4.2

Question 1

The existence of a related party transaction may be indicated when another entity

Answer 1

Absorbs expenses of the corporation.

Typical related party transactions include interest-free or low interest loans, real estate sales at prices different from appraisal values, nonmonetary exchanges of similar property, and loans with no scheduled terms. Thus, when another entity absorbs the interest cost for a loan or otherwise provides an advantage that would not be characteristic of an arm’s-length transaction, the existence of related parties may be indicated.

Question 2

Buldger Retailing, Inc., has an internal auditing staff of four full-time auditors. The auditor has determined that the internal auditors are competent and objective. The auditor may share which of the following responsibilities with Buldger’s internal auditors?

Answer 2

Performing substantive procedures.

An internal auditor may provide direct assistance to the auditor in completing some aspect of the audit work, for example, understanding internal control or performing tests of controls or substantive procedures. However, the reporting responsibility rests solely on the auditor. Thus, judgments about (1) assessments of the risks of material misstatement, (2) the materiality of misstatements, (3) the sufficiency of tests, (4) the evaluation of significant accounting estimates, and (5) other matters affecting the report should be made by the auditor.

Question 3

For a reporting entity that has participated in related party transactions that are material, disclosure in the GAAP-based financial statements should include

Answer 3

The nature of the relationship and the terms and manner of settlement.

Disclosure in GAAP-based financial statements of a reporting entity that has participated in material related party transactions should include (1) the nature of the relationship; (2) a description of the transactions; (3) the dollar value of the transactions; (4) the amounts due from or to related parties; and (5) if not otherwise apparent, the terms and manner of settlement.

Question 4

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

Answer 4

Reviewing confirmations of compensating balance arrangements.

The auditor performs procedures to identify material transactions that may be indicative of previously undetermined relationships. These procedures include reviewing confirmations of compensating balance arrangements for indications that balances are or were maintained for or by related parties (AU-C 550 and AS 2410).

Question 5

Which of the following steps should an auditor perform first to determine the existence of related parties?

Answer 5

Inquire about the existence of related parties from management.

When obtaining an understanding of the entity’s related party relationships and transactions, the auditor should inquire of management regarding (1) the identity of the entity’s related parties, including changes from the prior period; (2) the relationships of the entity with those parties; and (3) the types and purposes of transactions with them.

Question 6

In which of the following instances would it be appropriate for the auditor to refer to the work of an appraiser in the auditor’s report?

Answer 6

An adverse opinion is expressed based on a difference of opinion between the client and the auditor’s external specialist about the value of certain assets.

An auditor’s external specialist has expertise in a field other than accounting or auditing. Expertise in a field other than accounting or auditing may include valuation of nonfinancial assets, such as land and buildings, jewelry, or antiques. If, after considering the work of the auditor’s external specialist, the auditor concludes that managements’ assertions are materially misstated, a qualified or adverse opinion should be expressed. When the opinion is modified, the auditor may report the work of the external specialist when it is relevant to understanding the opinion modification (AU-C 620).

Question 7

During an audit, an internal auditor may provide direct assistance to an independent CPA in

Obtaining an understanding of internal control:
Performing tests of controls:
Performing substantive testing:

Answer 7

Yes
Yes
Yes

The auditor may request direct assistance from the internal auditor when performing the audit. Thus, the auditor may appropriately request the internal auditor’s assistance in obtaining the understanding of internal control, performing tests of controls, or performing substantive procedures (AU-C 610). The internal auditor may provide assistance in all phases of the audit as long as (1) the internal auditor’s competence and objectivity have been tested, and (2) the independent auditor supervises, reviews, evaluates, and tests the work performed by the internal auditor to the extent appropriate.

Question 8

Which of the following statements is true about related party transactions?

Answer 8

The auditor should consider whether an identified related party transaction outside the normal course of business is appropriately accounted for and disclosed.

