CPAExcl 4-Audit Evidence

Question 1

What is the only component of the audit risk model that the auditor controls?

Answer 1

Detection risk.

Question 2

List the 2 broad categories of substantive procedures.

Answer 2

1. Tests of details

2. Substantive analytical procedures.

Question 3

How might the auditor’s decisions about the extent of audit procedures lower detection risk?

Answer 3

Increasing the sample sizes for audit testing will lower detection risk.

Question 4

Define analytical procedures.

Answer 4

Evaluations of financial information through analysis of plausible relationships among both financial and non-financial data.

Question 5

Identify the 2 categories of substantive tests of details.

Answer 5

1. Tests of Ending Balances

2. Tests of Transactions

Question 6

Identify the 4 considerations that determine the effectiveness and efficiency of analytical procedures used for substantive purposes.

Answer 6

1. Nature of the assertion;
2. Plausibility and predictability of the relationship;
3. Availability and reliability of data; and
4. Precision of the expectation

Question 7

How might the auditor’s decisions about the timing of audit procedures lower detection risk?

Answer 7

Moving the auditor’s important substantive procedures away from an interim date (before year-end) to year-end will lower detection risk.

Question 8

How might the auditor’s decisions about the nature of audit procedures lower detection risk?

Answer 8

Choosing audit procedures that provide a stronger basis for conclusions will lower detection risk.

Question 9

Identify the 3 purposes that might be served by performing analytical procedures.

Answer 9

1. Audit planning (required).
2. As a form of substantive evidence (not required).
3. A final review (required)

Question 10

List the five assertions about classes of transactions and events during the period (income statement).

Answer 10

1. Accuracy;
2. Occurrence;
3. Completeness;
4. Cutoff; and
5. Classification

Question 11

Describe what the valuation or allocation assertion means.

Answer 11

It means that the dollar amounts attributed to the elements of the company’s financial statements are appropriate and in accordance with GAAP (or other applicable financial reporting framework).

Question 12

What are the AICPA’s guidelines to rank the reliability of audit evidence?

Answer 12

1. Direct personal knowledge by the auditor is the most reliable audit evidence.
2. Evidence obtained from an independent outside source is the next most reliable.
3. Evidence obtained from the entity under effective internal control is next.
4. Documentary evidence is more reliable than verbal responses to inquiries (and original documents are more reliable than faxes and photocopies).

Question 13

Describe what the rights and obligations assertion means.

Answer 13

It means that the company has all the rights associated with its reported assets and all the obligations associated with its reported liabilities; any limitations on such rights or obligations must be appropriately disclosed.

Question 14

Describe what the completeness assertion means.

Answer 14

It means that there are no omissions of transactions that should have been reported.

Question 15

What is meant by “sufficient” and “appropriate” when “Sufficient Appropriate Audit Evidence” is mentioned?

Answer 15

1. “Sufficient” refers to the quantity of evidence that is required; and
2. “Appropriate” refers to the quality of the evidence involved, in terms of “relevance” and “reliability.”

Question 16

Define audit evidence.

Answer 16

All the information used by the auditor in arriving at the conclusions on which the audit opinion is based. Audit evidence includes the information contained in the accounting records underlying the financial statements and other information.

Question 17

Describe what the existence (occurrence) assertion means.

Answer 17

It means that the recorded transactions are valid economic events of the period in which they are reported, i.e., the recorded transactions/items are properly recorded.

Question 18

List the three broad categories of assertions under AICPA professional standards.

Answer 18

1. Account balances at the end of the period (there are 4 assertions related to the balance sheet);
2. Classes of transactions and events during the period (there are 5 assertions related to the income statement);
3. Presentation and disclosure (there are 4 assertions related to the footnotes applicable to any of the financial statements).

Question 19

Define assertion.

Answer 19

Implicit or explicit statements of fact by management that are associated with the entity’s financial statements.

Question 20

List the four assertions about account balances at the end of the period (balance sheet).

Answer 20

Existence;
Completeness;
Rights and obligations; and
Valuation and allocation

Question 21

List the four assertions about presentation and disclosure (footnotes).

