Performing Further Procedures and Obtaining Evidence

Question 1

Why do auditors emphasize transaction cycles?

Answer 1

Control risk is generally constant within a particular category of transactions, as all transactions are processed the same way. So, the transaction cycle is the highest level of aggregation for which control risk may be viewed as a constant.

Question 2

What is meant by the term “transaction cycle.”

Answer 2

A group of essentially homogeneous transactions (i.e., transactions of the same type)

Question 3

List the three categories of incompatible functions associated with segregations of duties.

Answer 3

1. Authorization of transactions (execution function)
2. Accounting (recordkeeping function)
3. Access to assets (custody function)

Question 4

List some examples of major transaction cycles.

Answer 4

• Revenue/receipts
• Expenditures/disbursements
• Payroll
• Inventory (especially for manufactured inventory)
• Fixed assets
• Investing/financing

Question 5

Identify the key accounting documents in the revenue/receipts (sales) transaction cycle, each of which should be prenumbered.

Answer 5

• Sales invoices
• Shipping documents for outbound shipments
• Receiving documents for inbound shipments including sales returns

Question 6

List two access controls applicable to the revenue/receipts (sales transactions) business process.

Answer 6

1. Limit access to computer passwords limit access.

2. Ensure cash receipts are handled by someone without access to accounts receivable record keeping.

Question 7

How should employee responsibilities be allocated to facilitate a proper segregation of duties in the revenue/receipts (sales transactions) cycle?

Answer 7

1. An independent employee should review customer statements.
2. An independent department should grant credit to customers.
3. An independent clerk in the shipping/receiving area should account for returns.

Question 8

Identify the objectives of internal control related to revenue/receipts (sales transactions).

Answer 8

• Goods and services are provided in accordance with management’s orders.
• Terms of sale are in accordance with management’s orders.
• Credit terms and limits are properly established.
• Deliveries of goods and services result in accurate and timely billings.
• Sales discounts and billings are in accordance with management’s authorization.

Question 9

Describe management’s role in the execution of transactions controls in revenue/receipts (sales).

Answer 9

Management should:

1. Review terms of sale and note approval.
2. Establish general approval of sales within certain limits and specifically approve sales over those limits.
3. Approve all adjusting journal entries.

Question 10

What comparison techniques can the auditor use to ensure appropriateness of transactions in the cash receipts business cycle?

Answer 10

1. Initial cash receipts listing (remittance listing) compared to total recorded in cash receipts journal and to bank deposit
2. Cash accounts reconciled to bank statements by independent person.

Question 11

What control mechanisms can be used to ensure the appropriate execution of transactions in the cash receipts business cycle?

Answer 11

Adjusting journal entries should be approved by management.

Bank reconciliations should be reviewed by management.

Question 12

List some procedures used to ensure segregation of duties in the cash receipts business cycle.

Answer 12

To ensure segregation of duties, the next activities should be handled separately (by separate individuals):

• Opening mail, handling checks received, and preparing remittance listing
• Making deposits (daily)
• Applying payments received to customer accounts
• Preparing bank reconciliations on a timely basis

Question 13

List access controls that can be used in the cash receipts business cycle.

Answer 13

• Employees with access to cash should be bonded.

- Access to cash receipts should be limited to those authorized.

Question 14

List the internal control objectives related to the Cash Receipts business cycle.

Answer 14

• Access to cash receipts records and accounts receivable records is limited to authorized personnel.
• Detailed cash and account balance records are reconciled with control accounts and bank statements monthly.
• All cash receipts are recorded in period received.

Question 15

Identify the objectives of internal control related to the expenditures/disbursements transaction cycle.

Answer 15

Disbursements are for authorized expenditures as approved by management.
Disbursements are recorded at the proper amounts and classifications.
The supporting accounting records are agreed to the general ledger accounts.
Management authorizes any adjusting journal entries are authorized by management.
Access to cash and disbursement records is limited to authorized personnel.

Question 16

List some procedures used to ensure segregation of duties in the Expenditure business cycle.

Answer 16

1. Separate purchasing department
2. Purchasing personnel independent from receiving and recording
3. Bank reconciliations are prepared by someone not having other involvement in handling cash receipts, disbursements, or record-keeping.

Question 17

List two access controls applicable to the expenditures/disbursements transaction cycle.

Answer 17

1. Cash disbursement employees should be bonded.

2. Access to cash disbursements or related documents should be limited to authorized personnel.

Question 18

Describe management’s role in the execution of transactions controls over cash disbursements in the expenditures/disbursements transaction cycle.

Answer 18

• Management approves all adjusting entries approved by management.
• Only authorized personnel should be able to place an order for goods and services on the entity’s behalf.
• The department requesting the purchase should approve the goods or services received before payment is made.

Question 19

What is the difference between an accounts payable system and a vouchers payable system?

Answer 19

An accounts payable system aggregates payables to identify the total owed to any individual vendor. A vouchers payable system keeps track of individual transactions for which payment is owed without summarizing the totals by vendor.

Question 20

The auditor can use what comparison techniques to ensure appropriateness of transactions in the expenditure business cycle?

Answer 20

The auditor can compare:

1. Suppliers’ monthly statements with recorded payables.
2. Purchase orders to receiving document to vendor’s invoice.

Question 21

Identify three access controls applicable to the payroll transaction cycle.

