Assessment 3

Question 1

Which of the following statements reflects an auditor’s responsibility for detecting errors and fraud?

An auditor is responsible for detecting employee errors and simple fraud, but not for discovering fraud involving employee collusion or management override.

An auditor should plan the audit to detect errors and fraud that are caused by departures from GAAP.

An auditor is not responsible for detecting errors and fraud unless the application of GAAS would result in such detection.

An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.

Answer 1

An auditor should design the audit to provide reasonable assurance of detecting errors and fraud that are material to the financial statements.

Explanation:

Standards require that an auditor design the audit to provide reasonable assurance of detecting misstatements due to errors and fraud that are material to the financial statements.

Question 2

To obtain an understanding of a continuing client’s business in planning an audit, an auditor most likely would:

perform tests of details of transactions and balances.

review prior-year working papers and the permanent file for the client.

read specialized industry journals.

reevaluate the client’s internal control.

Answer 2

review prior-year working papers and the permanent file for the client.

Explanation:

To obtain an understanding of a continuing client’s business in planning an audit, an auditor most likely would review the prior-year working papers and permanent file.

These records provide a concise, ready source of pertinent matters relating to the client’s business.

Such matters include the organization and operating characteristics of the client, its products, capital structure, related parties, and production, distribution, and compensation methods.

These matters do not generally change dramatically from one year to the next, making the prior-year working papers the best place to begin to obtain an understanding as part of planning the audit.

Other procedures which aid in understanding the client’s business include:

• • inquiring about current business developments affecting the entity,
• • reading the current year’s interim financial statements, and
• • considering the effects of applicable accounting and auditing pronouncements, particularly new ones.

For a new client, reading specialized trade journals would help the auditor obtain an understanding of the industry in which the client operates, e.g., economic conditions, government regulation, changes in technology, and accounting practices and financial trends common in the industry. The auditor has worked with this client before, so reading the industry journals would not be the best use of the auditor’s time in the planning stage.

The client’s internal control is reevaluated (the auditor obtains an understanding of the effectiveness of the internal controls) and tests of details are performed during fieldwork.

Question 3

Which of the following characteristics of prospective financial statements would require the practitioner to include in a report on the prospective financial statements a paragraph that restricts the use and distribution of the report?

They are considered a financial projection.

They are considered a financial forecast.

They contain a range of forecasted results.

They are prepared by a practitioner who lacks independence.

Answer 3

They are considered a financial projection.

Projected, or prospective, financial statements are either financial forecasts or financial projections that include the summaries of significant assumptions and accounting policies.

A financial projection report is restricted in its use and distribution.

A financial forecast report may be generally distributed.

A prospective financial statements report that does not contain a financial projection may be generally distributed.

A general distribution forecast compilation report may be prepared by a practitioner who lacks independence

Question 4

In evaluating the results of audit procedures performed on fair value measurements, the auditor should evaluate:

I. whether fair value measurements and disclosures are in conformity with the applicable financial reporting framework taken in context with the financial statements taken as a whole.

II. the sufficiency and competence of the audit evidence obtained from auditing fair value measurements and disclosure, as well as the consistency of that evidence with other audit evidence obtained and evaluated.

I only

II only

Both I and II

Neither I nor II

Answer 4

Both I and II

Explanation:

The auditor should evaluate the sufficiency and competence of the audit evidence obtained from auditing fair value measurements and disclosures as well as the consistency of that evidence with other audit evidence obtained and evaluated during the audit.

The auditor’s evaluation of whether the fair value measurements and disclosures in the financial statements are in conformity with the applicable financial reporting framework is determined in the context of the financial statements taken as a whole.

Question 5

AU-C 800.07 defines a special purpose framework as all of the following except:

a basis of accounting that the reporting entity uses to comply with the requirements of a governmental regulatory agency to whose jurisdiction the entity is subject.

the cash receipts and disbursements basis of accounting.

a basis of accounting that the reporting entity uses to file its income tax return.

All of the answer choices are included in a special purpose framework.

Answer 5

All of the answer choices are included in a special purpose framework.

Explanation:

A special purpose framework includes the cash, tax, regulatory, and contractual bases of accounting.

• • Cash basis: the cash receipts and disbursements basis of accounting
• • Tax basis: a basis of accounting that the reporting entity uses to file its income tax return
• • Regulatory basis: a basis of accounting that the reporting entity uses to comply with the requirements of a governmental regulatory agency to whose jurisdiction the entity is subject
• • Contractual basis: a basis of accounting that is required by the covenants of the entity’s bank loan

Question 6

Which of the following procedures would be most appropriate for testing the completeness assertion as it applies to inventory?