Answer 21

1. Occurrence and Rights and Obligations;
2. Completeness;
3. Classification and Understandability; and
4. Accuracy and valuation

Question 22

List the three categories of audit procedures.

Answer 22

1. Risk assessment procedures;
2. Tests of control; and
3. Substantive procedures

Question 23

What are risk assessment procedures?

Answer 23

Procedures performed to obtain an understanding of the entity and its environment, including internal control, to assess the risk of material misstatement, whether due to fraud or error.

Question 24

What are tests of control?

Answer 24

Procedures performed to obtain information about the operating effectiveness of controls in preventing or detecting and correcting material misstatements at the relevant assertion level.

Question 25

What are substantive procedures?

Answer 25

Procedures performed to detect material misstatements at the relevant assertion level; these consist of tests of details and substantive analytical procedures.

Question 26

What is meant by the term projected misstatements?

Answer 26

The auditor’s best estimate of misstatements in populations suggested by audit sampling. (The AICPA formerly used the term likely error for this concept.)

Question 27

What matters must be documented by the auditor in connection with the evaluation of misstatements?

Answer 27

1. The threshold for determining what is viewed as clearly trivial.
2. All misstatements accumulated during the audit (and whether they have been corrected).
3. The auditor’s conclusion as to whether any uncorrected misstatements are material (individually or in the aggregate), and the basis for that conclusion.

Question 28

What is meant by the term judgmental misstatements?

Answer 28

Differences arising from the judgments of management that the auditor considers unreasonable; or the selection of accounting policies deemed inappropriate.

Question 29

Define misstatement.

Answer 29

A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and that which is required for the item to be in accordance with the applicable reporting framework.

Question 30

Describe the auditor’s responsibility to accumulate misstatements identified during the audit.

Answer 30

The auditor should accumulate identified misstatements, except for those that are clearly trivial. (Clearly trivial means clearly inconsequential.)

Question 31

What is meant by the term factual misstatements?

Answer 31

Misstatements for which there is no doubt.

Question 32

What is contained in the permanent file of the audit documentation?

Answer 32

The permanent file contains documentation of matters having ongoing audit significance.

Question 33

Define report release date.

Answer 33

The date the auditor grants the entity permission to use the auditor’s report; (that date must be documented).

Question 34

List 3 purposes of audit documentation.

Answer 34

1. Provides the principal support for the auditor’s report
2. Documents the auditor’s compliance with GAAS
3. Assists in controlling the audit engagement

Question 35

What is meant by the term documentation completion date under the AICPA and PCAOB standards, respectively.

Answer 35

Under AICPA standards (applicable to audits of “non-issuers”) - The auditor should complete the assembly of the final audit file no later than 60 days after the “report release date.”
Under PCAOB standards (applicable to audits of “issuers”) - The auditor should complete the assembly of the final audit file no later than 45 days after the “report release date.”

Question 36

What changes can the auditor make to the audit documentation after the documentation completion date?

Answer 36

The auditor must not delete audit documentation before the end of the retention period;
The auditor may add to the documentation but must document any materials added, by whom, when, the reasons for the change, and the effect on the auditor’s conclusions

Question 37

What are the audit documentation retention requirements under the AICPA and PCAOB standards, respectively.

Answer 37

Under AICPA standards (applicable to audits of “non-issuers”) - The audit documentation should be retained for at least 5 years from the report release date.
Under PCAOB standards (applicable to audits of “issuers”) - The audit documentation should be retained for at least 7 years from the report release date

Question 38

When might negative confirmations be justified?

Answer 38

1. The financial statement item involves a large number of small (immaterial) accounts;
2. Control risk is low (that is, internal control is viewed as effective);
3. Recipients are expected to pay attention to the request

Question 39

List 2 alternative procedures for a nonresponse to a positive confirmation (usually performed after a second request was sent, but no response was received).

Answer 39

First - verify subsequent cash receipts; or

Second - Examine underlying documents for apparent validity

Question 40

What is meant by the term positive confirmation?