Answer 21

1. Access to personnel files should be limited to authorized personnel.
2. Access to payroll checks should be limited to authorized personnel.
3. Personnel with access to payroll checks should be bonded.

Question 22

What comparisons should be made within the entity to ensure the appropriateness of payroll transactions?

Answer 22

Payroll information should be periodically matched to information in personnel files.
Payroll checks should be compared to entries on the payroll register.
Amounts on the payroll register should be agreed to the applicable general ledger accounts.

Question 23

Describe management’s role in the execution of transactions controls in the payroll transaction cycle.

Answer 23

1. A responsible official should review and approve payroll
2. An independent person should verify computations.
3. Management should approve overtime payments.
4. Payroll for management should be appropriately reviewed and approved.

Question 24

Identify the objectives of internal control related to the production/manufacturing inventory transaction cycle.

Answer 24

“Resources obtained and used are accurately recorded in a timely manner.
Transfers of finished goods are accurately recorded.
Related expenditures are appropriately classified.
Access to inventory is restricted to authorized personnel.
Comparisons are made of actual inventory to recorded amounts.

Question 25

Describe management’s role in the execution of transactions controls in the production/manufacturing inventory transaction cycle.

Answer 25

1. Acquisition and distribution of inventory should be in accordance with management’s authorization.
2. Management should establish general approval of transactions with specified limits and require specific approval for amounts over those limits.
3. Management should approve any adjusting journal entries.

Question 26

Identify the objectives of internal control in the fixed assets transaction cycle.

Answer 26

• Transactions are recorded accurately in accordance with management’s authorization.
• Estimates used to record depreciation and the like are reasonable and consistent over time.
• Assets are safeguarded with appropriate property insurance in force.
• Supporting details records are properly maintained.
• Management approves any adjusting journal entries.

Question 27

Identify the objectives of internal control in the investing/financing transaction cycle.

Answer 27

• Transactions are recorded accurately in accordance with management’s authorization.
• Investment assets should be reasonably secure from loss.
• Supporting detailed records should be maintained and compared to the general ledger.
• Management approves any adjusting journal entries.

Question 28

How should employee responsibilities be allocated to facilitate a proper segregation of duties in the production/manufacturing inventory transaction cycle.?

Answer 28

• Authorization, bookkeeping (recording), and custody of inventory should be separate.
• Sales returns should be counted by receiving clerk, who prepares an appropriate receiving document.

Question 29

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

Answer 29

Detection risk

Question 30

Performing analytical procedures may serve what three purposes?

Answer 30

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

Question 31

List the two broad categories of substantive procedures.

Answer 31

1. Tests of details

2. Substantive analytical procedures

Question 32

Define “analytical procedures.”

Answer 32

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

Question 33

Identify the two categories of substantive tests of details

Answer 33

1. Tests of ending balances

2. Tests of transactions

Question 34

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

Answer 34

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

Question 35

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

Answer 35

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

Question 36

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

Answer 36

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

Question 37

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

Answer 37

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

Question 38

Coverage Ratios (also known as leverage ratios):

Answer 38

Measures of the entity’s ability to meet its obligations over time (i.e., measures of long-term risk to creditors and the extent to which the entity has borrowed up to its available capacity).

Question 39

Liquidity Ratios (also known as solvency ratios):

Answer 39

Measures of an entity’s short-term ability to meet its obligations.

Question 40

Activity Ratios (also known as turnover or efficiency ratios):

Answer 40

Measures of an entity’s effectiveness putting its assets to use.

Question 41

Profitability Ratios:

Answer 41

Measures of an entity’s operating success (failure) for a period of time.

Question 42

Describe what the existence (occurrence) assertion means.

Answer 42

The existence (occurrence) assertion 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 43

Describe what the completeness assertion means

Answer 43

The completeness assertion means that there are no omissions of transactions that should have been reported.

Question 44

Describe what the rights and obligations assertion means.

Answer 44

The rights and obligations assertion 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 45

Describe what the valuation or allocation assertion means.

Answer 45

The valuation or allocation assertion means that the dollar amounts attributed to the elements of the company’s financial statements are appropriate and in accordance with generally accepted accounting principles (GAAP) or other applicable financial reporting framework.

Question 46

Define “audit evidence.”

Answer 46

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 47

Define “assertions.”

Answer 47

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

Question 48

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

Answer 48

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

Question 49

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

Answer 49

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

Question 50

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

Answer 50

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

Question 51

List the four assertions about presentation and disclosure (footnotes)

Answer 51

1. Occurrence and rights and obligations
2. Completeness
3. Classification and understandability
4. Accuracy and valuation

Question 52

What is meant by “sufficient” and “appropriate” when “sufficient appropriate audit evidence” is mentioned?

Answer 52

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

Question 53

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

Answer 53

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

Question 54

“Reliability” is affected by________

Answer 54

Reliability is affected by the source and nature of evidence and depends upon individual circumstances however, the SAS offers the following guidelines:

1. Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly or by inference (e.g., observation of the application of a control is more reliable than inquiry of entity personnel about the application of a control).
2. Evidence is more reliable when obtained from independent (knowledgeable) sources outside the entity;
3. Evidence generated internally is more reliable when the related controls are effective;
4. Evidence is more reliable when it exists in documentary form (whether paper or electronic); and
5. Evidence provided by original documents is more reliable than evidence based on photocopies/facsimiles (faxes).