The auditor should inspect any contracts or agreements to evaluate whether (1) the business purpose (or lack of a business purpose) implies that the transaction’s intent was fraudulent, (2) the terms are consistent with management’s explanations, and (3) the accounting and disclosure are appropriate. The auditor also should obtain evidence of appropriate authorization and approval.

Question 9

Which of the following events most likely would indicate the existence of related parties?

Answer 9

Selling real estate at a price significantly different from appraised value.

The following suggest the existence of related party transactions: (1) exchanging property for similar property in a nonmonetary transaction, (2) borrowing or lending at rates significantly above or below market rates, (3) selling realty at a price materially different from its appraised value, and (4) making loans with no scheduled repayment terms.

Question 10

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

Answer 10

Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date.

Related party transactions may involve window dressing at the end of the period. For example, a shareholder may repay a loan just before the balance sheet date, and the entity may then lend the same amount to the same party after the beginning of the next period (AU-C 550).

Question 11

The auditor’s evaluation of the reasonableness of accounting estimates

Answer 11

Considers that management bases its judgment on both subjective and objective factors.

Estimates are based on both subjective and objective factors. Thus, control over estimates may be difficult to establish. Given the potential bias in the subjective factors, the auditor should adopt an attitude of professional skepticism toward both the subjective and objective factors.

Question 12

Which of the following statements is true about the use of the work of an auditor’s specialist?

Answer 12

The auditor should obtain an understanding of the methods and assumptions used by the specialist.

AU-C 620, Using the Work of an Auditor’s Specialist, states that the auditor should evaluate the adequacy of the work of the auditor’s specialist. This process includes (1) obtaining an understanding of any significant assumptions and methods used by the specialist and (2) evaluating the relevance and reasonableness of those assumptions and methods in the circumstances and in relation to the auditor’s other findings and conclusions.

Question 13

As part of the audit of fair value estimates and disclosures, an auditor may need to test the entity’s significant assumptions. In these circumstances, the auditor should

Answer 13

Evaluate whether the assumptions individually and as a whole form a reasonable basis for the fair value estimates.

Observable market prices are not always available for fair value estimates. In this case, the entity uses valuation methods based on the assumptions that the market would employ to estimate fair values, if obtainable without excessive cost. Accordingly, GAAS require the auditor to evaluate whether the significant assumptions form a reasonable basis for the estimates. Because assumptions often are interdependent and must be consistent with each other, the auditor should evaluate them independently and as a whole.

Question 14

Miller Retailing, Inc., maintains a staff of three full-time internal auditors. The independent auditor has found that they are competent and objective. Moreover, the work of the internal auditors is relevant to the audit, and it is efficient to consider how that work may affect the audit. The independent auditor most likely will

Answer 14

Nevertheless need to make direct tests of assertions about material financial statement amounts for which the risks of material misstatement are high.

The auditor has the sole reporting responsibility and makes all judgments about matters affecting the report. When amounts are material and the risks of material misstatement are high or the evaluation of the evidence is highly subjective, the consideration of the internal auditors’ work cannot alone reduce audit risk to an acceptable level. Thus, direct testing of those assertions by the auditor cannot be eliminated (AU-C 610).

Question 15

An auditor is assessing the appropriateness of management’s rationale for selecting a model to measure the fair value of debt securities. If, during the current year, an active trading market for the debt security was introduced, the auditor should validate each of the following criteria, except whether the valuation model is

Answer 15

Consistently applied from prior periods.

The active trading market for the debt security was introduced in the current year. Therefore, a prior period cannot be used to validate the valuation model.

Question 16

In using the work of an auditor’s external specialist, an agreement should exist between the auditor and the specialist as to the nature of the specialist’s work. This agreement most likely should include

Answer 16

The applicability of the same confidentiality requirements to the auditor and the specialist.