Answer 40

A response is requested whether or not the confirming party agrees with the entity’s recorded amount. A non-response indicates a “loose end” that must be resolved.

Question 41

List the 2 general types of confirmations.

Answer 41

Positive;

Negative

Question 42

What is meant by the term negative confirmation?

Answer 42

A response is only requested in the event the confirming party disagrees with the identified balance. A non-response is viewed as indicating that party’s agreement.

Question 43

Identify 3 factors affecting the nature of estimation uncertainty.

Answer 43

The nature of estimation uncertainty varies with:

1. The nature of the accounting estimate;
2. The extent to which there is an accepted method (or model) to be used; and
3. The subjectivity of any assumptions or the degree of judgment involved.

Question 44

What further substantive procedures should the auditor perform in responding to significant risks?

Answer 44

The auditor should evaluate: (1) how management addressed estimation uncertainty in making the estimate; (2) whether management’s significant assumptions are reasonable; and (3) whether management has the intent and ability to carry out specific actions, as relevant.

Question 45

What is the auditor’s basic responsibility when auditing accounting estimates?

Answer 45

Evaluate the reasonableness (and the adequacy of related disclosures) of any significant accounting estimates relative to GAAP or other applicable financial reporting framework.

Question 46

What is meant by the term estimation uncertainty?

Answer 46

The susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement. (The risks of material misstatement increase when there is high estimation uncertainty.)

Question 47

What matters should the auditor document in connection with accounting estimates?

Answer 47

1. The basis for the auditor’s conclusions about the reasonableness of accounting estimates resulting in significant risks and their disclosure; and
2. Any indications of possible management bias.

Question 48

List some audit procedures that might be used to assess accounting estimates.

Answer 48

1. Inquire of management to understand how the estimate was developed;
2. Review and test management processes;
3. Develop an independent expectation for comparison to the entity’s estimate;
4. Review subsequent events for additional evidence.

Question 49

What is meant by the term observable inputs?

Answer 49

Assumptions that market participants would use in pricing an asset or liability based on market data from sources independent of the reporting entity.

Question 50

What is the auditor’s basic responsibility regarding Fair Value Measurement and Disclosures?

Answer 50

The auditor must obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures comply with GAAP. The auditor should also determine that the methods used to determine fair value are consistently and appropriately applied.

Question 51

Define “fair value.”

Answer 51

The amount at which the asset could be bought or sold in a current transaction between willing parties, that is, other than in a forced or liquidation sale.

Question 52

What is meant by the term unobservable inputs?

Answer 52

An entity’s own judgments about what assumptions market participants would use. (Estimation uncertainty increases when the fair value estimates are based on unobservable inputs instead of observable inputs.)

Question 53

What is the best evidence of fair value?

Answer 53

Published price quotations in an active market.

Question 54

What is meant by the term asserted claim?

Answer 54

Also referred to as “pending or threatened litigation” - a claim that has already been filed (pending) or when the other party has announced an intention to sue (threatened).

Question 55

What is the lawyer’s responsibility for communicating omissions of asserted and unasserted claims that should have been included in the letter of inquiry?

Answer 55

Regarding asserted claims - the lawyer’s letter should inform the auditor directly of such an omission from the letter of inquiry;
Regarding unasserted claims - the lawyer should inform management of such an omission and encourage management to discuss the matter with the auditor (but the lawyer will not inform the auditor directly)

Question 56

What is the auditor’s purpose in obtaining a lawyer’s letter?

Answer 56

To corroborate management’s responses to the auditor’s inquiries about litigation-related issues.

Question 57

List the three matters the lawyer’s letter should address regarding “Unasserted” claims.

Answer 57

1. The nature of the litigation;
2. How management intends to respond if the claim is asserted; and
3. An evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss

Question 58

What is meant by the term unasserted claims?

Answer 58

Audited entity has exposure to litigation but no one has yet filed a law suit or announced an intention to sue.

Question 59

Under what circumstances might an auditor NOT be required to obtain a letter from the entity’s legal counsel?

