or possibly lower would be reasonable. In an attribute sampling application, two deviation rates are generated. One, the MTR, is preset as discussed above. The second, referred to as the projected rate (which is the sample rate of deviation plus the allowance for sampling risk) is determined after the selected sample has been audited. If MTR is less than the projected rate, the statistical evaluation indicates that the control should not be relied upon.

13

When an auditor increases the assessed level of control risk because certain control activities were determined to be ineffective, the auditor will most likely increase the:

A.
level of detection risk.

B.
extent of tests of controls.

C.
level of inherent risk.

D.
extent of tests of details.

You are correct, the answer is D.


Overall audit risk (AR) is a combination of inherent risk (IR), control risk (CR) (IR and CR together are the risk of material misstatement (RMM)), and detection risk (DR). The equation is:
•AR = IR × CR × DR, or AR = RMM × DR

If control risk is high, this means that the auditor must have a low detection risk in order to keep the audit risk at a low level. In order to lower detection risk, the auditor would perform more tests of details (substantive procedures). In other words, the auditor would increase the extent of tests of details.

14

An auditor's analytical procedures most likely would be facilitated if the entity:

A.
segregates obsolete inventory before the physical inventory count.

B.
uses a standard cost system that produces variance reports.

C.
corrects material weaknesses in internal control before the beginning of the audit.

D.
develops its data from sources solely within the entity.

The correct answer is B.


Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. A basic premise underlying the application of analytical procedures is that plausible relationships among data may reasonably be expected to exist and continue in the absence of known conditions to the contrary. Because a standard cost system is a budgeted unit cost system designed to alert management when actual costs of production differ from expected costs, the plausible relationships the auditor looks for in analytical procedures have already been established in a standard cost system. Therefore, an auditor's analytical procedures most likely would be facilitated if the entity uses a standard cost system that produces variance reports.

15

Which of the following statements is correct concerning significant deficiencies in an audit?

A.
An auditor is required to search for significant deficiencies during an audit.

B.
All significant deficiencies are also considered to be material weaknesses.

C.
An auditor may communicate significant deficiencies during an audit or after the audit's completion.

D.
An auditor may report that no significant deficiencies were noted during an audit.

You are correct, the answer is C.


A significant deficiency is a matter that comes to an auditor's attention that represents a significant deficiency in the design or operation of internal control and that merits attention by those charged with governance.

Generally, significant deficiencies are reported at the conclusion of the audit. However, because timely communication may be important, the auditor may choose to communicate significant matters during the course of the audit. Therefore, an auditor may communicate significant deficiencies during an audit or after the audit's completion.

The purpose of an audit is to express an opinion on the financial statements, not to express an opinion on the effectiveness of the internal control. The auditor is required to understand the design and operation of internal control in order to identify types of potential misstatements, consider factors that affect the risk of material misstatements, and design the auditing procedures. Therefore, the auditor is not required to search for significant deficiencies during an audit.

Because the consideration of internal control is limited, the auditor may not necessarily identify all deficiencies in internal control that might be significant deficiencies and cannot state “no significant deficiencies were noted” during an audit. The communication may, however, state, “We did not identify any deficiencies in internal control that we consider to be material weaknesses…”

A material weakness is a deficiency in internal control such that there is a reasonable possibility that a material misstatement of the entity's financial statements will not be prevented, or detected and corrected on a timely basis. A significant deficiency is less severe than a material weakness. Determining if a significant deficiency is also a material weakness requires professional judgment.

16

An auditor ordinarily sends a standard confirmation request to all banks with which the client has done business during the year under audit, regardless of the year-end balance. A purpose of this procedure is to:

A.
provide the data necessary to prepare a proof of cash.

B.
request a cutoff bank statement and related checks be sent to the auditor.

C.
detect kiting activities that may otherwise not be discovered.

D.
seek information about contingent liabilities and security agreements.

The correct answer is D.


One portion of the standard bank confirmation form requests the bank to list all known contingent liabilities and security agreements existing between the bank and auditor's client. Such information can only be obtained from bank confirmations. The alternatives can all be achieved by other procedures.

17

Which one of the following tend to be most predictable for purposes of analytical procedures applied as substantive tests?

