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Flashcards in NINJA SECTION 2 UNDERSTAND THE ENTITY Deck (20):
1

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

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

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

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

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

The correct answer is C.

Likely frauds that can occur in the revenue cycle include shipping goods to nonexistent customers (which are stolen by employees), failing to bill “customers” (these could again be employees) for goods shipped, recording sales without an underlying transaction in order to inflate the sales and accounts receivable figures, creating fictitious credit memos for “returned” goods (a method of stealing cash), and booking sales in periods earlier than they actually occurred (to hike up the sales figures). A client most likely will overstate revenue and accounts receivable in a fraudulent scheme. Only the “authorization of credit memos by personnel who receive cash may permit the misappropriation of cash” is a likely scenario which would benefit either the entity or certain dishonest employees.

Intentionally recording claims for goods returned in other customer's accounts is incorrect because recording such claims in the wrong account is likely to be quickly detected when customers who have not received the credit complain.

2

What are application controls?

Application controls are classified as follows:

Input controls
Processing controls
Output controls
Program (or process) change controls would be classified as general controls.

“Application controls” refers to the transactions and data relating to each computer-based application system and are, therefore, specific to each such application. The objectives of application controls, which may be manual or programmed, are to ensure the completeness and accuracy of the records and the validity of the entries made therein. Application controls consist of input controls, processing controls, and output controls.

3

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

A.
The entity has rights to the inventory.

B.
Inventory is properly valued.

C.
Inventory is properly presented in the financial statements.

D.
Inventory is complete.

The correct answer is D.

Testing that all inventory on hand is reflected in the ending inventory balance is an example of the completeness assertion. That the entity has rights to the inventory is an example of the rights and obligations assertion. Inventory is properly valued is an example of the valuation assertion. Inventory is properly presented in the financial statements is an example of the accuracy and

4

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

A.
Performing tests of controls concerning the segregation of duties

B.
Evaluating the reasonableness of management's accounting estimates

C.
Reviewing confirmations of compensating balance arrangements

D.
Scanning the accounting records for recurring transactions

The correct answer is C.

The following procedures can assist in identifying material transactions with related parties:

Provide audit team members the names of identified related parties so that they can look for transactions with these parties as they audit.
Review the minutes of board of directors meetings for references to these transactions.
Review proxy and other SEC material for references to these transactions.
Review conflict-of-interest statements obtained by the company from management (to look for entity names which may appear in the accounting records during the audit).
Review the extent of business transacted with major customers and suppliers.
Consider whether transactions are occurring but not being recorded in the accounting records (for example, services provided for free or corporate expenses paid by a board member).
Review accounting records for large, unusual, or nonrecurring transactions or balances, especially near the end of the period.
Review confirmations of compensating balance arrangements for indications that balances are or were maintained for or by related parties.
Review invoices from law firms that may indicate related party transactions.
Review confirmations of loans receivable and payable for information on guarantees. Determine the relationship of the guarantors to the entity.
Tests regarding segregation of duties would be performed in order to determine control risk. Judging the reasonableness of accounting estimates would be a substantive procedure used to audit the assertion of valuation and allocation.


The FASB ASC Glossary defines related parties as, among others, management, owners, family members of owners or management, affiliates, or any party which “can significantly influence the management or operating policies” such that the entity might be “prevented from fully pursuing its separate interests.”

Related party transactions must be fully disclosed in the notes to the financial statements, including the nature of the relationship involved, a description of the transaction, the dollar amounts of the transaction, and amounts due to and from related parties.

Transactions which the auditor should be particularly alert for include borrowing, lending, sale, or exchange of property at interest rates or prices significantly different from market rates or with no scheduled terms of repayment (AU-C 550).

The auditor is required to perform procedures for determining the existence of related parties, identifying related party transactions, and auditing and properly disclosing these transactions.

5

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

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

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

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

D.
The accounts payable manager issues purchase orders.

The correct answer is D.

An individual in the purchasing department should issue purchase orders with the appropriate supervisory approval. The accounts payable clerk is responsible for verifying the arithmetic on the vendor invoice, comparing the vendor invoice to the receiving report and purchase order, processing the payment for the invoice, sending the check elsewhere for signature and mailing, and then filing all of the supporting documentation after payment.