Answer 59

If the entity had no litigation, claims, or assessments having financial reporting relevance and, accordingly, did not engage legal counsel. (In such a case, the management representations letter would include a statement to that effect.)

Question 60

What is the effect of a limitation in the lawyer’s response to the letter of inquiry on the audit report?

Answer 60

This would be considered a scope limitation sufficient to prevent an unqualified opinion and likely resulting in a disclaimer of opinion.

Question 61

List the two types of letters involved in the communication with the entity’s lawyers.

Answer 61

1. Letter of inquiry - management’s letter to the entity’s lawyer(s) (as requested by the auditor) asking the lawyer to provide litigation-related information directly to the auditor;
2. Lawyer’s letter - the lawyer’s response directly to the auditor.

Question 62

List the 4 matters the lawyer’s letter should address regarding “Asserted” claims.

Answer 62

1. The nature of the litigation;
2. The progress of the case to date;
3. How management is responding or intends to respond to the litigation; and
4. An evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amount or range of potential loss.

Question 63

What are the 2 basic categories of issues usually addressed by the management representations letter under the AICPA’s clarified auditing standards?

Answer 63

1. Financial statements; and

2. Information provided.

Question 64

When should the management representations letter be dated?

Answer 64

It should have the same date as the auditor’s report.

Question 65

What would be the effect on an audit opinion of management’s unwillingness to sign the management representations letter?

Answer 65

This would be considered a scope limitation; probably resulting in disclaimer or withdrawal.

Question 66

What periods should be covered in the management representations letters?

Answer 66

All periods included in audit report.

Question 67

What is the purpose of obtaining the required management representations letter?

Answer 67

To document in writing the essence of management’s verbal responses to the auditor’s important verbal inquiries.

Question 68

List the members of management who are responsible for signing the management representations letter.

Answer 68

The Chief Executive Officer (CEO) and Chief Financial Officer (CFO).

Question 69

List audit procedures used to identify the existence of related parties.

Answer 69

1. Inquire of management as to the existence of related entities;
2. Review prior year’s audit documentation;
3. Review any applicable SEC filings (for a public company);
4. Inquire of predecessor auditors if applicable;
5. Review stockholder listings of closely held companies to identify major stockholders.

Question 70

What is meant by the term arm’s length transaction?

Answer 70

A transaction conducted on such terms and conditions between a willing buyer and a willing seller who are unrelated and are acting independently of each other and pursuing their own best interests.

Question 71

What is the primary focus of the auditor regarding an entity’s transactions with related parties?

Answer 71

Evaluating the adequacy of disclosure about the related party transactions.

Question 72

Identify 3 responsibilities of the auditor when related party transactions have been identified.

Answer 72

1. Obtain an understanding of the business purpose of the related party transaction;
2. Determine if the related party transaction was authorized by board of directors (those charged with governance);
3. Evaluate the adequacy of the disclosures of the related party transactions.

Question 73

What is meant by the term related party?

Answer 73

One party that controls or can significantly influence the management or operating policies of another party.

Question 74

List 3 audit procedures that an auditor might use to identify an entity’s transactions with a related party.

Answer 74

1. Review minutes of board of directors’ meetings (those charged with governance) for activities with related parties;
2. Inquire of management as to such transactions; and
3. Examine underlying documents for unusual or large transactions or transactions with terms or conditions that are inconsistent with prevailing market conditions.

Question 75

What is meant by the term dual dating the auditor’s report?

Answer 75

The auditor uses one date for the overall audit report, but specifies a later date to address a particular subsequent event. The later date is limited to the specific subsequent event, and does not imply responsibility for other matters beyond the basic date of the report.

Question 76

If management revised the financial statements because of subsequently discovered facts that became known to the auditor after the report release date, what should the auditor do?

Answer 76

1. The auditor should perform appropriate audit procedures on the revision.
2. The auditor should assess whether management’s actions are appropriate and timely to inform users about previously issued (erroneous) financial statements.
3. If the resulting opinion differs from that previously expressed, add an other-matter paragraph to the auditor’s report to comment on that change of opinion.

