A-4 2013

Question 1

When is audit evidence gathered during an audit?

Answer 1

The auditor gathers audit evidence when performing: Risk assessment procedures; Tests of controls: Substantive procedures; Other audit procedures.

Question 2

What factors should be considered when evaluating the reliability of audit evidence?

Answer 2

The following factors should be considered when evaluating the reliability of audit evidence: The auditor’s direct personal knowledge (e.g., from observation, examination, inspection, or recalculation) provides more persuasive evidence than knowledge obtained indirectly; Evidence obtained from independent external sources is more reliable than internally generated evidence; Evidence sent directly to the auditor is more valid than evidence received and held by the client; Internal evidence generated under strong, effective internal controls is more reliable than that generated under weak controls; Evidence in documentary form is more reliable han oral evidence; Consistentcy among evidence provides a greater degree of assurance; The accuracy and completeness of information produced by the client should be evaluated.

Question 3

How is the relevance of evidence determined?

Answer 3

To be relevant, evidence must related to the financial statement assertions under consideration. PCAOB standards state that the relevance of audit evidence depends on the design and timing of the audit procedure.

Question 4

What influences the auditor’s decision regarding the sufficiency of evidential matter?

Answer 4

The risk of material misstatement; The quality of audit evidence.

Question 5

List some of the standard auditing procedures used in most audits. (FIVE CARROT CARS)

Answer 5

Footing, crossfooting, and recalculation; Inquiry; Vouching; Examination/Inspection. Confirmation; Analytical procedures; Reperformance; Reconciliation; Observation; Tracing. Cutoff review; Auditing related accounts simultaneously; Representation letter; Subsequent events review.

Question 6

What should the direction of testing be if the auditor is concerned about the existence or occurrence assertion?

Answer 6

Vouching backward from the accounting records (financial statements, journal entries, etc.) to source documents provdes evidence of existence or occurrence.

Question 7

What should the direction of testing be if the auditor is concerned about the completeness assertion?

Answer 7

Tracing forward from source documents to the accounting records (i.e., financial statements, journal entries, etc.) provides evidence of completeness.

Question 8

Which departments are responsible for preparing the sales order, approving the sales order, preparing the bill of lading, and preparing the invoice?

Answer 8

Sales department: Prepares the sales order. Credit department: Approves the sales order. Shipping department: Prepares the bill of lading. Billing department: Prepares the invoice.

Question 9

Which department should approve write-offs of uncollectible accounts?

Answer 9

The treasurer’s department should approve write-offs of uncollectible accounts.

Question 10

A listing of cash receipts should be sent to which three departments?

Answer 10

The cashier, accounts receivable (billing), and general accounting departments should each receive a copy of the cash receipts listing.

Question 11

What are some common audit procedures related to the revenue cycle?

Answer 11

Audit procedures related to the revenue cycle might include: Trace a sample of shipping documents to sales invoices and the sales journal (completeness); Vouch a sample of sales transactions from the sales journal to the shipping documents (existence); Examine sales transactions from shortly before and after year-end for recording in the proper period (cutoff); COnfirmation of a sample of accounts receivable (existence); Testing of the allowance for uncollectible accounts (valuation).

Question 12

Compare and contrast positive, negative, and blank confirmations.

Answer 12

Positive confirmation: Customer is requested to return confirmation to the auditor. Should be used when: accounts are large, errors are expected, or items are disputed. Negative confirmation: Customer is requested to reply only if amount stated by auditor is incorrect. Should be used when: combined assessed level of inherent and control risk is low, a large number of small balances are being confirmed, and recipients are not expected to disregard the confirmations. Blank confirmation: A positive confirmative that does not include the balance, instead requesting the recipient to provide this information. Blank confirmations provide greater assurance but may result in lower response rates.

Question 13

In a purchase transaction, which departments are responsible for preparing the purchase order, preparing the receiving report, recording the payable, approving the invoice, signing the check, and mailing the check?

Answer 13

Purchsing department: Prepares the purchase order. Receiving department: Prepares the receiving report. Accounts payable department: Records the payable and approves the invoice. Treasurer’s department: Signs and mails the check.

Question 14

What documents should be compared before an invoice is approved for payment, and why?

Answer 14

The purchase order, receiving report, and vendor invoice should be compared before an invoice is approved for payment. This is to ensure that the company does not pay for goods that were not ordered or that were ordered but not received.

Question 15

What are some common audit procedures related to the expenditure cycle?

Answer 15

Audit procedures related to the expenditure cycle might include: Performing a search for unrecorded liabilities (completeness); Accounts payable confirmation (existence); Examination of purchases before and after year-end for recording in the proper period (cutoff).

Question 16

When might accounts payable confirmations be usedm and to whom would they be sent?

