Special matters that require special consideration Flashcards
(13 cards)
Which of the following procedures will most likely provide evidence regarding the completeness of the amount recorded as investments in securities on the balance sheet?
A. Inspecting securities on hand.
B. Reading financial statement disclosures.
C. Testing subsequent transactions for evidence of settlement.
D. Confirming loans to determine if securities are pledged as collateral.
C. Testing subsequent transactions for evidence of settlement.
When auditing financial statements, an auditor will test to determine whether the client has recorded all owned investments in securities (ie, completeness) and valued them properly (ie, valuation). The auditor may use a single procedure to perform both internal control and substantive testing.
Settlement statements typically indicate the purchase date and price of a security along with its sale date and price. The auditor might perform a test to determine whether settlement statements are reviewed for accuracy (eg, internal control test). Concurrently, the auditor might also test settlement statements for evidence of settlement (ie, sale) of securities purchased before year end and sold subsequent to year end, providing evidence of the value of investments that should have been recorded on the year end balance sheet (eg, completeness substantive test).
(Choice A) Inspecting securities on hand tests for existence, not completeness.
(Choice B) Reading financial statement disclosures helps the auditor determine that required information is disclosed but does not identify securities that are missing from the balance sheet.
(Choice D) Not all investment securities are pledged as loan collateral. Therefore, confirming loans to determine whether securities were pledged as collateral does not provide assurance of completeness.
Things to remember:
A settlement statement indicates the purchase date and price of a security along with the sale date and price. These statements can help determine completeness. For example, a sale after year end might indicate an investment owned at year end that should have been recorded on the balance sheet.
The Year 1 financial statements of ABC, Inc. are prepared on the going concern basis of accounting. The footnotes to the financial statements accurately describe conditions giving rise to doubt about the going concern assumption and management’s plans to address it. However, the auditor has determined that the financial statements should be prepared on the liquidation basis of accounting, not the going concern basis. Which of the following reporting options does the auditor have?
A. Qualified opinion.
B. Unmodified opinion with a going concern section.
C. Adverse opinion.
D. Unmodified opinion with an emphasis-of-matter paragraph.
C. Adverse opinion.
Financial statements (F/S) are usually prepared on the assumption that an entity will remain in business for a reasonable period (ie, going concern assumption). If the entity is not expected to remain in operation for at least a year, the liquidation basis should be used instead. For example, under liquidation accounting, assets are valued to reflect the cash proceeds expected from their sale regardless of their cost to the entity or accumulated depreciation.
Because using the going concern basis instead of the liquidation basis will inevitably have a pervasive effect across the F/S, only an adverse opinion is appropriate. A qualified opinion is appropriate only when the F/S contain a misstatement that is material but not pervasive (Choice A).
If the going concern basis is appropriate but there is substantial doubt about the going concern assumption, the entity must disclose the conditions or events giving rise to the doubt and management’s plans to address them. If those plans do not alleviate the doubt, a going concern section should be included (Choice B). If those plans do alleviate the doubt, the auditor may consider including an emphasis-of-matter paragraph(Choice D).
Things to remember:
If financial statements (F/S) have been prepared on the going concern basis but the going concern basis is inappropriate, an auditor should issue an adverse opinion. A going concern section or emphasis-of-matter paragraph addressing a going concern disclosure should be used only when the F/S appropriately use the going concern basis and disclose substantial doubt.
Li, CPA, is planning the audit of the Year 5 financial statements of a manufacturing client. New manufacturing technology is quickly being adopted in the client’s industry. Implementing the technology will require the company to incur substantial debt to finance the new equipment. Li believes that if the client does not implement the technology, it will likely cease to be competitive by Year 10. In which situation is Li likely to determine that there is increased risk regarding management’s evaluation of the client’s ability to continue as a going concern?
The client has decided toadopt the technology in Year 6
The client has decided not toadopt the technology
A. Yes Yes
B. Yes No
C. No Yes
D. No No
Risks of material misstatement can relate to internal or external factors. External factors include changes in the technological landscape. For example, new technologies can create doubt about an entity’s ability to continue as a going concern for a reasonable time (ie, going-concern assumption).