Question 77

What procedures should the predecessor auditor perform when reissuing an audit report?

Answer 77

1. Read the subsequent financial statements and compare to those previously audited.
2. Make inquiries of management and obtain written representations from management about issues affecting the previous representations obtained from management.
3. Obtain a representations letter from the successor auditor about known relevant matters.

Question 78

When would a subsequent event require disclosure in (but not adjustment of) the financial statements?

Answer 78

When material events or circumstances arise after the balance sheet date.

Question 79

When is the auditor’s report normally dated?

Answer 79

When the auditor has obtained sufficient appropriate audit evidence as a reasonable basis for the opinion. (The date of the auditor’s report cannot precede the completion of fieldwork and may be later than that.)

Question 80

What should the auditor do when subsequently discovered facts become known to the auditor (either before or after the report release date)?

Answer 80

Discuss the matter with management (and possibly those charged with governance) and determine whether the financial statements require revision. If so, inquire how management will deal with the matter.

Question 81

List 4 audit procedures the auditor might perform to identify subsequent events.

Answer 81

1. Inquiry of management;
2. Review minutes of board meetings (or those charged with governance);
3. Review the lawyers’ letters in response to the letter(s) of inquiry; and;
4. Scan the accounting records subsequent to year end for unusual activities

Question 82

What is meant by the term subsequent events?

Answer 82

Events or transactions that occur after the balance sheet date up to the date of the auditor’s report which have a material effect on the financial statements and, therefore, require either financial statement adjustment or disclosure.

Question 83

When would a subsequent event require adjustment of the financial statements?

Answer 83

When material events or circumstances clarify (that is, provide better information about) circumstances already in effect as of the balance sheet date.

Question 84

What period of time defines a subsequent event?

Answer 84

The period after the balance sheet date up to the date of the auditor’s report.

Question 85

What is meant by the term mitigating factors when the auditor is evaluating an entity’s going concern issues?

Answer 85

Those aspects of management’s strategy that might be expected to improve the entity’s cash flows (that is, generate cash inflows or reduce cash outflows).

Question 86

When the auditor has substantial doubt about an entity’s ability to continue as a going concern, what further evidence-gathering responsibilities does the auditor have?

Answer 86

1. Inquire about management’s strategy to overcome the entity’s financial difficulties; and
2. Evaluate the feasibility of the “key” elements of management’s plans with emphasis on “mitigating factors.”

Question 87

What communication is required with those charged with governance when there is “substantial doubt regarding an entity’s ability to continue as a going concern”?

Answer 87

1. Nature of conditions identified;
2. The possible effect on financial statements and disclosures; and
3. The effect on the auditor’s report.

Question 88

Describe the auditor’s reporting responsibilities when the auditor has substantial doubt about an entity’s ability to continue as a going concern.

Answer 88

1. Consider the adequacy of disclosure about these issues relative to GAAP or other applicable financial reporting framework (is there a misstatement?); and
2. If the financial statements (including disclosure) are consistent with the requirements of the applicable framework, the auditor should add an emphasis-of-matter paragraph after the unmodified opinion.

Question 89

What is meant by the term reasonable period of time when the auditor is assessing an entity’s going concern issues?

Answer 89

A period of time not to exceed one year beyond the date of the financial statements being audited.

Question 90

List some indicators that might suggest to an auditor substantial doubt about the entity’s ability to continue as a going concern.

Answer 90

1. Negative trends (recurring losses, negative cash flows from operating activities, etc.);
2. Internal matters (labor problems, dependence on a single project or customer);
3. External matters (litigation, general decline in the economy or industry, etc.); and
4. Other indicators (defaults on debt, violations of debt covenants, etc.).

Question 91

List routine audit procedures that should identify whether there is “substantial doubt about an entity’s ability to continue as a going concern.”

Answer 91

1. Analytical procedures;
2. Review for subsequent events;
3. Review loan agreements for compliance with restrictive debt covenants;
4. Read minutes of meetings of the board or those charged with governance;
5. Inquire of management about legal liability issues and obtain lawyers’ letters.