A.
Data subject to audit testing in the prior year

B.
Transactions subject to management discretion

C.
Relationships involving income statement accounts

D.
Relationships involving balance sheet accounts

The correct answer is C.


Substantive analytical procedures are generally more applicable to large volumes of transactions that tend to be predictable over time. Tests of details are more appropriate to obtain audit evidence regarding certain relevant assertions about account balances, including existence and valuation.

Analytical procedures can encompass the investigation of identified fluctuations and relationships that are inconsistent with other relevant information or deviate from significantly predicted amounts.

Data subject to audit testing in prior years and transactions subject to management decisions have no bearing on analytical procedures. The relationships involving balance sheet items are not predictable over time and do not have plausible relationships.

18

What are substantive procedures?

Substantive procedures are tests of transaction details and account balances and analytical procedures performed to detect material misstatements in the account balances, transaction class, and disclosure components of the financial statements. These tests are used to test financial statement assertions.





Example


Examples of substantive audit procedures include testing the fair presentation of an account balance or transactions by confirmation, recalculation, observation and examination (e.g., physical inventory), examination of documents, vouching and tracing, scanning, and analytical procedures.




Uncertainties involved in substantive testing constitute detection risk. Detection risk (DR) is composed of two other risks—analytical procedure risk (AP) and tests-of-detail risk (TD).

DR = AP × TD

19

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

A.
inspect the property ledger and the insurance and tax records and then tour the client's facilities.

B.
tour the client's facilities and then inspect the property ledger and the insurance and tax records.

C.
analyze the repair and maintenance account and then tour the client's facilities.

D.
tour the client's facilities and then analyze the repair and maintenance account.

The correct answer is A.


In performing a search for unrecorded retirements of fixed assets, an auditor would first review those client's records that indicated the existence of fixed assets and then, knowing what fixed assets were claimed to be in existence, would attempt to verify their existence by physical observation. The property ledger and the insurance and tax records would all be records that would indicate the existence of fixed assets. A tour of the client's facilities would be the best way to verify the existence of fixed assets by physical observation. If an asset that was listed on the client's records failed to be found, this would indicate an unrecorded retirement of fixed assets.

20

In assessing control risk, an auditor ordinarily selects from a variety of techniques, including:

A.
inquiry and recalculation.

B.
reperformance and observation.

C.
comparison and confirmation.

D.
inspection and verification.

The correct answer is B.


Recalculation, comparison, confirmation, and verification are all substantive tests or tests of details of transactions. Of the alternatives provided, only reperformance and observation are both techniques to test whether the controls are functioning effectively and as prescribed by management. Tests of controls allow the auditor to conclude on the assessed level of control risk.

21

The risk of incorrect acceptance and the likelihood of assessing control risk too low relate to the:

A.
allowable risk of tolerable misstatement.

B.
preliminary estimates of materiality levels.

C.
efficiency of the audit.

D.
effectiveness of the audit.

You are correct, the answer is D.


The risk of incorrect acceptance and the likelihood of assessing control risk too low relate to the effectiveness of the audit because each increases the probability that audit objectives will not be achieved. Conversely, audit efficiency is affected by the risks of incorrect rejection and of assessing control risk too high because each of these is likely to lead to excess audit effort.

22

“In connection with an audit of our financial statements, management has prepared, and furnished to our auditors, a description and evaluation of certain contingencies.” The foregoing passage most likely is from:

A.
an audit inquiry letter to legal counsel.

B.
a management representation letter.

C.
an audit committee's communication to the auditor.

D.
a financial statement footnote disclosure.

. The correct answer is A.


Contingencies are conditions that may or may not involve possible gain or loss for the entity. They are usually referred to in the context of legal claims and assessments, and they must be disclosed to the auditor by management during the course of the audit. The auditor, with client permission (the client drafts the letter in order to give the attorney permission to respond), sends a letter to the client's attorney(s) to request a direct response on the probability of an unfavorable outcome on these issues as well as an estimated range of potential loss. The statement in the question is most likely from an audit inquiry letter to legal counsel.