Question 55

List the three categories of audit procedures

Answer 55

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

Question 56

What are risk assessment procedures?

Answer 56

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 57

What are substantive procedures?

Answer 57

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

Question 58

What are tests of control?

Answer 58

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 59

Describe what is meant by “audit plan” that an auditor is responsible for establishing under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 59

The audit plan is more specific than the audit strategy and deals with the nature, timing, and extent of the auditor’s planned procedures (including risk assessment procedures, tests of controls, and substantive procedures).

Question 60

List the matters to be evaluated by the auditor under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 60

• Results of analytical procedures performed as the overall review
• Misstatements accumulated during the audit
• Qualitative aspects of the company’s accounting practices
• Conditions identified related to fraud risk
• Presentation (including disclosures) of the financial statements
• Adequacy of evidence obtained

Question 61

What is the auditor’s objective for identifying and assessing risks of material misstatement under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 61

To identify and appropriately assess the risks of material misstatement, thereby providing a basis for designing and implementing responses to the risks of material misstatement

Question 62

Describe the different treatments regarding financial statement assertions between the AICPA’s Statements on Auditing Standards and the Public Company Accounting Oversight Board’s (PCAOB) auditing standards.

Answer 62

The PCAOB identifies 5 financial statement assertions, whereas the AICPA identifies 13 assertions in total of three categories of assertions [involving (1) account balances at period-end; (2) transactions and events for the period; and (3) presentation and disclosure]. The AICPA’s discussion of assertions is consistent with International Standards on Auditing.

Question 63

Under Public Company Accounting Oversight Board (PCAOB) auditing standards, what is the purpose of risk assessment procedures?

Answer 63

The auditor should perform risk assessment procedures sufficient to provide a reasonable basis for identifying and assessing the risks of material misstatement and designing further audit procedures.

Question 64

What is the auditor’s objective for audit risk as prescribed by Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 64

To conduct the audit of financial statements in a manner that reduces audit risk to an appropriately low level associated with “reasonable” assurance

Question 65

What is the auditor’s objective for obtaining audit evidence under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 65

To plan and perform the audit to obtain appropriate audit evidence that is sufficient to support the opinion

Question 66

List the specific risk procedures an auditor should perform in assessing the risks of material misstatement under Public Company Accounting Oversight Board (PCAOB).

Answer 66

• Obtain an understanding of the company and its environment.
• Obtain an understanding of internal control over financial reporting.
• Consider information from client acceptance/retention, planning, prior audits, and other engagements for the company.
• Perform analytical procedures.
• Inquire about the RMM.

Question 67

List the circumstances that impact the extent of supervision under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 67

• Size and complexity of the company
• Nature of the work assigned to engagement personnel
• Capabilities of each engagement team member
• Risks of material misstatement

Question 68

List the five financial statement assertions identified by Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 68

1. Existence
2. Completeness
3. Rights and obligations
4. Valuation or allocation
5. Presentation and disclosure

Question 69

What are the engagement partner’s basic responsibilities under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 69

The engagement partner is responsible for the engagement and its performance, including the proper supervision of the engagement team members and compliance with PCAOB standards.

Question 70

What is the auditor’s objective for the consideration of materiality in planning and performing the audit under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 70

To apply the concept of materiality appropriately in planning and performing audit procedures

Question 71

List the two categories of auditor responses regarding risks of material misstatement under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 71

1. Overall responses

2. Responses involving the nature, timing, and extent of audit procedures at the relevant assertion level

Question 72

List the two levels at which the risks of material misstatement should be assessed as prescribed by Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 72

1. At the financial statement level

2. At the assertion level

Question 73

What is the auditor’s objective for evaluating audit results under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 73

To evaluate the results of the audit to determine whether the audit evidence obtained is sufficient and appropriate to support the opinion

Question 74

What is the auditor’s objective regarding audit planning as prescribed by Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 74

The objective is to plan the audit so that the audit is conducted effectively subject to an appropriately low level of audit risk.

Question 75

What is the auditor’s objective as it relates to responding to the risks of material misstatement under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 75

To address the risks of material misstatement through appropriate overall audit responses and audit procedures

Question 76

What is the auditor’s objective for supervision of the audit engagement under Public Company Accounting Oversight Board (PCAOB) auditing standards?

Answer 76

To supervise the audit engagement so that the work is performed as directed and supports the conclusions reached

Question 77

Describe what is meant by “overall strategy” that an auditor is responsible for establishing under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 77

The overall strategy involves rather high level audit resource allocation issues involving the scope, timing, and direction of the audit activities.

Question 78

Define “misstatement.”

Answer 78

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 79

What is meant by the term “factual misstatements”?

Answer 79

Misstatements for which there is no doubt

Question 80

What is meant by the term “judgmental misstatements”?

Answer 80

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

Question 81

What is meant by the term “projected misstatements”?

Answer 81

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 82

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

Answer 82

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

Question 83

The auditor must document what matters in connection with the evaluation of misstatements?

Answer 83

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 84

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

Answer 84

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

Question 85

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

Answer 85

Under AICPA standards (applicable to audits of “nonissuers”): 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 86

Define “report release date.”

Answer 86

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

Question 87

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

Answer 87

Under AICPA standards (applicable to audits of “nonissuers”): The audit documentation should be retained for at least five years from the report release date.

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

Question 88

List three purposes of audit documentation.