Question 92

Identify the 4 assertions for account balances at the end of the period.

Answer 92

1. Existence;
2. Completeness;
3. Rights and obligations; and
4. Valuation and allocation.

Question 93

Identify several substantive procedures usually performed in every audit area.

Answer 93

Agree financial statement elements, or trial balance from which financial statement elements are derived, to underlying accounting records (general ledger);
Scan the entity’s journals and ledgers for any “unusual” items;
Make inquiries of management and other personnel; document inquiries and management’s responses in the management representations letter; and
Perform specific analytical procedures - consider historical trends and events within the industry

Question 94

What is the schedule of interbank transfers used for?

Answer 94

It is used to verify that transfers between the entity’s bank accounts are recorded properly (and to detect kiting, which overstates the cash balance).

Question 95

What is the purpose of a bank confirmation?

Answer 95

1. It verifies the existence and ownership of bank accounts; and
2. It also provides evidence about the completeness and terms of notes payable with bank.

Question 96

What is meant by the term kiting?

Answer 96

An overstatement of the true cash balance at year-end caused by recording the receipt, while failing to record the disbursement, associated with a transfer between the entity’s cash accounts.

Question 97

List some typical audit procedures applicable to cash accounts.

Answer 97

1. Review and test the entity’s bank reconciliations;
2. Prepare and test a schedule of interbank transfers if there are multiple bank accounts with transfers among them;
3. Prepare proof of cash if fraud is suspected;
4. May count petty cash, but usually do not due to its immateriality;
5. Inquire about minimum balance requirements on bank accounts.

Question 98

What is meant by the term cutoff bank statement?

Answer 98

Short period bank statement obtained directly from the bank (normally for a 10-day period) useful in verifying the deposits in transit and providing some (usually partial) evidence about outstanding checks on a bank reconciliation.

Question 99

What does the proof of cash compare?

Answer 99

Compares the beginning balance per the bank plus deposits minus checks clearing the bank versus the beginning balance per the books plus receipts minus disbursements according to the books.

Question 100

Describe how the auditor performs the “cutoff test” for sales.

Answer 100

Examine the last few transactions before year-end and the first few after year-end. Agree the entries on the sales journal to the shipping documents (existence); and agree the shipping documents to the sales journal (completeness).

Question 101

Identify 2 audit procedures that address the rights and obligations assertion for accounts receivable.

Answer 101

1. Inquire about receivables pledged as collateral.

2. Read the debt agreements for any discussion of collateral.

Question 102

Identify several audit procedures that address the existence assertion for accounts receivable.

Answer 102

1. Verify subsidiary ledger agrees with the general ledger control account
2. Confirm individually material accounts and selected others.
3. Investigate exceptions (disputed balances) from confirmations
4. Complete alternate procedures for nonresponses to positive confirmations.

Question 103

What is meant by the term lapping related to accounts receivable?

Answer 103

An attempt to cover up a theft of receipts, where a clerk might apply a different customer’s payment to a prior customer’s account (whose payment was stolen) to conceal the theft.

Question 104

What is the main audit procedure that addresses the completeness assertion for accounts receivable?

Answer 104

Perform cutoff test of sales to verify that sales transactions are recorded in the proper period. Sales transactions may be recorded prematurely, violating the existence assertion, or recorded belatedly, which violates the completeness assertion.

Question 105

Identify several audit procedures that address the valuation assertion for accounts receivable.

Answer 105

1. Review the aged trial balance (and test its accuracy).
2. Inquire about individually large, delinquent items.
3. Estimate uncollectible accounts based on time outstanding (that is, based on each category of age).
4. Review receiving documents after year-end for sales returns.

Question 106

Describe the basic steps associated with the auditor’s participation in an entity’s physical count of inventory.

Answer 106

1. Review and evaluate the entity’s written counting procedures.
2. Perform test counts for selected count tags to compare to client counts.
3. Determine that all inventory tags are properly accounted for
4. Be alert for and inquire about any obsolete or damaged items.

Question 107

Describe how the auditor might address the existence assertion of for inventory in the entity’s possession.