Auditors evaluate whether there is substantial doubt about the going-concern assumption to determine whether the appropriate disclosures have been made. Although this determination will be made later in the audit, the auditor will first evaluate the risk of a going-concern problem to plan appropriate procedures.
In this scenario, new technology threatens the client’s long-term survival. However, because the entity is required to disclose substantial doubt about its ability to continue as a going concern only for the short term (usually one year), the new technology does not itself pose a risk for the Year 5 audit.
By contrast, making an investment in new technology requires cash outflows or increased debt. Generally, additional debt or decreased liquid assetsincrease the probability that an entity will be unable to meet its commitments in the short term, threatening the going concern assumption. The auditor is therefore more likely to assess the risk as high and increase testing.
Things to remember:
In audit planning, auditors should consider risks to the entity’s ability to continue as a going concern for a reasonable period of time (usually one year). Such risks may be increased by external factors (eg, new technologies) either directly or by way of the entity’s response.
After considering an entity’s negative trends and financial difficulties, an auditor has substantial doubt about the entity’s ability to continue as a going concern. The auditor’s considerations relating to management’s plans for dealing with the adverse effects of these conditions most likely would include management’s plans to
A. Increase current dividend distributions.
B. Pay down existing lines of credit.
C. Increase ownership equity.
D. Purchase assets formerly leased.
C. Increase ownership equity.
An entity usually prepares financial statements on the assumption that it will continue in business for a reasonable period (ie, going concern assumption), typically one year. For example, by depreciating assets over their useful lives, the entity assumes its business will continue as long as those assets last.
When substantial doubt exists about the going concern assumption, the financial statements must contain a footnote disclosing that doubt. To determine whether the disclosure is adequate, the auditor must evaluate management’s plans to alleviate (ie, mitigate) the substantial doubt. If the plans do alleviate the doubt, the footnote should disclose the conditions that gave rise to the doubt and describe the plans. If the plans do not alleviate the doubt, the footnote should indicate that substantial doubt remains even after consideration of the plans.
Plans that might mitigate doubt about the going concern assumption typically involve increasing net cash flows over the coming year. This may be accomplished by, for example, obtaining additional financing through loans or stockholders’ equity (eg, selling common stock), cutting expenditures, or selling assets.
(Choices A, B, and D) Increasing dividends, paying down lines of credit, or purchasing assets formerly under lease would all require additional cash outflows, which would increase, not mitigate, doubt about the entity’s ability to continue as a going concern.
Things to remember:
Management’s plans to mitigate substantial doubt about an entity’s ability to continue as a going concern typically involve increasing net cash flows (eg, obtaining loans, increasing equity).
In searching for unrecorded liabilities, an auditor most likely would examine the
A. Cutoff bank statement for deposits recorded in the books, but not by the bank.
B. Details of accounts receivable confirmations that are classified as “exceptions.”
C. Files of purchase requisitions for items ordered just before the year end.
D. Receiving reports for items received before year end, but not yet recorded.
D. Receiving reports for items received before year end, but not yet recorded.
Auditors testing completeness of liabilities verify that all liabilities have been properly recorded in the financial statements. The risk is that entities understate liabilities to increase their financial position. To test completeness, auditors search for events or conditions that indicate liabilities have been incurred and then verify that those liabilities were recorded. Receiving reports can help identify goods received but not yet paid for (ie, identify liabilities); auditors then verify that any identified liabilities were recorded.
(Choice A) To identify liabilities, auditors would most likely examine cash disbursements, not deposits, occurring after year end because these payments may be linked to unrecorded liabilities.
(Choice B) Confirmations are an effective way to test for existence, rights, and obligation of accounts receivable (ie, assets), not liabilities. Confirmations with exceptions indicate that an entity’s records under audit do not match its customer’s records and will be investigated.
(Choice C) Purchase requisitions for items ordered right before year end will likely create a liability for the period after year end, when goods are received. However, auditors are primarily concerned with liabilities related to the year-end balance.
Things to remember:
Auditors testing for completeness of liabilities verify that all liabilities have been properly recorded in the financial statements. The risk is that entities will understate liabilities to increase their financial position. To test completeness, auditors search for events or conditions that indicate liabilities have been incurred and then verify that those liabilities were recorded.