Answer 16

Accounts payable confirmations might be used when: Internal control is weak; There are disputed amounts; Monthly vendor statements are not available. They would be sent to vendors with small or zero balances, because errors often involve unrecorded liabilities. Note: Confirmation of recorded accounts payable will not provide evidence regarding unrecorded liabilities, but confirmations sent to vendors with zero (or small) balances might provide such evidence.

Question 17

Define lapping.

Answer 17

Delaying the recording of cash receipts to conceal the theft of cash.

Question 18

Define kiting.

Answer 18

Overstatement of bank balances by transferring cash between banks and reporting the amount in both bank balances simultaneously.

Question 19

What are the primary audit procedures used to test the existence, completeness, and valuation of cash?

Answer 19

Primary audit procedures include: Standard bank confirmations sent to all banks with which the client has done business during the year; Testing of the year-end bank reconciliation.

Question 20

What are some common audit procedures related to the inventory cycle?

Answer 20

Audit procedures related to inventory might include: Observing the physical inventory count; Performing test counts and tracing into the inventory report; Performing cutoff testing of purchases and sales; Verifying appropriate presentation and disclosure; Inquiring about obsolete or damaged goods.

Question 21

What are some common audit procedures related to the investment cycle?

Answer 21

Audit procedures related to long-term investments might include: Confirmation of securities held and unsettled transactions (existence); Physical inspection and count of securities (existence); Evaluation of presentation and disclosure in the financial statements; Recomputation of gains, losses, amortization, dividend income, and interest income (valuation); Review of the minutes of board of directors’ meetings; Inquiry of management (supplemented by a representation letter) regarding intent and ability to hold versus sell securities (classification).

Question 22

What are some audit procedures related to the property, plant, and equipment cycle?

Answer 22

Audit procedures related to property, plant, and equipment might include: Vouching additions and reviewing retirements (existence); Reviewing repair and maintenance expense (completeness and classification); Performing cutoff tests (cutoff); Recalculating depreciation and gain or loss on disposals (valuation).

Question 23

What functions should be segregated related to payroll and personnel? (ARC)

Answer 23

The following duties should be segregated: Authorization (human resources, supervisory staff, timekeeping, and cost accounting); Recordkeeping (payroll department); Custody of assets (treasurer).

Question 24

List some common audit procedures for payroll.

Answer 24

Audit procedures related to payroll may include: Evaluate segregation of duties; Observe payroll distribution, use of time cards, etc.; Test direct deposit transfers and underlying employee authorizations; Vouch time on payroll summaries to time cards and approved time reports; Compare total recorded payroll with total payroll checks issued; Test extensions and footings of payroll; Verify pay rates and payroll deductions with employee records from personnel; Recalculate gross and net pay on a test basis; Recalculate any year-end accruals; compare payroll costs with standards or budgets.

Question 25

What are some common audit procedures related to the debt (financing cycle)?

Answer 25

Obtain a listing of all debt outstanding and agree to general ledger. Confirm notes and bonds directly with creditors. Recompute amortization of bond premiums or discounts. Test a sample of debt receipts and payments and compare interest expense to debt balance for reasonableness. Review debt activity shortly before and after year-end to ensure that transactions are reported in the proper period. Review board minutes for evidence of new debt. Trace all new debt contracts to the financial statements. Compare debt disclosures to other audit evidence to ensure that all disclosed information related to debt has occurred.

Question 26

What are some common audit procedures related to stockholders’ equity and treasury stock?

Answer 26

Vouch stock transactions to supporting documentation. Review minutes from the board of directors’ meetings for authorization of stock transactions. Review the articles of incorporation. Analyze the retained earnings account since the last audit. Verify authorized, issued, and outstanding shares of stock by confirming with the stock transfer agent or reviewing the stock certificate book.

Question 27

Define related parties.

Answer 27

Related parties may include the reporting entity’s affiliates, principal owners, and management, as well as any members of their immediate families.

Question 28

How can the auditor determine whether related parties exist?

Answer 28

The auditor can identify related parties by: Evaluating the company’s procedures for identifying and accounting for related party transactions; Asking management; Reviewing the reportin entity’s filings with the SEC; Reviewing material transactions for related party evidence; Reviewing prior year’s audit documentation or inquiring of the predecessor auditor.

Question 29

What is the auditor’s primary concern with respect to related party transactions?

Answer 29

The auditor is primarily concerned with proper disclosure of related party transactions in accordance with GAAP.

Question 30

What are the auditor’s responsibilities when evaluating estimates?

Answer 30

The auditor’s responsibilities with respect to estimates are to: Assess management’s written policies and practices; Evaluate the degree of estimation uncertainty with the accounting estimate; Verify that all material estimates have been developed; Determine that accounting estimates are reasonable; Ensure that accounting estimates are properly disclosed in conformity with GAAP.

Question 31

What procedures might an auditor use to evaluate an estimate?