Answer 88

1. Provides the principal support for the auditor’s report
2. Documents the auditor’s compliance with generally accepted accounting standards (GAAS)
3. Assists in controlling the audit engagement

Question 89

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

Answer 89

• 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.
• The auditor must not delete audit documentation before the end of the retention period.

Question 90

Describe the limited changes in audit documentation that are permitted after the documentation completion date.

Answer 90

No documentation can be deleted, but documentation can be added. It must indicate the date the information was added, the name of the person preparing the additional documentation, and the reason for adding it.

Question 91

Describe the level of detail in the audit documentation required by Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 91

The documentation should be prepared in sufficient detail to permit an experienced auditor without prior connection to the engagement to understand the procedures performed and the conclusions reached and to determine who performed the work and on what date.

Question 92

List the three general documentation requirements under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 92

1. Demonstrate the auditor’s compliance with PCAOB standards.
2. Support the basis for the auditor’s conclusions regarding every relevant financial statement assertion.
3. Demonstrate that the underlying accounting records agree to or reconcile with the financial statement elements.

Question 93

Differentiate between the requirements of the American Institute of Certified Public Accountants (AICPA) and of the Public Company Accounting Oversight Board (PCAOB) regarding “retention” of audit documentation.

Answer 93

AICPA: Requires retention of audit documentation for 5 years for audits of “nonissuers.”
PCAOB: Requires retention of audit documentation for 7 years for audits of “issuers.”

Question 94

What are deemed “significant findings or issues” that must be documented by the auditor?

Answer 94

• Issues involving the application of accounting principles
• Circumstances causing modification of planned audit procedures
• Matters that could result in modification of the auditor’s procedures
• Material misstatements
• Significant deficiencies or material weaknesses in internal control
• Difficulties in applying auditing procedures
• Disagreements among members of audit team

Question 95

Differentiate between the requirements of the American Institute of Certified Public Accountants (AICPA) and of the Public Company Accounting Oversight Board (PCAOB) regarding the documentation completion date.

Answer 95

AICPA: A complete and final set of audit documentation should be assembled no later than 60 days after the report release date for audits of “nonissuers.”
PCAOB: A complete and final set of audit documentation should be assembled no later than 45 days after the report release date for audits of “issuers.”

Question 96

List the five conditions required for an engagement to report whether a previously reported material weakness continues to exist under Public Company Accounting Oversight Board (PCAOB) auditing standards.

Answer 96

1. Management accepts responsibility for internal control over financial reporting.
2. Management evaluates the effectiveness of the specific controls that address the material weakness.
3. Management provides an assertion that the specific control is effective.
4. Management supports its assertion with evidence.
5. Management provides a written report to accompany the auditor’s report.

Question 97

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

Answer 97

Either:
Verify subsequent cash receipts; or
Examine underlying documents for apparent validity.

Question 98

What is meant by the term “negative confirmation”?

Answer 98

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

Question 99

List the two general types of confirmations.

Answer 99

Positive

Negative

Question 100

What is meant by the term “positive confirmation”?

Answer 100

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

Question 101

When might negative confirmations be justified?

Answer 101

• When the financial statement item involves a large number of small (immaterial) accounts
• When control risk is low (i.e., internal control is viewed as effective)
• When recipients are expected to pay attention to the request

Question 102

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

Answer 102

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

Question 103

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

Answer 103

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

Question 104

Define “view-only access.”

Answer 104

Permitting a user to view, but not change, a file.

Question 105

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

Answer 105

The auditor should evaluate:

• How management addressed estimation uncertainty in making the estimate.
• Whether management’s significant assumptions are reasonable.
• Whether management has the intent and ability to carry out specific actions, as relevant.

Question 106

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

Answer 106

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

Question 107

Identify three factors affecting the nature of estimation uncertainty.

Answer 107

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 108

Define Estimation Uncertainty

Answer 108

The susceptibility of an accounting estimate and related disclosures to an inherent lack of precision in its measurement.

Question 109

What is the best evidence of fair value?

Answer 109

Published price quotations in an active market

Question 110

What is meant by the term “observable inputs”?

Answer 110

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

Question 111

What is the auditor’s basic responsibility regarding fair value measurement and disclosures?

Answer 111

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

Question 112

Define “fair value.”

Answer 112

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 113

What is meant by the term “unobservable inputs”?

Answer 113

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 114

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

Answer 114

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 Lawyer’s letter: The lawyer’s response directly to the auditor

Question 115

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

Answer 115

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

Question 116

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 116

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 117

What is meant by the term “unasserted claims”?

Answer 117

An audited entity has exposure to litigation, but no one has yet filed a lawsuit or announced an intention to sue.

Question 118

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

Answer 118

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 119

What is meant by the term “asserted claim”?

Answer 119

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 120

List the four matters the lawyer’s letter should address regarding “asserted” claims.

Answer 120

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
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 121

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

Answer 121

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

Question 122

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

Answer 122

1. The nature of the litigation
2. How management intends to respond if the claim is asserted
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 123

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

Answer 123

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

Question 124

What periods should be covered in the management representations letters?

Answer 124

All periods included in audit report

Question 125

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

Answer 125

The chief executive officer (CEO) and chief financial officer (CFO)

Question 126

When should the management representations letter be dated?