Answer 107

Participate in the client’s count of inventory and perform test counts of selected inventory tags to verify the accuracy of the entity’s counts. (Select a sample of items on the entity’s inventory listing and agree them to the auditor’s test counts.)

Question 108

How might the auditor address the rights and obligations assertion for inventory?

Answer 108

Inquire of management about any inventory held on consignment or pledged as collateral. The auditor might also read the entity’s debt agreements for any discussion of collateral, such as inventory.

Question 109

Identify a few audit procedures that might address the valuation assertion for inventory.

Answer 109

1. Perform price tests (to evaluate the appropriateness of the inventory’s cost/unit - e.g., agree unit costs to a recent supplier’s invoice).
2. Test the extensions (quantity times cost/unit) and foot the total.
3. Perform lower of cost or market analysis. Might calculate the inventory turnover ratio to identify slow-moving inventory.

Question 110

Describe how the auditor might address the completeness assertion for inventory.

Answer 110

1. Test sales cut-off (regarding cost of goods sold, decreases to inventory)
2. Test purchases cut-off (regarding purchases of inventory).

Question 111

What is meant by the term derivative?

Answer 111

A derivative is a financial instrument or other contract whose value is derived (hence, the name derivative) from its relationship to something else known as the underlying. The underlying can be another financial instrument, a physical commodity, currency, etc.

Question 112

What is the auditor’s basic responsibility if estimates of fair value for financial instruments are based on management’s valuation model?

Answer 112

The auditor should obtain sufficient appropriate audit evidence about the fair value based on that model.

Question 113

What else should the auditor do if estimates of fair value for financial instruments are obtained from third-party sources (such as broker-dealers)?

Answer 113

The auditor should obtain an understanding of the methods they used.

Question 114

What is usually considered to be the best evidence of fair value for a financial instrument that is measured at fair value?

Answer 114

Quoted market prices obtained from financial publications, national exchanges, or NASDAQ.

Question 115

What audit procedures might an auditor perform to evaluate an investment in securities that is based on cost?

Answer 115

The auditor might inspect the documentation of the purchase price, confirm the existence of the security with the appropriate outside parties, and test the amortization of any premium or discount.

Question 116

What audit procedures might an auditor perform to evaluate an investment in securities that is based on the investee’s financial results?

Answer 116

The auditor would normally read the audited financial statements of the investee.

Question 117

What considerations might be helpful to the auditor in determining whether a decline in fair value for a financial instrument is other than temporary?

Answer 117

1. How much (and how long) the fair value is below the carrying value.
2. Whether the financial condition of the issuer has deteriorated.
3. Whether a rating agency has downgraded the security.
4. Whether dividends have been reduced or eliminated (or interest payments not made).
5. Whether the entity recorded losses on the security after the period-end

Question 118

What is meant by the term hedge?

Answer 118

A hedge is a defensive strategy designed to protect against the risk of adverse price or interest rate movements to achieve a state of balance.

Question 119

Identify a few audit procedures that address the existence assertion for fixed assets.

Answer 119

1. Verify that detailed (subsidiary) listing supports general ledger account
2. Examine underlying documents to evaluate any additions
3. Trace proceeds from any disposals (retirements) to cash receipts journal and to bank statement.

Question 120

Identify 2 audit procedures that address the rights and obligations assertion for fixed assets.

Answer 120

1. Inquire about any fixed assets pledged as collateral for debts
2. Read the entity’s debt agreements for any discussion of collateral, such as fixed assets.

Question 121

Describe how the auditor might address the valuation assertion for fixed assets.

Answer 121

1. Review calculations for depreciation expense

2. Inquire of management as to whether any assets have become impaired.

Question 122

Describe how the auditor might address the completeness assertion for fixed assets.

Answer 122

Review repairs and maintenance expense accounts to see if any transactions should have been capitalized instead of expensed.

Question 123

Give an example of an analytical procedure to evaluate dividends payable at year-end.

Answer 123

The auditor might estimate the dividends payable, in view of the declared dividends/share (per the minutes of board meetings) times the number of shares outstanding at year-end.