Scanning perpetual inventory, production, and purchasing records

Examining paid vendor invoices

Tracing inventory items from the tag listing back to the physical inventory quantities

Performing cutoff procedures for shipping and receiving

Answer 6

Performing cutoff procedures for shipping and receiving

Explanation:

The completeness assertion states that every transaction that should have been recorded actually was recorded.

Testing for the completeness assertion is testing to see that the list is not complete, and performing cutoff procedures accomplishes this task.

Scanning records, examining paid invoices, and tracing items from the tag listing back to the physical inventory does not determine if the item has or has not been recorded.

Question 7

A compilation report is always required when financial statements prepared by the accountant are expected to be used by which of the following?

Management only

Third parties only

Management and third parties

A compilation report is only required whenever the accountant is engaged to subject the financial statements to compilation procedures.

Answer 7

A compilation report is only required whenever the accountant is engaged to subject the financial statements to compilation procedures.

Explanation:

AR-C 80.A9 states, “Both management and the accountant have an interest in documenting the terms of the compilation engagement before the commencement of the engagement to help avoid misunderstandings with respect to the engagement.”

Therefore, the compilation report is only required whenever the accountant is engaged to subject the financial statements to compilation procedures.

AR-C 80.08 states, “As a condition for accepting an engagement to perform a compilation with respect to an entity’s financial statements,…the accountant should obtain the agreement of management that it acknowledges and understands its responsibility…to include the accountant’s compilation report in any document containing financial statements that indicates that the entity’s accountant has performed a compilation engagement on such financial statements unless a different understanding is reached.”

When the accountant is engaged to report on compiled financial statements the financial statements should be accompanied by a written report.

The accountant’s objective in reporting on the financial statements is to prevent misinterpretation of the degree of responsibility the accountant is assuming when his or her name is associated with the financial statements.

It is optional for each page of the financial statements compiled by the accountant to include a reference, such as “See accountant’s compilation report” or “See independent accountant’s compilation report.” [AR-C 80.A22]

Question 8

As part of a fraud audit, a CPA wishes to identify employees with invalid Social Security numbers in the client’s payroll-transaction data. Which of the following audit tests of controls using computer-assisted audit techniques would best meet the objective?

Obtaining statistics on the population of the payroll file to identify unusual pay amounts to employees

Comparing Social Security numbers paid in the payroll transaction file to a file of government- authorized Social Security numbers

Randomly selecting 25 payments from the payroll report and comparing the results to employee Social Security cards in the human resources records

Comparing the payroll transaction file to the employee master file to extract payments to employees who are not in the employee master file

Answer 8

Comparing Social Security numbers paid in the payroll transaction file to a file of government- authorized Social Security numbers

Explanation:

When the information is in electronic form, the auditor may carry out certain audit procedures through computer-assisted audit techniques (CAATs). CAATs enable more extensive testing of electronic transactions and large account files, such as comparing Social Security numbers in the payroll transaction file to a government-authorized file. CAATs are often used in the following areas:

– Inspection of records or documents: Consists of examining records or documents, whether internal or external, in paper form, electronic form, or other media

– Inspection of tangible assets: Consists of physical examination of the assets

– Recalculation: Consists of checking the mathematical accuracy of documents or records

– Reperformance: Consists of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data

Question 9

Which of the following is a correct statement regarding the nature and timing of communications between an accounting firm performing an initial audit of an issuer and the issuer’s audit committee?

Prior to accepting the engagement, the firm must orally affirm its independence to the audit committee with all members present.

The firm must address all independence impairment issues on the date of the audit opinion.

Communications related to independence may occur in any form prior to issuance of the financial statements.

Prior to accepting the engagement, the firm should describe in writing all relationships that, as of the date of the communication, may reasonably be thought to bear on independence.

Answer 9

Prior to accepting the engagement, the firm should describe in writing all relationships that, as of the date of the communication, may reasonably be thought to bear on independence.

Explanation:

Prior to accepting an initial engagement pursuant to the standards of the PCAOB, a registered public accounting firm must:

1. describe, in writing, to the audit committee of the issuer, all relationships between the registered public accounting firm or any affiliates of the firm and the potential audit client or persons in financial reporting oversight roles at the potential audit client that, as of the date of the communication, may reasonably be thought to bear on independence;
2. discuss with the audit committee of the issuer the potential effects of the relationships described above in (1) on the independence of the registered public accounting firm, should it be appointed the issuer’s auditor; and
3. document the substance of its discussion with the audit committee of the issuer.