A management representation letter is provided to the auditors at the end of the audit regarding representations for the financial statements; the completeness of information provided to the auditors; assertions about recognition, measurement, and disclosure; and information concerning subsequent events. As this letter is addressed to the auditors, it would not make reference to information that was “furnished to our auditors.”

The auditor is required to communicate with the audit committee, not the other way around.

Financial statement footnote disclosures would be specific regarding contingencies and potential losses associated with them. A footnote would not state in general terms that “management has prepared and furnished to our auditors a description…of…contingencies.”

23

Which of the following is not generally considered necessary if an auditor applies principal substantive tests to details of balance sheet accounts at an interim date?

A.
The auditor should assess the difficulty in controlling the incremental audit risk associated with applying substantive tests at an interim date.

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

C.
The auditor should consider whether there are rapidly changing business conditions or circumstances that might predispose management to misstate financial statements in the remaining period.

D.
Assessing control risk below the maximum is required in order to have a reasonable basis for extending audit conclusions from an interim date to the balance sheet date.

. The correct answer is D.


Assessing control risk below the maximum is not required to have a reasonable basis for extending audit conclusions from an interim date to the balance sheet date. However, if the auditor assesses control risk at the maximum during the remaining period, he or she should consider whether the effectiveness of certain of the substantive tests to cover that period will be impaired.

24

Which of the following statements is correct about the sample size in statistical sampling when testing internal controls?

A.
The auditor should consider the tolerable rate of deviation from the controls being tested in determining sample size.

B.
As the likely rate of deviation decreases, the auditor should increase the planned sample size.

C.
The allowable risk of assessing control risk too low has no effect on the planned sample size.

D.
Of all the factors to be considered, the population size has the greatest effect on the sample size.

The correct answer is A.


In testing internal controls, the auditor would use attribute sampling, which would assist the auditor with estimating the extent to which prescribed procedures are being followed and/or the degree of clerical accuracy in an internal control.

In order to determine sample size, the auditor must define:
•the reliability level (confidence level),
•the maximum tolerable rate of deviation (the rate of deviations detected that would cause the auditor to place less than full reliance on the control being evaluated), and
•the expected population deviation rate.

The following are true regarding testing of controls with statistical sampling:
•As the likely rate of deviation increases (not decreases), the auditor should increase the planned sample size.
•The allowable risk of assessing control risk too low has an effect on the planned sample size. The risk of assessing control risk too high has no effect on the planned sample size. This risk affects auditor efficiency.
•Of all the factors to be considered, the tolerable rate of deviation (or maximum tolerable rate) has the greatest effect on the sample size.
•The auditor should be concerned about the characteristics of the population (the items comprising the account balance or class of transactions of interest).

25

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

A.
Inquire about the existence of related party transactions.

B.
Determine whether accounting estimates deviate from historical patterns.

C.
Confirm inventories at locations outside the entity.

D.
Review the lawyer's letter for information about litigation.

The correct answer is D.


Of the listed procedures, reviewing the lawyer's letter for information about litigation would most likely assist the auditor in determining whether management has identified all accounting estimates that could be material to the financial statements. Related party transactions and inventories outside the entity are not estimated amounts. Reviewing the historical pattern of accounting estimates will not usually reveal an unidentified accounting estimate.

26

Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of subsequent events?

A.
Confirming a sample of material accounts receivable established after year-end

B.
Comparing the financial statements being reported on with those of the prior period

C.
Investigating personnel changes in the accounting department occurring after year-end

D.
Inquiring as to whether any unusual adjustments were made after year-end

The correct answer is D.


The auditor is required to perform some detailed audit procedures after the balance sheet date. Such procedures may reveal subsequent events. Examples of these procedures are cutoff procedures and evaluation of assets and liabilities at the balance sheet dates (e.g., subsequent collection of receivables). In addition, the auditor is required to do the following procedures related to subsequent events:
•Read and review interim financial statements
•Inquire of management and, when appropriate, those charged with governance: ◦the current status of items in the financial statements that were accounted for on the basis of tentative, preliminary, or inconclusive data
◦any unusual adjustments that have been made since the balance sheet date

•Read minutes of stockholders', directors', and officers' meetings
•Inquire of legal counsel
•Observe events in subsequent period
•Scan records for unusual transactions
•Obtain letter of representation on subsequent events

27

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

A.
Valuation and allocation

B.
Completeness

C.
Rights and obligations

D.
Presentation and disclosure

The correct answer is B.