Question 124

Identify a few audit procedures to address the existence assertion for accounts payable.

Answer 124

1. Compare the general ledger control account to the supporting detailed listing of payables.
2. Agree selected items to vendors’ invoices
3. May choose to confirm payables (but usually do not, since completeness is typically a greater concern than existence with respect to liability accounts).

Question 125

Identify an audit procedure that addresses the rights and obligations assertion for accounts payable.

Answer 125

Inquire of management about any transactions with related parties that result in obligations.

Question 126

Give an example of an analytical procedure to evaluate interest payable at year-end.

Answer 126

The auditor might estimate the accrued interest for the time period involved, based on the interest rate (and payment dates) specified in the underlying debt agreements.

Question 127

Give an example of an analytical procedure to evaluate wages and salaries payable at year-end.

Answer 127

The auditor might estimate the wages and salaries payable based on the number of days to be accrued relative to the payroll for a normal pay period.

Question 128

Describe the basic steps that comprise the auditor’s search for unrecorded liabilities.

Answer 128

1. Review cash disbursements after year-end and examine underlying documents to identify liabilities of the period under audit.
2. Examine unpaid invoices (and receiving documents) at the time of the test.
3. Inquire of management as to the completeness of liabilities (document that in the management representations letter).

Question 129

Give an example of an audit procedure for completeness of Long-term Liabilities.

Answer 129

1. Verify due dates for payments in the loan agreements
2. Trace cash disbursements from the accounting records to the bank statement
3. Examine canceled notes if paid in full.

Question 130

Identify a few audit procedures that address the valuation assertion for long-term liabilities.

Answer 130

1. Trace related cash receipts (for increases) and disbursements (for decreases) from the accounting records to the bank statement for anydebt activities.
2. Examine underlying loan documents for issuance of new debt and scheduled payments.
3. Recalculate the amortization of any discount or premium involved.

Question 131

Identify a few audit procedures that address the existence assertion for long-term liabilities.

Answer 131

1. Obtain copies of new loan agreements for the audit documentation.
2. Verify authorization of new debt in minutes of meetings of those charged with governance.
3. Trace the proceeds received from the accounting records to the bank statement.

Question 132

Identify an audit procedure that addresses the rights and obligations assertion for long-term liabilities.

Answer 132

1. Review loan documents for any restrictive debt covenants to be disclosed.
2. Review the loan documents (or inquire of management) to identify the current portion of long-term debt to be reclassified as a current liability.

Question 133

Identify an audit procedure that addresses the existence assertion for stockholder’s equity.

Answer 133

If the entity has an external registrar, confirm the outstanding shares of stock.

Question 134

Identify an audit procedure that addresses the valuation assertion for stockholder’s equity.

Answer 134

1. Review the cash receipts journal and the cash disbursements journal for any changes related to the stock accounts.
2. Compare the subsidiary ledger related to the stock accounts to the general ledger balance.
3. Verify the par value on the stock certificate or the stated value in the minutes of meetings of those charged with governance.

Question 135

Identify a few audit procedures that address the rights and obligations assertion for stockholder’s equity.

Answer 135

1. Review minutes of meetings of those charged with governance for authorization of stock-related transactions.
2. Review the entity’s compliance with contracts for employee stock plans.
3. Inquire of management about any restrictions applicable to retained earnings.

Question 136

Identify an audit procedure that addresses the completeness assertion for stockholder’s equity.

Answer 136

1. Read the minutes of meetings of those charged with governance for authorization of any stock-related transactions that should have been recorded.
2. Verify that all certificate numbers are accounted for.

Question 137

List the 5 assertions related to income-statement items (that is, for transactions and events during the period).

Answer 137

1. Accuracy;
2. Occurrence;
3. Completeness;
4. Cutoff; and
5. Classification.

Question 138

When is the detailed testing of payroll (or other expense accounts) typically performed?

Answer 138

Usually performed only when the auditor ‘s analytical procedures suggest that there is a risk of material misstatement relating to payroll (or other expense accounts).