Answer 126

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

Question 127

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

Answer 127

1. Financial statements

2. Information provided

Question 128

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

Answer 128

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

Question 129

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

Answer 129

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 130

What is meant by the term “related party”?

Answer 130

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

Question 131

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

Answer 131

• Inquire of management as to the existence of related entities.
• Review prior year’s audit documentation.
• Review any applicable Securities and Exchange Commission filings (for a public company).
• Inquire of predecessor auditors if applicable.
• Review stockholder listings of closely held companies to identify major stockholders.

Question 132

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

Answer 132

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.
3. Examine underlying documents for unusual or large transactions or transactions with terms or conditions that are inconsistent with prevailing market conditions.

Question 133

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

Answer 133

Evaluating the adequacy of disclosure about the related party transactions

Question 134

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

Answer 134

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 135

PCAOB auditing standards require the auditor to obtain an understanding of the company’s processes for three specific matters regarding related party issues. What are they?

Answer 135

1. How the company identifies related parties and transactions with related parties
2. How the company authorizes and approves transactions with related parties
3. How the company accounts for and discloses relationships and transactions with related parties in the financial statements.

Question 136

PCAOB auditing standards suggest that the auditor should make certain inquiries of others (in addition to management or the audit committee). Identify some examples of such others to whom inquiry should be made.

Answer 136

• Internal auditors
• In-house legal counsel
• Chief compliance or ethics officer
• Director of human resources

Question 137

PCAOB auditing standards require the auditor to make certain inquiries of management about related-party issues. What are those specific matters about which the auditor should inquire of management?

Answer 137

• Names of the related parties, nature of the relationships, and changes from the prior period
• Background information about related parties, including location, industry, size, and so on
• Transactions involving related parties, including terms and business purposes
• Any related-party transactions not authorized according to the company’s established policies

Question 138

What are some examples of information that may indicate that related parties or transactions with related parties previously undisclosed to the auditor might exist?

Answer 138

• Purchasing or selling at significantly different than market prices
• Sales transactions that have unusual terms or transactions that lack economic substance
• Borrowing or lending at significantly different than normal terms
• Guarantees outside the normal course of business

Question 139

PCAOB auditing standards suggest that the auditor should make certain inquiries of the company’s audit committee (or its chair) about related-party issues. What matters should the auditor inquire about?

Answer 139

The audit committee’s understanding of the company’s relationships, significant related-party transactions, and whether any member of the audit committee has any concerns about related-party issues

Question 140

What should the auditor do when a related-party transaction is determined to be a significant risk?

Answer 140

• Read the underlying documents for consistency with other audit evidence about the business purpose.
• Determine whether the transaction has been authorized and approved in accordance with established policies and whether any exceptions to established policies were granted.
• Evaluate the financial capability of the related parties with respect to significant responsibilities.
• Perform other procedures as necessary.

Question 141

What is the auditor’s objective in connection with the PCAOB auditing standard entitled Related Parties?

Answer 141

The auditor’s objective is “to obtain sufficient appropriate audit evidence to determine whether related parties and relationships and transactions with related parties have been properly identified, accounted for, and disclosed in the financial statements.”

Question 142

What are some sources of information that may indicate that related parties or transactions with related parties previously undisclosed to the auditor might exist?

Answer 142

• Filings with the SEC and other regulatory agencies
• Confirmations and lawyer letters
• Internal reports (e.g., by the internal auditors or from a whistleblower program)
• Shareholder registers identifying major shareholders
• Contracts and other agreements involving significant unusual transactions

Question 143

In evaluating the reasonableness of an accounting estimate, an auditor concentrates on key factors and assumptions that are:

Answer 143

1. significant to the accounting estimate;
2. sensitive to variations;
3. deviations from historical patterns; and
4. subjective and susceptible to misstatement and bias.

The auditor does not focus on key factors and assumptions that are objective and not susceptible to bias. Objectivity would potentially support the reasonableness of the estimate.

Question 144

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

Answer 144

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 145

What is meant by the term “subsequent events”?

Answer 145

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

Question 146

List four audit procedures an auditor might perform to identify subsequent events.

Answer 146

1. Inquire 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.
4. Scan the accounting records subsequent to year-end for unusual activities.

Question 147

When is the auditor’s report normally dated?

Answer 147

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 148

What period of time defines a subsequent event?

Answer 148

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

Question 149

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

Answer 149

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

Question 150

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

Answer 150

When material events or circumstances arise after the balance sheet date

Question 151

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

Answer 151

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

Question 152

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 152

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

Question 153

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

Answer 153

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.

EX:“February 16, 20X1, except for Note XY, as to which the date is March 1, 20X1”

Question 154

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 154

• Nature of conditions identified
• The auditor’s consideration of management’s plans
• The possible effect on financial statements and disclosures
• The effect on the auditor’s report

Question 155

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

Answer 155

• Perform substantive analytical procedures.
• Review for subsequent events.
• Review loan agreements for compliance with restrictive debt covenants.
• Read minutes of meetings of board or of those charged with governance.
• Inquire of management about legal liability issues, and obtain lawyers’ letters.

Question 156

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

Answer 156

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

Question 157

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 157

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

Question 158

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

Answer 158

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

Question 159

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

Answer 159

• Consider the adequacy of disclosure about these issues relative to generally accepted accounting principles or other applicable financial reporting framework (is there a misstatement?).
• 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 160

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

Answer 160

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

Question 161

What exactly should the auditor evaluate when management claims that “supporting parties” will provide the necessary support to mitigate the entity’s financial stress?