Which of the following procedures would an auditor most likely perform to assist in the evaluation of loss contingencies?
A. Checking arithmetic accuracy of the accounting records.
B. Performing appropriate analytical procedures.
C. Obtaining a letter of audit inquiry from the client’s lawyer.
D. Reading the financial statements, including footnotes.
C. Obtaining a letter of audit inquiry from the client’s lawyer.
Companies may have pending lawsuits, assessments, or claims filed against them. The auditor must determine if these contingencies represent a loss that needs to be disclosed or accrued as a liability in the financial statements.
The auditor must identify if any loss contingencies exist by obtaining a letter (eg, management representation) from the client’s in-house lawyers outlining the status and potential magnitude of any pending assessments, lawsuits, or claims. The auditor will also obtain written corroborating information directly from external attorneys engaged to assist with pending legal issues. This information will allow the auditor to determine if a loss contingency should be accrued or disclosed.
(Choice A) Checking the arithmetic accuracy of accounting records would not indicate if a situation exists that requires a loss contingency to be accrued or disclosed.
(Choice B) Performing appropriate analytical procedures might help the auditor identify legal expenses potentially associated with a contingent loss. However, the auditor would need to get input from the client’s lawyers to evaluate if a contingent loss exists.
(Choice D) If a contingent loss exists but is not properly recorded in the financial information, reading the financial statements would not highlight this oversight.
Things to remember:
Pending lawsuits, assessments, or claims can result in a contingent liability or the need for financial statement disclosure. Requesting a letter from the client’s lawyers outlining the existence, status, and magnitude of such contingencies can help the auditor determine how the contingencies should be handled from a financial reporting perspective.
“In connection with an audit of our financial statements, management has prepared, and furnished to our auditors a description and evaluation of certain contingencies.”
The foregoing passage most likely is from a(an)
A. Audit inquiry letter to legal counsel.
B. Management representation letter.
C. Audit committee’s communication to the auditor.
D. Financial statement footnote disclosure.
A. Audit inquiry letter to legal counsel.
Contingencies arise from pending legal actions. Depending on the probability of outcome and whether the settlement amount can be estimated, contingencies may result in liabilities on the balance sheet or footnote disclosures to the financial statements. Client management provides the primary source of information regarding contingencies.
An auditor may prepare and arrange for management to sign a letter of inquiry to a client’s legal counsel (ie, an attorney letter) requesting corroborating evidence (eg, description, evaluation, likelihood of loss, estimated loss amount) when contingencies are considered material to the financial statements. Although management requests the inquiry, the letter should be physically mailed, and the response received, by the auditor.
The passage quoted in this question indicates that “management has prepared, and furnished to our auditors a description and evaluation of certain contingencies.” The management representation letter comes from management to the auditors and refers to the management team as ‘we,’ not as ‘management’ (Choice B). Any audit committee communication would not reference what management has done (ie, prepared, furnished) (Choice C). Instead, it would reference any information requested by the committee or provided to the auditor.
(Choice D) Financial statement footnote disclosures provide financial information, not information about what management has given the auditors.
Things to remember:
Information about contingencies is obtained first from client management. An inquiry letter to the client’s legal counsel (ie, the attorney letter) corroborates management’s contingency information.
An auditor believes there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period. In evaluating the entity’s plans for dealing with the adverse effects of future conditions and events, the auditor most likely would consider, as a mitigating factor, the entity’s plans to
A. Accelerate research and development projects related to future products.
B. Operate at increased levels of production.
C. Issue stock options to key executives.
D. Negotiate reductions in required dividends on preferred stock.
D. Negotiate reductions in required dividends on preferred stock.
Management must evaluate whether an entity can continue as a going concern for a reasonable period (typically one year from the date the financial statements are issued). An auditor then assesses that evaluation. The primary issue that auditors consider is entities’ ability to generate positive cash flow because a company is most likely to fail if it is unable to pay its debts on time.