The agreement should be documented and should cover (1) the nature, objectives, and scope of the work; (2) the roles of the auditor and specialist; (3) the nature, timing, and extent of communications between the auditor and specialist; and (4) the need for the specialist to observe confidentiality requirements. The agreement between the auditor and the auditor’s external specialist generally is documented in an engagement letter. A matter that should be included is the need for the confidentiality provisions of the relevant ethical requirements that apply to the auditor also to apply to the specialist. For example, a member of the AICPA may use a third-party service provider to render professional services to clients. The member should have a contract with the third-party service provider to maintain the confidentiality of the information (Ethics Ruling). Other requirements may be imposed by law or regulation.

Question 17

Based on past experience with a client, an auditor determined performance materiality for fixed assets should be calculated at 1/4 of total materiality (5% of total gross fixed assets). Calculate performance materiality based on the following:

Fixed assets (gross) at 1/1/2017: $1,000,000
Capital expenditures: 250,000
Dispositions: 200,000
Accumulated depreciation at 1/1/2017: 400,000
Accumulated depreciation at 12/31/2017; 370,000

Answer 17

$13,125

Materiality is a matter of professional judgment about whether misstatements could reasonably influence the economic decisions of users as a group, given their common informational needs. Performance materiality is the amount(s) set by the auditor at less than the materiality for (1) the statements as a whole or (2) particular classes of transactions, balances, or disclosures. Performance materiality is an adjustment to reduce to an appropriately low level the probability that the sum of (1) uncorrected and (2) undetected misstatements (whether or not individually material) exceeds the applicable materiality.
$13,125 = [$1,000,000 (fixed assets (gross) at 1/1/2017) + $250,000 (capital expenditures) – $200,000 (dispositions)] × [5% (total materiality %) × 1/4 (performance materiality)].

Question 18

George Karl, an auditor with extensive experience in the retail industry, is assigned to audit the reasonableness of accounting estimates in the Year 1 financial statements of Haas Company. Haas, which was formed in Year 1, markets fishing lures. Which of the following is the least important consideration for Karl’s audit of the reasonableness of accounting estimates?

Answer 18

Karl has never been involved in an audit of a company that sells fishing lures.

The auditor evaluates the reasonableness of estimates. Among the factors considered are (1) the entity’s experience in making past estimates, (2) any changes that may cause factors different from those previously considered to become significant, and (3) the need to obtain written representations from management regarding the key factors and assumptions. Karl has extensive experience in the retail industry and therefore most likely has an acceptable level of competence. If necessary, Karl may seek the help of a specialist before conducting the audit.

Question 19

An auditor most likely modifies the opinion if the entity’s financial statements include a note on related party transactions

Answer 19

Stating without substantiation that a particular related party transaction occurred on terms equivalent to those that would have prevailed in an arm’s-length transaction.

The auditor should obtain sufficient appropriate evidence about a management assertion that related party transactions were conducted on terms equivalent to those that prevail in arm’s-length transactions. Management is responsible for substantiating the assertion. The auditor evaluates management’s support for the assertion.

Question 20

The work of internal auditors may affect the independent auditor’s

I. Procedures performed in obtaining an understanding of internal control
II. Procedures performed in assessing the risks of material misstatement
III. Substantive procedures performed in gathering direct evidence

Answer 20

I, II, & III.

The internal audit function is part of the client’s internal control. The auditor should obtain an understanding of this function when obtaining an understanding of internal control. The auditor also may use the internal auditors to provide direct assistance under certain conditions. A primary purpose of internal auditors is to review, assess, and monitor internal control. Thus, their work is relevant to the understanding of internal control and the assessment of risk. Moreover, some procedures performed by internal auditors, such as confirmations, may provide direct evidence about material misstatements.

Question 21

When a management’s specialist has assumed full responsibility for taking the client’s physical inventory, reliance on the specialist’s work is acceptable if

Answer 21

The auditor conducted the same audit tests and procedures as would have been applicable if the client employees took the physical inventory.

The auditor is responsible for the observation of inventories. The auditor performs this procedure whether the client or an external specialist takes the physical inventory. The auditor should (1) examine the specialist’s program, (2) observe its procedures and controls, (3) make or observe some physical counts, (4) recompute calculations, and (5) test intervening transactions.