Answer 161

The auditor should evaluate both the intent and the ability of those parties to provide the necessary support.

Question 162

Define “nonsampling risk.”

Answer 162

Any mistake by the auditor other than sampling risk that is not a direct consequence of using a sampling approach

Question 163

Define “Type I error.”

Answer 163

The risk of underreliance on controls (i.e., the risk of assessing control risk too high); or incorrect rejection of the fairness of an account balance (The AICPA considers this an error related to efficiency.)

In auditing, Type 1 errors - false rejection - are the lesser evil. In Type 1 errors, the auditor thinks that controls are not working when they really are or thinks that a balance is materially misstated when it is really OK. As a result, the auditor does extra work.

Question 164

List the two general approaches to audit sampling.

Answer 164

Statistical

Nonstatistical

Question 165

Define “Type II Error.”

Answer 165

The risk of over-reliance on controls (i.e., the risk of assessing control risk too low); or incorrect acceptance of the fairness of an account balance (The AICPA considers this an error related to effectiveness.)

Type 2 errors - false acceptance - are the greater evil. In Type 2 errors, the auditor thinks that controls are working when they really are not or thinks that a balance is OK when it really is not. As a result, the auditor misses a MM and issues the wrong opinion on the FS.

Question 166

Define “sampling risk.”

Answer 166

The risk that the sample may not be truly representative of the population

Question 167

List the two types of statistical sampling.

Answer 167

1. Attributes sampling (regarding internal controls)

2. Variables sampling (regarding substantive tests).

Question 168

Define “sampling.”

Answer 168

Application of an audit procedure to less than 100% of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class

Question 169

Define Attributes Sampling:

Answer 169

Sampling for purposes of deciding whether internal controls are working as designed (tests of controls).

Question 170

Define Variables Sampling:

Answer 170

Sampling for purposes of deciding whether account balances (such as inventory or receivables) are fairly stated (substantive tests of details).

Question 171

List the eight steps in attributes sampling plan.

Answer 171

1. Identify sampling objective.
2. Define what constitutes an occurrence.
3. Identify relevant population.
4. Determine sampling method.
5. Determine sample size.
6. Select the sample.
7. Evaluate results.
8. Document sampling procedures.

Question 172

List the two sampling approaches acceptable for statistical sampling applications.

Answer 172

Random

Systematic

Question 173

Define “random sampling.”

Answer 173

Sampling methodology where each item in the population has the same probability of being selected

Question 174

Define “systematic sampling.”

Answer 174

Sampling methodology whereby every nth item in the population is chosen as part of the sample (usually with a random starting point)

Question 175

List the two sampling approaches normally associated with judgmental (nonstatistical) sampling applications.

Answer 175

Block

Haphazard

Question 176

Define “block sampling.”

Answer 176

Sampling methodology where a group of contiguous items are selected (e.g., selecting all transactions for the month of June)

Question 177

Define “haphazard sampling.”

Answer 177

Sampling methodology where items are selected arbitrarily with no conscious biases

Question 178

List the factors that directly relate to sample size.

Answer 178

• Expected error rate

- Population size—not explicitly considered in attributes sampling

Question 179

List the factors that are inversely related to sample size.

Answer 179

1. Tolerable error rate
2. Risk of overreliance; Type II error
3. Risk of underreliance

Question 180

What is the formula for the observed deviation rate for the sample?

Answer 180

(No. errors in the sample) / Sample size

Question 181

List the three factors, as indicated by AICPA tables, that determine sample size for an attributes sampling application.

Answer 181

• Expected error rate (related to the variation in population)
• Tolerable error rate (related to precision)
• Risk of over-reliance (Type II error rate)

Question 182

What is the formula to obtain the sample size for probability proportionate to size (PPS) sampling?

Answer 182

n = reliability factor (from PPS tables) × Book value / Tolerable error

Question 183

List the items that are inversely related to sample size in variables sampling.

Answer 183

1. Allowance for sampling risk
2. Risk of incorrect acceptance (Type II error)
3. Risk of incorrect rejection (Type I error)

Question 184

List the items that are directly related to sample size in variables sampling.

Answer 184

1. Estimated population standard deviation

2. Population size—considered explicitly in variables sampling

Question 185

What is the basic sample size formula?

Answer 185

Sample size = (Estimated population standard deviation × Coefficient of reliability × Population size / Allowance for sampling risk) squared

Question 186

What is the purpose of stratification?

Answer 186

To reduce the overall variability within a population

Question 187

List the two parameters of a normal distribution

Answer 187

1. Mean

2. Variance

Question 188

List the various types of classical variables sampling techniques.

Answer 188

1. Difference estimation
2. Ratio estimation
3. Mean-per-unit estimation

Question 189

List the eight basic steps in variables sampling.

Answer 189

1. Identify sampling objectives.
2. Identify relevant population.
3. Select specific sampling technique.
4. Calculate the sample size.
5. Determine selection method.
6. Conduct the sample.
7. Evaluate sample and project to population.
8. Document the sampling procedures.

Question 190

What is the relevant “sampling unit “ in PPS sampling?

Answer 190

An individual dollar amount associated with the financial statement element involved.

Question 191

What is the primary advantage of PPS sampling?

