Specific Matters that Require Special Consideration Flashcards
An auditor most likely would inspect loan agreements under which an entity’s inventories are pledged to support management’s financial statement assertion of
A. Completeness of disclosures
B. Valuation of inventory
C. Existence of inventory
D. Completeness of inventory
A.
The valuation, existence, and completeness of the inventory are not in question. The inventory is collateral for a loan; disclosure is the issue.
In establishing the existence and ownership of long-term investments in the form of publicly-traded stock, an auditor most likely would inspect the securities or
A. Correspond with the investee company to verify the number of shares owned
B. Confirm the number of shares owned that are held by an independent custodian
C. Apply analytical procedures to the dividend income and investments accounts
D. Inspect the cash receipts journal for amounts that could represent the sale of securities
B.
Confirmation from a third-party custodian provides evidence as to the existence and ownership of securities. In the event of a sale close to the period end, an investee company might not yet be aware of a sale unrecorded in the audit client books; further, if the investment is held by a custodian, the investee company might not realize the audit client has an ownership interest. In the event of a sale close to the period end, analytics applied to the dividend income and investment accounts would not necessarily detect an unrecorded sale. A sale of stolen securities most likely would not appear in the cash receipts journal.
Which of the following is least likely to indicate the existence of a material weakness in internal control?
A. Fraud on the part of senior management
B. Previously issued financial statements were restated to reflect the correction of a material misstate-ment due to error or fraud
C. Those charged with governance exercise ineffective oversight of the entity’s financial reporting and internal control
D. There is substantial doubt about the entity’s ability to continue as a going concern
D.
Answers A. – C. are listed as indicators of material weaknesses by the standard setters. Their list also includes the identification by the auditor of a material misstatement of the financial statements in circumstances that indicate that the misstatement would not have been detected by the entity’s internal control. Substantial doubt about the entity’s ability to continue as a going concern does not indicate the existence of a material weakness in internal control. Editor note: The entity’s substantial doubt about their ability to continue as a going concern does not preclude a material weakness unless the doubt arises from a material misstatement (and hence material weakness). Otherwise, the auditor may issue an unmodified report if the entity concurs with the auditor from a going concern perspective.
Which of the following is the auditor’s primary means of obtaining corroboration of information furnished by management concerning litigation, claims, and assessments?
A. The minutes of stockholders and directors meetings.
B. A letter of representation supplied by management.
C. A review of contracts, leases, loan agreements, and similar documents.
D. A letter of audit inquiry to the client’s lawyer.
The correct answer is (D).
Letter of inquiry to be prepared by management and sent by the auditor and requests the entity’s external legal counsel to communicate directly with the auditor. Through a letter of inquiry, auditor requests entity’s legal counsel to inform the auditor of any litigation, claims, assessments, and unasserted claims that counsel is aware of and also counsel’s assessment of the outcome of the litigation, claims, and assessments, and an estimate of the financial implications, including costs involved. Hence, auditor’s primary means of obtaining corroboration of information furnished by management concerning litigation, claims, and assessments is via a letter of audit inquiry to the client’s lawyer.
An auditor’s inquiries of management disclosed that the entity recently invested in a series of energy derivatives to hedge against the risks associated with fluctuating oil prices. Under these circumstances, the auditor should
A. Perform analytical procedures to determine if the derivatives are properly valued
B. Examine the contracts for possible risk exposure and the need to recognize losses
C. Confirm the marketability of the derivatives with a commodity specialist
D. Document the derivatives in the auditor’s communication with the audit committee
B.
The auditor is required to design procedures to obtain reasonable assurance of detecting misstatements of assertions about derivatives and securities. When designing such procedures, the auditor should consider the inherent risk and control risk for these assertions. Analytical procedures would not provide sufficient evidence to determine the valuation of any investment. The auditor does not need to confirm the marketability of a derivative nor inform the audit committee of them.
Choice “B” is correct. Generally accepted accounting principles specify that, in order to qualify for hedge treatment, the entity must demonstrate and disclose a number of transaction features including risk exposure. The auditor would therefore need to examine the contracts to evaluate the character of the hedge and the degree to which losses should be recognized in the determination of income, as well as the character of any disclosures.
Which of the following statements extracted from a client’s lawyer’s letter concerning litigation, claims, and assessments most likely would cause the auditor to request clarification?
A. “We believe that the possible liability to the company is nominal in amount.”
B. “We believe that the action can be settled for less than the damages claimed.”
C. “We believe that the plaintiff’s case against the company is without merit.”
D. “We believe that the company will be able to defend this action successfully.”
B.