Answer 31

The auditor evaluates estimates by: Reviewing and testing management’s procedures; Developing an independent estimate for comparative purposes; Reviewing subsequent events and transactions that corroborate the estimate value.

Question 32

Explain the auditor’s responsibility when auditing fair values.

Answer 32

The auditor should obtain sufficient appropriate evidence to provide reasonable assurance that the fair value measures disclosed by the client are in conformity with the applicable financial reporting framework. The auditor is not responsible for predicting future conditions, but must base his or her evaluation on information available at the time of the audit.

Question 33

What are some common audit procedures related to contingencies, including pending litigation or possible future litigation?

Answer 33

Audit procedures related to pending or threatening litigation might include: Obtaining and reviewing the response from a letter of inquiry to the client’s attorney; Inquiry of management; Reviewing minutes of meetings of stockholders, board of directors, and other executives committees; Reviewing correspondence and invoices from lawyers; Reviewing contracts, loan agreements, loan guarantees, leases, and correspondence from taxing authorities.

Question 34

What is the effect on the auditor’s opinion if a client refuses to permit inquiry of its attorney, or if the attorney refuses to respond?

Answer 34

If a client does not permit inquiry of its attorney, the auditor would generally disclaim an opinion or withdraw from the audit. If a lawyer has devoted substantial attention to litigation but refuses to respond to the auditor’s letter of inquiry, a scope limitation sufficient to preclude an unmodified opinion exists (i.e., a qualified opinion or disclaimer of opinion would be issued, depending on materiality).

Question 35

What is the prupose of applying analytical procedures during the overall review stage of the audit?

Answer 35

To evaluate the overall financial statement presentation, to assess the conclusions reached, and to assist in forming an opinion on whether the financial statements are free of material misstatement.

Question 36

What circumstances would increase the likelihood of a misstatement being considered material?

Answer 36

The misstatement: 1. Affects trends in profitability, masks trends, or changes a loss to income. 2. Affects compliance with loan covenants, contracts, or regulatory provisions. 3. Increases management compensation. 4. Affects significant financial statement elements. 5. Can be detremined objectively.

Question 37

Give examples of management bias under PCAOB standards.

Answer 37

Selective correction of misstatements brought to management’s attention during the audit. The identification by management of additional adjusting entires that offset misstatements accumulated by the auditor. Bias in the selection and application of accounting principles. Bias in accounting estimates.

Question 38

Describe the required characteristics of the engagement quality reviewer.

Answer 38

The engagement quality reviewer must be a partner who is not otherwise associated with the engagement and who is competent, independent, objectives, and acts with integrity.

Question 39

When does a significant engagement deficiency exist?

Answer 39

1. The engagement team failed to obtain sufficient appropriate evidence. 2. The engagement team reached an inappropriate overall conclusion. 3. The engagement report is not appropriate for the circumstatences. 4. The firm is not independent of the client.

Question 40

What are the types of financail ratios?

Answer 40

Liquidity ratios–measure short-term ability to pay obligations. Activity ratios–measure effective use of assets. Profitability ratios–measure the financial performance of an entity. Investor ratios–measure items of interest to investors. Coverage ratios–measure security for long-term creditors/investors.

Question 41

What are some limitations of using financial ratios?

Answer 41

While ratios are useful they have the following limitations: Few industry benchmars exist for comparison; Dissimilar business units make analysis difficult; Management may manipulate financial data and ratios; Inflation can reduce comparability of balance sheet items; the choice or change in accounting principles can effect ratios and reduce comparability.

Question 42

How are the current ratio, quick (acid-test) ratio, and cash ratio calculated?

Answer 42

Current ratio = Current assets / Current liabilities. Quick ratio = (Cash and cash equivalents + Marketable securities + Net receivables) / Current liabilities. Cash ratio = (Cash and cash equivalents / Marketable securities) / Current liabilities.

Question 43

How are accounts receivable turnover and inventory turnover calculated?

Answer 43

Accounts receivable turnover = Net credit sales / Average accounts receivable. Inventory turnover = Cost of goods sold / Average inventory. Note: Dividing 365 by the turnover provides a measure of turnover in days.

Question 44

How are the net profit margin and the return on total assets calculated?

Answer 44

Net profit margin = Net income / Net sales. Return on total assets = Net Income / Average total assets.

Question 45

How are earnings per share (EPS) and the price/earnings (P/E) ratio calculated?

Answer 45

EPS = (Net income - Preferred dividends) / Weighted average number of common share outstanding. P/E ratio = Market price per share / Diluted earnings per share.

Question 46

How are the debt/equity ratio, the debt ratio, and times interest earned calculated?

Answer 46

Debt/Equity = Total liabilities / Common stockholder’s equity. Debt ratio = Total liabilities / Total assets. Times interest earned = Earnings before interest and taxes / Interest.