Answer 191

Efficiency—If there are few differences between audit and book values, PPS sampling may result in smaller sample sizes than other sampling methods.

Question 192

What is the primary disadvantage of PPS sampling?

Answer 192

PPS sampling does not work very well in dealing with understatements or zero (unrecorded) balances.

Question 193

State the formula for calculating sample size for PPS sampling.

Answer 193

n = “Reliability factor” × Book value/

Tolerable misstatement
 (net of expected misstatements)

Question 194

State the formula for calculating sampling interval for PPS sampling.

Answer 194

Sampling interval = Tolerable misstatement (net of expected misstatements) / Reliability factor; or alternatively

Sample interval = Population book value / Sample size

Question 195

What is the projected misstatement for accounts having a book value greater than or equal to the sample interval?

Answer 195

The projected misstatement is the “actual “ misstatement identified.

Question 196

What is the projected misstatement for accounts having a book value less than the sample interval?

Answer 196

The projected misstatement is based on the “tainting percentage “ applied to the sample interval.

Question 197

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

Answer 197

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

C-R-O-V-A-E

Question 198

Identify several substantive procedures usually performed in every audit area.

Answer 198

• 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 199

What is the schedule of interbank transfers used for?

Answer 199

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 200

What is meant by the term “kiting”?

Answer 200

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 201

What does the proof of cash compare?

Answer 201

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 202

What is the purpose of a bank confirmation?

Answer 202

• To verify the existence and ownership of bank accounts

- To provide evidence about the completeness and terms of notes payable with the bank

Question 203

What is meant by the term “cutoff bank statement”?

Answer 203

It is a 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 204

List some typical audit procedures applicable to cash accounts.

Answer 204

• Review and test the entity’s bank reconciliations.
• Prepare and test a schedule of interbank transfers if there are multiple bank accounts with transfers among them.
• Prepare proof of cash if fraud is suspected.
• Count petty cash (but usually do not do so due to its immateriality).
• Inquire about minimum balance requirements on bank accounts.

Question 205

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

Answer 205

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 206

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

Answer 206

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 207

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

Answer 207

1. Inquire about receivables pledged as collateral.

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

Question 208

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

Answer 208

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 209

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

Answer 209

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 210

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

Answer 210

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 211

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

Answer 211

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

Question 212

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

Answer 212

-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 213

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

Answer 213

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

Question 214

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

Answer 214

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 215

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

Answer 215

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 216

What is meant by the term derivative?

Answer 216

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 217

What is meant by the term hedge?

Answer 217

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 218

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

Answer 218

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

Question 219

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 219

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

Question 220

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

Answer 220

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

Question 221

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 221

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

Question 222

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

Answer 222

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 223

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

Answer 223

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

Question 224

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

Answer 224

1. Review calculations for depreciation expense

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

Question 225

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

Answer 225

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 226

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

Answer 226

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

Question 227

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

Answer 227

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 228

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

Answer 228

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 229

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

Answer 229

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

Question 230

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

Answer 230

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

Question 231

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

Answer 231

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 232

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

Answer 232

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 233

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

Answer 233

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 234

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

Answer 234

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 235

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

Answer 235

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 236

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

Answer 236

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 237

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

Answer 237

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 238

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

Answer 238

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 239

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

Answer 239

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

Question 240

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

Answer 240

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 241

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

Answer 241

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 242

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

Answer 242

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).

Question 243

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

Answer 243

Accuracy;
Occurrence;
Completeness;
Cutoff; and
Classification.

Question 244

Define “general controls.”

Answer 244

Controls that have pervasive effects on all the specific computer processing applications

Question 245

List the types of physical safeguards used to protect the data files.

Answer 245

1. File labels
2. File protection rings
3. File protection plans

Question 246

List some internal control implications associated with an IT environment.

Answer 246

• Segregation of duties may be undermined (a disadvantage).
• Audit trail may be lacking (a disadvantage).
• Computer processing is uniform (an advantage).

Question 247

List some controls that can be put in place/built in hardware and systems software.

Answer 247

1. Parity check
2. Echo check
3. Diagnostic routines
4. Boundary protection

Question 248

List the five categories of general controls.

Answer 248

1. Organization and operation
2. Systems development and documentation
3. Hardware and systems software
4. Access
5. Data and procedures

Question 249

List the IT duties that should be segregated (in connection with “organization and operation”).

Answer 249

1. Systems analyst
2. Programmer
3. Operator
4. Librarian
5. Security

Question 250

List the three types of control totals.

Answer 250

Batch totals
Hash totals
Record count

Question 251

Define “application controls.”

Answer 251

Information processing controls that apply to the processing of specific computer applications (controls around input, processing, and output)

Question 252

Define “hash totals.”

Answer 252

An arbitrary total that has no meaningful interpretation outside the context in which it was created. It is used only to validate the integrity of the data being examined.

Question 253

Define “record count.”

Answer 253

A counting mechanism in an IT system that keeps track of the number of records processed to determine that the appropriate number was accounted for

Question 254

What is the purpose of validity checks?

Answer 254

To determine whether the data under review is recognized as a legitimate possibility

Question 255

What is the purpose of processing application controls?

Answer 255

To ensure the processing of data is accurate and as authorized.

Question 256

What is the purpose of processing application controls?

Answer 256

To ensure the processing of data is accurate and as authorized.

Question 257

What is the objective of input application controls?