Question 10

The procedure, “The accountant should request written representation from members of management who have appropriate responsibilities for the financial statements..,” is:

required for a review only.

required for both a compilation and review.

not required for a review but required for a compilation.

not required for either a compilation or a review.

Answer 10

The accountant is only required to obtain a management representation letter when performing a review of the financial statements of a nonissuer. This procedure is not required for a compilation, due to the fact that the accountant does not express any assurance in a compilation.

Question 11

The procedure, “The accountant should request written representation from members of management who have appropriate responsibilities for the financial statements..,” is:

required for a review only.

required for both a compilation and review.

not required for a review but required for a compilation.

not required for either a compilation or a review.

Answer 11

required for a review only.

Explanation:

The accountant is only required to obtain a management representation letter when performing a review of the financial statements of a nonissuer.

This procedure is not required for a compilation, due to the fact that the accountant does not express any assurance in a compilation.

Question 12

INTERNAL AUDIT FUNCTION:

Which of the following internal control procedures most likely would justify a reduced assessed level of control risk concerning property, plant, and equipment acquisitions?

Periodic physical inspection of property, plant, and equipment by the internal audit staff

Comparison of current-year property, plant, and equipment account balances with prior-year actual balances

The review of prenumbered purchase orders to detect unrecorded trade-ins

Approval of periodic depreciation entries by a supervisor independent of the accounting department

Answer 12

Periodic physical inspection of property, plant, and equipment by the internal audit staff

Explanation:

An entity’s internal audit function is likely to be relevant to the audit if the nature of the internal audit function’s responsibilities and activities are related to the entity’s financial reporting, and the auditor expects to use the work of the internal auditors to modify the nature or timing or reduce the extent of audit procedures to be performed.

In this situation, the internal audit function is related to the entity’s financial reporting process as it relates to a specific asset account. Therefore, the auditor could reduce the extent of audit procedures to be performed by the internal audit staff performing period physical inspections.

Comparison of account balances with prior-year balances could result in additional testing and a higher risk assessment if there are significant differences from expectations. Risk would only be reduced if results matched expectations.

Depreciation has little to do with asset acquisitions, nor does reviewing prenumbered purchase orders to detect unrecorded trade-ins.

Question 13

INTERNAL CONTROL:

Misstatements in a batch computer system caused by incorrect programs or data may not be detected immediately because:

errors in some transactions may cause rejection of other transactions in the batch.

the identification of errors in input data typically is not part of the program.

there are time delays in processing transactions in a batch system.

the processing of transactions in a batch system is not uniform.

Answer 13

there are time delays in processing transactions in a batch system.

Explanation:

Some of the specific risks that IT poses to an entity’s internal control include the following:

– Unauthorized access to data that may result in destruction of data or improper changes to data

– The possibility of IT personnel gaining access privileges beyond those necessary to perform their assigned duties

– Unauthorized changes to data in master files

– Unauthorized changes to systems or programs

– Failure to make necessary changes to systems or programs

– Potential loss of data or inability to access data as required

– Time delays in the processing of transactions is a specific risk that IT poses as noted in the potential loss of data or inability to access data as required.

Question 14

INTERNAL CONTROL: ERRORS AND FRAUD

Field, CPA, is auditing the financial statements of Miller Mailorder, Inc., (MMI) for the year ended January 31, 20X1. Field has compiled a list of possible errors and fraud that may result in the misstatement of MMI’s financial statements, and a corresponding list of internal controls that, if properly designed and implemented, could assist MMI in preventing or detecting the errors and fraud. Select the internal control that most likely could assist MMI in preventing invoices from being sent to allies in a fraudulent scheme, and sales from being recorded for fictitious transactions.

Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed.

Shipping documents are compared with sales invoices when goods are shipped.

Shipping clerks compare goods received from the warehouse with approved sales orders.

Approved sales orders are required for goods to be released from the warehouse.

Answer 14

Sales invoices are compared with shipping documents and approved customer orders before invoices are mailed.

Explanation:

Comparing sales invoices with shipping documents and approved customer orders before invoices are mailed is the best control in preventing invoices from being sent to allies in a fraudulent scheme, and sales from being recorded for fictitious transactions.

Fraudulent sales would not appear with the approved customer orders, but they would have a sales invoice and possibly a shipping document (depending on the scheme).