If the accounts payable manager were able to issue purchase orders, he could order items for personal use (or for resale through his own side business) and then process payment for them through the company's records.

6

In auditing accounts payable, an auditor's procedures most likely would focus primarily on management's assertion of:

A.
existence.

B.
presentation and disclosure.

C.
completeness.

D.
valuation and allocation.

The correct answer is C.

The primary focus of an auditor in the examination of liabilities (e.g., accounts payable) is to verify that all of the entity's liabilities have been recorded. AU-C 315.A114 notes that assertions about completeness are concerned with whether all accounts that should be presented in the financial statements are recorded. Completeness thus would be the assertion on which the auditor would concentrate in auditing the liability of accounts payable.

7

The only way to determine risk within an organization is through:

A.
observation and inspection.

B.
inspection and interrogation.

C.
observation, inspection, and interrogation.

D.
None of the answer choices are correct.

The correct answer is D.

Be careful of the word “only.” Observation and inspection are ways to support inquiries (interrogation) of management, but other empirical evidence may be available.

Risk assessment procedures include:

inquiries of management and others within the entity,
analytical procedures, and
observation and inspection.
In addition, the auditor may perform other procedures where the information obtained may be helpful in identifying risks of material misstatement. These procedures may include inquiries of others outside the entity (such as legal counsel), reviewing information from external sources (such as reports by analysts or banks), or reviewing trade journals or regulatory publications.

8

After identifying related party transactions, an auditor most likely would:

A.
substantiate that the transactions were consummated on terms equivalent to those prevailing in arm's-length transactions.

B.
discuss the implications of the transactions with third parties, such as the entity's attorneys and bankers.

C.
determine whether the transactions were approved by those charged with governance.

D.
ascertain whether the transactions would have occurred if the parties had not been related.

You answered D. The correct answer is C.

The correct answer is C.

AU-C 550.A21 states:



Quote


Authorization involves the granting of permission by a party or parties with the appropriate authority (whether management, those charged with governance, or the entity's shareholders)....


AU-C 550.A21 gives the procedures to be considered. One procedure is to determine whether the transaction has been approved by the board of directors or other appropriate officials.

Discussing the implications of the transactions with third parties, such as the entity's attorneys and bankers, is suggested as an additional procedure which is not required but which might be useful.

It will generally not be possible to determine whether the transactions would have occurred if the parties had not been related.

It is usually difficult to ascertain whether a related party transaction was completed on terms that are equal to that of an arm's-length transaction.

9

How does FASB define related parties?

The FASB ASC Glossary defines related parties as, among others, management, owners, family members of owners or management, affiliates, or any party which “can significantly influence the management or operating policies” such that the entity might be “prevented from fully pursuing its separate interests.”

Related party transactions must be fully disclosed in the notes to the financial statements, including the nature of the relationship involved, a description of the transaction, the dollar amounts of the transaction, and amounts due to and from related parties.

Transactions which the auditor should be particularly alert for include borrowing, lending, sale, or exchange of property at interest rates or prices significantly different from market rates or with no scheduled terms of repayment (AU-C 550).

The auditor is required to perform procedures for determining the existence of related parties, identifying related party transactions, and auditing and properly disclosing these transactions.

10

Green, CPA, is auditing the financial statements of Ajax Co. Ajax uses the DP Service Center to process its payroll. DP's financial statements are audited by Blue, CPA, who recently issued a report on DP's policies and procedures regarding the processing of other entity's transactions. In considering whether Blue's report is satisfactory for Green's purposes, Green should:

A.
make inquiries concerning Blue's professional reputation.

B.
assess control risk at the maximum level.

C.
review the audit programs followed by Blue.

D.
perform tests of controls at the DP Service Center.

The correct answer is A.

An auditor may choose to rely or not rely on the work of another auditor, In either case, the auditor should inquire as to the reputation of the other auditor.

11

Prior to or in conjunction with the information-gathering procedures performed during an audit, members of the audit engagement team are required to discuss the potential for material misstatement due to fraud. The discussion should include which of the following?