There are, however, certain mitigating factors that may reduce the risk of going out of business by improving cash flow, such as plans to:
Increase ownership equity through stock issuances for cash
Dispose of marketable assets that are not needed in the operations of the business
Delay or reduce optional expenditures, such as R&D
Entities can also restructure items that require a cash payout (eg, negotiating reductions in required cash dividends on preferred stock, offering a stock dividend instead of a cash one).
(Choice A) Accelerating research and development projects related to future products involves spending more money currently, not less.
(Choice B) Operating at increased levels of production would require more cash for additional resources (eg, labor, materials). In addition, it does not necessarily guarantee improved cash flow; the entity’s losses could increase.
(Choice C) Although issuing employee stock options could improve cash flow if the options were converted to shares of stock, it would have only a minimal impact. As such, it is not the most likely option the auditor would consider as a mitigating factor.
Things to remember:
In assessing whether an entity can continue as a going concern, auditors will determine if there are any mitigating factors. Mitigating factors may reduce the risk of going out of business by improving cash flow and would include negotiating reductions in required cash dividends on preferred stock.
In planning an audit, an auditor established materiality at $40,000. The auditor received an attorney’s letter indicating that it was probable that each of three lawsuits would be settled for $30,000. Which of the following actions should the auditor take?
A. Add a separate paragraph to the audit report disclosing the contingencies and their amounts.
B. Ask the client to disclose the contingencies in the notes to the financial statements.
C. Ask the client to record the liability for the three contingencies.
D. Add a paragraph to the auditor’s opinion disclosing a scope limitation.
C. Ask the client to record the liability for the three contingencies.
An auditor will obtain a letter from each attorney engaged to help the client respond to any litigation, claims, or assessments. This letter helps the auditor determine whether contingent liabilities should be accrued or disclosed. If the attorney’s response indicates that a loss is reasonably possible or probable, the estimated loss must be clarified to determine the appropriate financial reporting.
A contingent liability must be accrued and disclosed if it is probable that the client will resolve the legal issue by making a payment that can be reasonably estimated. In this scenario, the attorney letter indicates that it is probable that pending lawsuits will require the client to pay $90,000 ($30,000 per lawsuit). Since this exceeds the $40,000 audit materiality level, the auditor should ask the client to record a $90,000 liability.
(Choice A) The financial statements, not the audit report, would disclose the contingencies.
(Choice B) Contingencies are disclosed without accrual either when it is reasonably possible (not probable) that the legal action will result in a settlement or if the settlement amount cannot be reasonably estimated. In this scenario, a financial statement accrual entry is required.
(Choice D) The audit scope is not limited because both the client and the client’s attorney responded to the auditor’s request for information.
Things to remember:
The auditor may learn it is probable a client will resolve legal actions (eg, lawsuits) by paying amounts that can be reasonably estimated. When this occurs, the auditor should ask the client to record a contingent liability.
Which of the following account balances is most likely to be based on management estimates?
A. Warranty obligations.
B. Cash.
C. Investment in ABC Co., accounted for under the equity method.
D. Accounts payable.
A. Warranty obligations.
Items that cannot be precisely measured for financial statement (F/S) presentation must be estimated. An estimate approximates an element, item, or account on the F/S.
One example is a warranty obligation. The exact amount of a new item’s warranty will not be known until customers actually request the warranty service, which may not occur for several years. Therefore, the warranty is not precisely measurable and must be estimated in the year of the item’s sale.
(Choices B and D) The amount of cash an entity has and the amount it owes to creditors (ie, accounts payable) are finite and can be reliably measured (eg, using confirmations and reconciliations) without estimates.
(Choice C) The equity method of accounting for investments determines account balances based on measurable amounts (ie, investee’s net income or loss and dividends), not management estimates.
Things to remember:
Some financial statement (F/S) items cannot be precisely measured and are determined by management through an estimation process. An estimate approximates an element, item, or account on the F/S. One example is warranty obligations, which are measured on the basis of unknown future customer claims.
Which of the following procedures most likely would assist an auditor to identify litigation, claims, and assessments?