Fictitious sales may have an invoice, but they would not have a shipping document.

Comparing these three documents would highlight discrepancies and alert management to the sales schemes. This procedure is an example of authorization and documentation being used as a control.

Question 15

APPLICATION CONTROLS/GENERAL IT CONTROLS:

Application controls are classified as all of the following except:

process change controls.

process controls.

input controls.

output controls.

Answer 15

process change controls.

Explanation:

Application controls are classified as follows:

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

Question 16

INTERNAL CONTROL/RISK ASSESSMENT:

In order to obtain an initial understanding of internal control sufficient to assess the risk of material misstatement of the financial statements, an auditor would most likely perform which of the following procedures?

Tests of key controls to determine whether they are effective

Expanded substantive testing to identify relevant controls

Analytical procedures to determine the need for specific controls

Risk assessment procedures to evaluate the design of relevant controls

Answer 16

Risk assessment procedures to evaluate the design of relevant controls

Explanation:

The auditor should obtain an understanding of internal control relevant to the audit.

In obtaining such an understanding, the auditor should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel.

Question 17

SERVICE ORGANIZATION:

Payroll Data Co. (PDC) processes payroll transactions for a retailer. Cook, CPA, is engaged to express an opinion on management’s description of PDC’s system and suitability of the design of controls. PDC’s system is relevant to the retailer’s internal control, so Cook’s report may be useful in providing the retailer’s independent auditor with information necessary to plan a financial statement audit. Cook’s report should:

contain a disclaimer of opinion on the operating effectiveness of PDC’s controls.

identify the controls that were tested to obtain reasonable assurance that PDC’s controls were operating effectively.

identify PDC’s controls relevant to specific financial statement assertions.

disclose Cook’s assessed level of control risk for PDC.

Answer 17

contain a disclaimer of opinion on the operating effectiveness of PDC’s controls.

Explanation:

There are two types of reports that a service organization, in this case PDC, may request from its auditor (“service auditor”):

Type 1) a report on management’s description of a service organization’s system and the suitability of the design of controls (also referred to as a type 1 report) and

Type 2) a report on management’s description of a service organization’s system and the suitability of the design and operating effectiveness of controls (also referred to as a type 2 report).

Cook’s report is only a description of PDC’s system and the suitability of the design of controls and therefore he must disclaim an opinion on the operating effectiveness of PDC’s controls.

He did not test whether the controls were operating with sufficient effectiveness to provide reasonable assurance that the related control objectives were achieved during the period under audit.

Question 18

VALUATION AND ALLOCATION ASSERTION:

An auditor tests an entity’s policy of obtaining credit approval before shipping goods to customers in support of management’s financial statement assertion of:

valuation and allocation.

completeness.

existence.

rights and obligations.

Answer 18

valuation and allocation.

Explanation:

Financial statement assertions can be classified according to the following broad categories:

Occurrence
Completeness
Accuracy
Cutoff
Classification
Existence
Rights and obligations
Completeness
Valuation and allocation

Obtaining credit approval before shipping goods to customers supports management’s financial statement assertion of valuation. Specifically, the collectibility of accounts receivable is more likely, thus the valuation of accounts receivable is proper.

Question 19

SCOPE LIMITATION => QUALIFIED OPINION/DISCLAIMER OF OPINION

Which of the following would cause an auditor of an entity’s financial statements to issue either a qualified opinion or a disclaimer of opinion?

Scope limitation involving a recorded uncertainty

Inadequate disclosure of an uncertainty

The use of inappropriate accounting principles

Unreasonable accounting estimates

Answer 19

Scope limitation involving a recorded uncertainty

Explanation:

A scope limitation involving a recorded uncertainty would cause an auditor of an entity’s financial statements to issue either a qualified opinion or a disclaimer.

A scope limitation is an audit constraint brought on by management or other issues that do not let the auditor complete the audit.

Since the auditor was unable to complete the audit, the auditor did not obtain all of the sufficient appropriate audit evidence, and the financial statements will have a qualified or disclaimer of opinion.

The auditor should express a qualified or an adverse opinion in the following situations: the auditor concludes that a matter involving a risk or an uncertainty is not adequately disclosed in the financial statements, the accounting principles used cause the financial statements to be materially misstated, or management’s estimate is unreasonable and its effect is to cause the financial statements to be materially misstated.