I.An exchange of ideas or “brainstorming” among the audit team members, including the auditor with final responsibility for the audit, about how and where they believe the entity's financial statements might be susceptible to material misstatement due to fraud, how management could perpetrate and conceal fraudulent financial reporting, and how assets of the entity could be misappropriated
II.An emphasis on the importance of detecting and preventing fraud
A.
I only

B.
II only

C.
Both I and II

D.
Neither I nor II

The correct answer is A.

AU-C 240.15 states that the discussion should include an exchange of ideas among team members. This discussion should also include how management could perpetrate and conceal fraudulent financial reporting, and how assets could be misappropriated.

12

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

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

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

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

D.
trust company places the securities in a bank safe-deposit vault under the custodian’s exclusive control.

The correct answer is A.

Proper segregation of duties separates control activities involving authorization, physical control, information processing, and performance reviews. A trust company that possesses the securities and has no direct contact with employees who have recordkeeping responsibilities separates the physical control and information processing control activities. Thus, segregation of duties is achieved and would help ensure against loss of an asset.

A trust company that holds both the securities and is registered in the name of the trust company has both the physical control of the asset and authorization.

By mailing interest and dividend checks to an employee that has authorization to sell securities, the person has both authorization and information processing/asset accountability controls.

A trust company that places securities in a bank under custodian controls does not address whether that trust company also has the ability to process accounting information or not.

13

Obtaining and understanding internal controls involves which of the following?

Understanding controls that exist in the audited company's industry
Evaluating the design of a control within the audited company
Determining if a control has been implemented within the audited company
A.
I and II

B.
II and III

C.
I and III

D.
I, II, and III

The correct answer is B.

Obtaining an understanding of internal control involves evaluating the design of a control and determining whether it has been implemented.

Evaluating the design of a control involves considering whether the control, individually or in combination with other controls, is capable of effectively preventing or detecting and correcting material misstatements. The auditor should consider the design of a control in determining whether to consider its implementation. An improperly designed control may represent a material weakness in the entity's internal control and the auditor should consider whether to communicate this to those charged with governance and management.
Implementation of a control means that the control exists and that the entity is using it.

14

Which of the following is a definition of control risk?

A.
The risk that a material misstatement will not be prevented or detected on a timely basis by the client's internal controls

B.
The risk that the auditor will not detect a material misstatement

C.
The risk that the auditor's assessment of internal controls will be at less than the maximum level

D.
The susceptibility of material misstatement assuming that there are no related internal controls, policies, or procedures

You are correct, the answer is A.

Control risk, a component of the risk of material misstatement, is the risk that a misstatement that could occur in a relevant assertion and that could be material, either individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the entity's internal control.

The risk that the auditor will not detect a material misstatement is detection risk.

The susceptibility of a relevant assertion to a misstatement that could be material, assuming that there are no related internal controls, is inherent risk.

The “risk that the auditor's assessment of internal controls will be at less than the maximum level” is a statement meant to distract from the actual answer. It is not an actual risk.

15

Tests designed to detect credit sales made before the end of the year that have been recorded in the subsequent year provide assurance about management's assertion of:

A.
presentation.

B.
cutoff.

C.
completeness.

D.
existence.

The correct answer is B.

Assertions about cutoff deal with recording items in the proper period. Completeness deals with whether all transactions and accounts that should be presented in the financial statements are included.

In this case, the sales have been recorded, so the records are complete, but they have been recorded in the incorrect period, which is a cutoff issue.
The cutoff date is the last day of the accounting period (i.e., the last day of each month or December 31, the last day of the fiscal year). This date (especially the fiscal year-end) is used to test the proper period controls, to test the occurrence assertion, and to test for the occurrence of events subsequent to cutoff which might have a material effect on the financial statements under audit.

“Proper cutoff” refers to the appropriate recording of transactions in the proper period, neither delaying some recordings to the next period nor accelerating some next-period transactions into the current-year account balances.

16

Audit procedures that center on observation and inspection include all of the following except:

A.
inspection of documents, records, and internal control manuals (e.g., an organizational chart).

B.
physical observation of the entity's premises and plant facilities (e.g., visiting the warehouse).

C.
evaluating whether the financial statements as a whole are presented fairly, in all material respects, in conformity with generally accepted accounting principles.