When the auditor traces serial numbers on equipment to a nonissuer's subledger, the auditor is verifying that all transactions and events that should have been recorded have been recorded. This is an example of testing for the completeness assertion.
•The valuation and allocation assertion tests that assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.
•The rights and obligations assertion tests that the entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
•“Presentation and disclosure” is a category of assertions, which includes occurrence and rights and obligations; completeness; classification and understandability; and accuracy and valuation assertions.

28

An auditor discovered that a client's accounts receivable turnover is substantially lower for the current year than for the prior year. This may indicate that:

A.
obsolete inventory has not yet been reduced to fair market value.

B.
there was an improper cutoff of sales at the end of the year.

C.
an unusually large receivable was written off near the end of the year.

D.
the aging of accounts receivable was improperly performed in both years.

You are correct, the answer is B.


The accounts receivable turnover ratio is:

Net Credit Sales
-------------------
Average Receivables
If the divisor (average receivables) of this ratio increases without a change in the net credit sales, the ratio would be lower. This situation would occur if the company did not properly cut off sales at the end of the year and recorded more in accounts receivable than should have been recorded.

The reduction of the value of obsolete inventory has nothing to do with the accounts receivable turnover ratio.

If the company had written off an unusually large receivable near the end of the year, the average receivables would decrease, and the ratio would be higher.

The aging of receivables would not change the average receivables calculation.

29

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

A.
issue a qualified opinion in the auditor’s report because of the lawyer’s scope limitation.

B.
withdraw from the engagement because of the lack of information furnished by the lawyer.

C.
disclaim an opinion on the financial statements because of the materiality of the litigation’s effect.

D.
add an explanatory paragraph to the auditor’s report because of the uncertainty.

You are correct, the answer is D.


If legal counsel is unable to form a conclusion with respect to litigations, claims, and assessments, the auditor may conclude that the financial statements are affected by an uncertainty concerning the outcome of a future event that cannot be reasonably estimated. If the auditor is unable to obtain sufficient appropriate audit evidence that the financial statements are free from material misstatement, the auditor is required to modify the opinion in addressing the effect, if any, of the legal counsel’s response on the auditor’s report as a result of the scope limitation.

A qualified opinion is issued when the auditor concludes that misstatements are material but not pervasive to the financial statements, or when the auditor is unable to obtain sufficient appropriate audit evidence, but the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive. A qualified opinion would not be issued in this instance because of the lawyer’s scope limitation because there was no scope limitation. A scope limitation would only occur in this instance when legal counsel refuses to furnish the information requested.

A disclaimer of opinion is issued when the auditor is unable to obtain sufficient appropriate audit evidence on which to base an opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. At this point, there can be no determination that the amounts involved are both material and pervasive.

Withdrawal from an engagement could occur when the auditor is unable to obtain sufficient appropriate audit evidence due to a management-imposed limitation. In this instance, this is not management imposed, thus withdrawal would not be necessary.

30

Which of the following statements about audit sampling risks is correct for a nonissuer?

A.
Nonsampling risk arises from the possibility that, when a substantive test is restricted to a sample, conclusions might be different than if the auditor had tested each item in the population.

B.
Nonsampling risk can arise because an auditor failed to recognize misstatements.

C.
Sampling risk is derived from the uncertainty in applying audit procedures to specific risks.

D.
Sampling risk includes the possibility of selecting audit procedures that are not appropriate to achieve the specific objective.

The correct answer is B.


Nonsampling risk includes all the aspects of audit risk that are not due to sampling. Examples of nonsampling risk include failure to properly define the audit population, failure to define clearly the nature of an audit exception, failure to recognize an error when one exists in the sample, and failure to evaluate sample findings properly.

Sampling risk arises from the possibility that, when a substantive test is restricted to a sample, conclusions might be different than if the auditor had tested each item in the population.

Audit risk is derived from the uncertainty in applying audit procedures to specific risks.

Nonsampling risk includes the possibility of selecting audit procedures that are not appropriate to achieve the specific objective.