Answer 257

To ensure that the input of data is accurate and as authorized

Question 258

Define “check digit.”

Answer 258

An arithmetic manipulation of a numeric field that captures the information content of that field and then gets “tacked” onto the end of that numeric field

Question 259

What is the purpose of limit tests?

Answer 259

To determine whether the data under review are all within some predetermined range

Question 260

What is the purpose of missing data checks?

Answer 260

To determine whether there are any omissions from fields in which data should have been present

Question 261

What is the purpose of output application controls?

Answer 261

To ensure the output data (and the distribution of any related reports) is accurate and as authorized

Question 262

Define “batch totals.”

Answer 262

The sum of a particular field in a collection of items used as a control total to ensure that all data has been entered into a system

Question 263

List some examples of logic checks.

Answer 263

Limit tests
Validity checks
Missing data checks
Check digits

Question 264

Define “integrated test facility (ITF).”

Answer 264

A fictitious division or department within the client created for the purpose of processing the “dummy” (test) data along with the client’s “live” data

Question 265

Define “parallel simulation.”

Answer 265

The processing of the client’s actual data using the auditor’s software and then comparing the auditor’s output to the client’s output for agreement

Question 266

Define “tagging transactions.”

Answer 266

The process of adding an electronic tagging to specific client transactions and tracing them through the client’s system

Question 267

What is data mining software?

Answer 267

Commercially available software (such as ACL or Idea) used to access a client’s electronic data and perform a broad range of audit tasks (such as performing analytical procedures and sampling for confirmation work, etc.)

Question 268

What is the purpose of test data procedures?

Answer 268

To process known errors to see if the client’s system catches them. The auditor only needs to include those errors that are important to the auditor (i.e., the auditor need not include every possible type of error). There may be a danger of contaminating the client’s database with the test data.

Question 269

Define “customized audit software.”

Answer 269

Programs specifically written to access the files of a particular client. The cost might be modest, but the benefits are limited to the specific client for whom the software was written.

Question 270

Define “generalized audit software.”

Answer 270

Audit software designed to access and test data files of many audit clients. Such audit software is not unique to a specific audit client. Such software is usually expensive to develop, but that cost can be spread over many audit clients. The cost per client may justify the large initial cost of development.

Question 271

Define “service organization.”

Answer 271

Independent organizations to which an entity may outsource the processing of its transactional data

Question 272

Define “distributed systems.”

Answer 272

A network of remote computers connected to the main system, allowing simple processing functions to be delegated to the employees at the remote sites

Question 273

Define “value-added network (VAN).”

Answer 273

A network maintained by an independent company that facilitates electronic data interchange (EDI) transactions between buying and selling companies

Question 274

Risk of material misstatement

Answer 274

• The risk that the financial statements are materially misstated before the audit.
• The combination of inherent risk and control risk.

Question 275

Control risk

Answer 275

-The risk that a misstatement will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or in the aggregate with other misstatements.

Question 276

What is a Bill of Lading?

Answer 276

A document issued by a carrier (or his agent) to acknowledge receipt of cargo for shipment and giving details and instructions relating to the shipment of a consignment of goods. Typically it will show the names of the consignor and consignee, the port of origin and destination, and route. It can be issued by the carrier shipping company or vessel operator or the captain of the ship.

Question 277

What are the objectives of the payroll department?

Answer 277

Objectives of Internal Controls over Payroll—The objectives are to provide reasonable assurance that:

• Payroll withholdings and deductions are based on appropriate supporting authorizations.
• Compensation is made only to valid employees at authorized rates and for services actually rendered.
• Gross pay, withholdings, deductions, and net pay are correctly computed.
• Payroll costs and liabilities are appropriately classified and summarized in the proper periods.
• Appropriate comparisons are made of personnel, payroll, and work records at reasonable intervals.
• Net pay and related withholdings are remitted to the appropriate employees and agencies.
• Access to sensitive personnel files and payroll records is limited to authorized personnel.

Question 278

Specific Substantive Audit Procedures

Answer 278

Inspection of Records/Documents—
Inspection of Tangible Assets—
Observation—
Inquiry—
Confirmation—
Recalculation—
Reperformance—
Analytical Procedures—Includes “scanning” to review accounting data to identify unusual items to be tested further.

Question 279

The auditor is required to communicate to those charged with governance certain matters related to the conduct of the audit. The matters to be communicated include:

Answer 279

-the auditor’s responsibility under generally accepted auditing standards,
-an overview of the planned scope and timing of the audit, and
-significant findings from the audit, including:
>the auditor’s views about qualitative aspects of the entity’s significant accounting practices,
>significant difficulties encountered during the audit,
>uncorrected misstatements,
>disagreements with management,
>management’s consultation with other accountants,
>significant issues discussed, or subject to correspondence, with management.

Question 280

An auditor may decide to increase the risk of incorrect rejection when:

Answer 280

the cost and effort of selecting additional sample items is low.

Question 281

Access controls

Answer 281

Access controls are designed to limit the use of the system and the entry to files of authorized persons. To test that online access controls are properly functioning, the auditor would enter invalid identification numbers or passwords to ascertain whether the system rejects them, thereby denying access.

Question 282

The primary reason an auditor requests letters of inquiry be sent to a client’s attorneys is to provide the auditor with:

Answer 282

-corroboration of the information furnished by management about litigation, claims, and assessments.