D.
All of the answer choices are audit procedures that center on observation and inspection.

The correct answer is C.

Evaluating whether the financial statements as a whole are presented fairly, in all material respects, in conformity with generally accepted accounting principles is the goal of the audit procedures.

Audit procedures would normally include the following:

Observation of entity activities and operations (e.g., watching an employee perform a tasks such as receiving an inventory shipment)
Inspection of documents, records, and internal control manuals (e.g., an organizational chart)
Reading reports prepared by management, those charged with governance, and internal auditors (e.g., quarterly management reports, interim financial statements, or minutes of board of directors' meetings)
Physical observation of the entity's premises and plant facilities (e.g., visiting the warehouse)
Tracing transactions through the information system relevant to financial reporting (e.g., performing a walkthrough)

17

When companies use information technology (IT) extensively, evidence may be available only in electronic form. What is an auditor’s best course of action in such situations?

A.
Assess the control risk as high

B.
Use audit software to perform analytical procedures

C.
Use generalized audit software to extract evidence from client databases

D.
Perform limited tests of controls over electronic data

The correct answer is C.

Information processing presents a couple of areas where control activities are affected: authorization of transactions and the maintenance of adequate documents and records. Auditors should be aware that the audit trail may not be available in traditional hardcopy form or source document, but the actual documentation is housed in the IT system itself. Generalized extraction software will provide evidence from the client databases.

18

An auditor's purpose in reviewing credit ratings of customers with delinquent accounts receivable most likely is to obtain evidence concerning management's assertions about:

A.
valuation and allocation.

B.
presentation and disclosure.

C.
existence.

D.
rights and obligations.

The correct answer is A.

The key to this type of question is to ask, “What does the evidence obtained by this procedure prove?” and “What question does this procedure help answer?”

When the auditor reviews the credit ratings of customers with delinquent accounts receivable, the question being asked is, “Will we really collect this much for this receivable?” or “Is this receivable really worth this much?” Thus, the procedure is providing evidence about the valuation and allocation assertion. The delinquency of receivables indicates that the accounts may not be paid. Thus, the ability of the customers to pay, as reflected in their credit ratings, may corroborate or contradict the carrying amount of accounts receivable; that is, evidence may indicate the need either to allow for the possible uncollectibility of the accounts or to write off the receivable directly, thereby reducing the carrying value of receivables.

19

Which of the following is an example of discrepancies in accounting records that could be used to assess the risk of material misstatement due to fraud?

A.
Inconsistent, vague, or implausible responses from management or employees arising from inquiries or analytical procedures

B.
Evidence of employees' access to systems and records inconsistent with that necessary to perform their authorized duties

C.
Unusual discrepancies between the entity's records and confirmation replies

D.
Unavailable or missing electronic evidence, inconsistent with the entity's record retention practices or policies

The correct answer is B.

Examples of discrepancies in accounting records that could be used to assess the risk of material misstatement due to fraud include the following:

Transactions that are not recorded in a complete or timely manner or are improperly recorded as to amount, accounting period, classification, or entity policy
Unsupported or unauthorized balances or transactions
Last-minute adjustments that significantly affect financial results
Evidence of employees' access to systems and records inconsistent with that necessary to perform their authorized duties
Tips or complaints to the auditor about alleged fraud
The other answer choices are examples of conflicting or missing evidential matter that could be used to assess the risk of material misstatement due to fraud.

20

Which of the following would an auditor ordinarily consider the greatest risk regarding an entity’s use of electronic data interchange (EDI)?

A.
Authorization of EDI transactions

B.
Duplication of EDI transmissions

C.
Improper distribution of EDI transactions

D.
Elimination of paper documents

The correct answer is C.

An EDI system must include controls to make certain that EDI transactions are processed by the proper entity, using the proper accounts.

EDI)
close
Electronic data interchange (EDI) is the exchange of documents in standardized electronic form between different entities in an automated manner directly from a computer application in one entity to an application in another. Advantages of an EDI system include reduced errors, costs, and processing time. It was developed in conjunction with the just-in-time (JIT) inventory system.