A. Inspect checks included with the client’s cutoff bank statement.
B. Obtain a letter of representations from the client’s underwriter of securities.
C. Apply ratio analysis on the current-year’s liability accounts.
D. Read the file of correspondence from taxing authorities.
D. Read the file of correspondence from taxing authorities.
Contingencies represent gains or losses that may occur in the future because of an event that has already occurred or an existing condition. Contingencies can result from asserted lawsuits (eg, litigation) as well as claims and assessments that may result in a future lawsuit (eg, defective products).
An auditor is required to determine if any contingencies are properly accounted for and disclosed. Procedures designed to identify contingent liabilities, including litigation, claims, and assessments, include:
Obtaining from management a list of all litigation, claims, and assessments
Reviewing minutes of meetings of the board of directors
Reviewing correspondence from relevant entities (eg, external attorneys, taxing authorities)
Reviewing legal expenses and attorney invoices
The auditor will also obtain an attorney letter of inquiry from each lawyer.
(Choice A) Inspecting cutoff bank statement checks identifies issues about the timing of disbursements made near or shortly after year end. It would not detect unrecorded contingencies.
(Choice B) A securities underwriter assists the entity in raising money from investors (eg, issuing common stock or bonds). Issuing debt or equity is not a contingent event.
(Choice C) Applying ratio analysis to liability accounts provides information about only recorded liabilities, not unrecorded contingencies.
Things to remember:
Contingencies represent gains or losses that may occur in the future because of an event that has already occurred or an existing condition. Contingencies include outstanding litigation, claims, and assessments. Procedures designed to identify contingencies include reviewing correspondence from relevant entities (eg, external attorneys, taxing authorities).
To satisfy the valuation assertion when auditing an investment accounted for by the equity method, an auditor would most likely
A. Inspect the stock certificates evidencing the investment.
B. Examine the investee company’s audited financial statements.
C. Review the broker’s advice or canceled check for the investment’s acquisition.
D. Obtain market quotations from financial newspapers or periodicals.
B. Examine the investee company’s audited financial statements.
During the audit, management makes certain assertions, including the assertion that financial statement amounts (eg, investments in other companies) are valued using GAAP-compliant methods. The auditor must perform tests to verify the accuracy of these assertions.
Accounting for an investment under the equity method means the investor recognizes its share of the investee’s income in the period earned. The investment is initially recorded at cost and adjusted if the cost exceeds the investor’s share of the investee’s net assets. Each reporting period, the investment book value is adjusted for the investor’s share of the investee’s earnings, making investee’s audited financial statements the most reliable source of information to validate the investment value.
(Choice A) Inspecting stock certificates indicates that an investment exists and is owned by the client but does not validate current investment book value.
(Choice C) Broker’s advice reflects ownership and cancelled checks confirm only the original purchase price. Neither document provides evidence of the investee’s assets or net income, which is needed to validate equity method investment value.
(Choice D) Market quotations reflect the investment’s current price. To value the investment over time, the equity method uses dividends received from the investment and investee income, not the investment’s market value.
Things to remember:
During the audit, management makes certain assertions, including the assertion that financial statement values are based on GAAP. Audited investee financial statements provide strong evidence in support of investment values accounted for under the equity method, validating management’s assertion
An attorney responding to an auditor as a result of the client’s letter of audit inquiry may appropriately limit the response to
A. Items which have high probability of being resolved to the client’s detriment.
B. Asserted claims and pending or threatened litigation.
C. Legal matters subject to unsettled points of law, uncorroborated information, or other complex judgments.
D. Matters to which the attorney has given substantive attention in the form of legal consultation or representation.
D. Matters to which the attorney has given substantive attention in the form of legal consultation or representation.
(Choice A) This answer is incorrect because the attorney must reply to matters, regardless of whether the probable resolution will be detrimental to the client.
(Choice B) This answer is incorrect because, in addition to replying to asserted claims and pending litigation, the attorney is obligated to reply to questions about unasserted claims and assessments.
(Choice C) This answer is incorrect because the attorney is not exempt from responding to legal matters subject to unsettled points of law, uncorroborated information, or other complex judgments.
(Choice D) This answer is correct because the professional standards statethat an attorney may appropriately limit his response to matters to which he has given substantive attention in the form of legal consultation or representation.