Question 20

EXAMINATION ENGAGEMENT: REPORTING ON PRO FORMA INFORMATION

An accountant has been engaged to examine pro forma adjustments that show the effects on previously audited historical financial statements due to a proposed disposition of a significant portion of an entity’s business. Other than the procedures previously applied to the historical financial statements, the accountant is required to:

reevaluate the entity’s internal control over financial reporting.
determine that the computations of the pro forma adjustments are mathematically correct.

Both I and II

I only

II only

Neither I nor II

Answer 20

II only

Explanation:

Pro forma financial statements show what the significant effects on historical financial information might have been had a consummated or proposed transaction (or event) occurred at an earlier date.

The auditor must apply the following procedures when performing an examination of pro forma financial statements:

• • Obtain an understanding of the underlying transaction or event
• • Obtain knowledge regarding each constituent of a combined entity in a business combination
• • Discuss with management their assumptions regarding the transaction or event
• • Evaluate whether adjustments are included for all the effects of the transaction or event
• • Obtain sufficient evidence in support of the adjustments (such as contracts, agreements, and decisions by the board of directors)
• • Evaluate whether management has clearly and comprehensively presented their assumptions and if the adjustments are consistent with the data used to develop them
• • Determine that computations of pro forma adjustments are mathematically correct and that the adjustments have been properly applied to the historical financial statements
• • Obtain written representation from management

The CPA is not required to reevaluate the entity’s internal control over financial reporting.

Question 21

How would increases in tolerable misstatement and assessed level of control risk affect the sample size in a substantive test of details?

Increases in tolerable misstatement and assessed level of control risk would increase the sample size.

An increase in tolerable misstatement would increase the sample size; an increase in assessed level of control risk would decrease the sample size.

An increase in tolerable misstatement would decrease the sample size; an increase in assessed level of control risk would increase the sample size.

Increases in tolerable misstatement and assessed level of control risk would decrease the sample size.

Answer 21

An increase in tolerable misstatement would decrease the sample size; an increase in assessed level of control risk would increase the sample size.

Explanation:

Tolerable error or the tolerable misstatement is the maximum monetary error in the related account balance or class of transactions that may exist without causing the financial statements to be materially misstated.

The tolerable error is a planning concept and is related to the auditor’s preliminary estimates of materiality.

The higher the auditor sets the tolerable error, the smaller the sample size the auditor will require.

Assessing control risk is the process of evaluating the effectiveness of an entity’s internal controls in preventing or detecting material misstatements in the financial statements.

The less an auditor can depend on internal control in preventing or detecting material misstatements in the financial statements (increasing the assessed level of control risk), the larger the sample size the auditor will require.

AICPA Audit Guide: Audit Sampling (2012), Table 4.4

Question 22

In auditing accounts receivable, the negative form of confirmation request most likely would be used when:

the total recorded amount of accounts receivable is immaterial to the financial statements taken as a whole.

response rates to properly designed positive confirmation requests were inadequate in prior years.

recipients are likely to return positive confirmation requests without verifying the accuracy of the information.

the combined assessed level of inherent risk and control risk relative to accounts receivable is low.

Answer 22

the combined assessed level of inherent risk and control risk relative to accounts receivable is low.

Explanation:

The purpose of a confirmation is to help the auditor verify client financial statement assertions.

Confirmation requests can be prepared in two ways. With a positive confirmation, third parties are either asked to fill in amounts from their records regarding transactions with the audit client, or requested to indicate whether they agree with information already stated in the confirmation.

The positive type of confirmation is a very strong form of audit evidence. With a negative confirmation, the third party usually responds only when the information provided by the auditor from the client’s records does not agree with the third party’s records.

Negative confirmations are considered to be a weak form of evidence. Therefore, the answer, “The combined assessed level of inherent risk and control risk relative to accounts receivable is low,” is correct; the auditor is not relying heavily on the negative confirmation evidence due to the low levels of inherent risk and control risk already measured in the audit process.

Question 23

Which of the following matters most likely would be included in a management representation letter?

An assessment of the risk factors concerning the misappropriation of assets

An evaluation of the litigation that has been filed against the entity

A confirmation that the entity has complied with contractual agreements

A statement that all material internal control weaknesses have been corrected

Answer 23

A confirmation that the entity has complied with contractual agreements

Explanation:

Management must make certain representations to the auditor regarding the financial statements; the completeness of information provided to the auditor; recognition, measurement, and disclosure; and information concerning subsequent events. The auditor would be looking for management to represent that the entity has complied with contractual agreements that may affect the financial statements.

The other three answer choices would not be included in a management representation letter.