The letter requests the attorney to provide an evaluation of the likelihood of an unfavorable outcome and an estimate, if one can be made, of the amout or range of potential loss concerning litigation, claims, and assessments. The statement that it is the attorney’s belief that the action can be settled for less than the damages claimed begs for a follow-up question (clarification) as to whether an estimate of how much less can be made; the other answers are definitive responses.
Option (A) is incorrect because when the possible liability is nominal, an auditor may not require clarify; as it is unlikely to have an impact on the financial statements.
Option (C) is incorrect because when the case against the company is without merit; it does not gives rise to contingent liabilities, which are required to be disclosed. An auditor may choose not make additional enquiries regarding the same.
Option (D) is incorrect because when a company is able to successfully defend a case; it will result in avoiding a contingent liability arising from the case. Therefore, the auditor may not make additional enquiries.
An auditor usually determines whether dividend income from publicly-held investments is reasonable by computing the amounts that should have been received by referring to
A. Stock ledgers maintained by independent registrars
B. Dividend records on file with the SEC
C. Records produced by investment services
D. Minutes of the investee’s board of directors
C.
Published dividend records provide the strongest evidence supporting dividends earned on publicly-held investments. Answers a., b., and d. are not common procedures.
For an initial audit engagement, the auditor should obtain sufficient appropriate audit evidence regarding opening balances about whether they contain misstatements that materially affect the current period’s financial statements by performing all the following procedures except
A. Determining whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated
B. When there was a predecessor auditor, making inquiries concerning the professional competence and independence of the predecessor auditor
C. Determining whether the opening balances reflect the application of appropriate accounting policies consistently applied or that any changes were handled appropriately
D. Evaluating whether audit procedures performed in the current period provide evidence relevant to the opening balances
B.
Although the auditor may make inquiries concerning the professional competence and independence of the predecessor auditor, the auditor is not required to do so.
Editor note: In addition to the procedures described in the other answer alternatives, the auditor should also perform one or both of the following procedures: (1) when the prior year financial statements were audited, reviewing the predecessor auditor’s audit documentation to obtain evidence regarding the opening balances and/or (2) performing specific audit procedures to obtain evidence regarding the opening balances.
Which of the following procedures would an auditor most likely perform to assist in the evaluation of loss contingencies?
A. Checking arithmetic accuracy of the accounting records
B. Performing appropriate analytical procedures
C. Obtaining a letter of audit inquiry from the client’s lawyer
D. Reading the financial statements, including footnotes
C.
Loss contingencies include those arising from litigation, claims and assessments. A letter of inquiry to the client’s lawyer is the auditor’s primary means of corroboration of the information furnished by management about such matters. The financial statements (including foot notes),which may include accrual or disclosure of loss contingencies, are par of the information furnished by management. Performing appropriate analytical procedures and checking the arithmetic accuracy of the accounting records are not likely t provide information about the evaluation of loss contingencies.
A lawyer’s response to an auditor’s inquiry concerning litigation, claims, and assessments may be limited to matters that are considered individually or collectively material to the client’s financial statements. Which parties should reach an understanding on the limits of materiality for this purpose?
A. The lawyer and the auditor
B. The client’s audit committee and the lawyer
C. The client’s management and the lawyer
D. The auditor and the client’s management
D.
A lawyer’s response may be limited to matters that are considered individually or collectively material to the financial statements provided that client management and the auditor have reached an understanding on the limits of materiality for this purpose.
To obtain assurance that all inventory items in a client’s inventory listing are valid, an auditor most likely would trace
A. Inventory tags noted during the auditor’s observation to items listed in receiving reports and vendors’ invoices
B. Items listed in receiving reports and vendors’ invoices to the inventory listing
C. Inventory tags noted during the auditor’s observation to items in the inventory listing
D. Items in the inventory listing to inventory tags and the auditor’s recorded count sheets
D.
To test that all items in the inventory listing are valid, the auditor would work from the inventory listing to the tags. An auditor would be unlikely to work directly from inventory tags to receiving reports and vendor invoices, or vice versa, without an intermediate step-as these documents don’t reference each other, this process would be awkward; moreover, neither of these procedures would test the items in the inventory listing. Working from inventory tags to the inventory listing tests that all items on tags are included in the inventory listing (completeness).
In evaluating the reasonableness of an entity’s accounting estimates, an auditor normally would be concerned about assumptions that are
A. Susceptible to bias
B. Consistent with prior periods
C. Insensitive to variations
D. Similar to industry guidelines
A.
Assumptions that are susceptible to bias provide an opportunity for the overstatement of assets and income and understatement of liabilities. Assumptions that meet the criteria of the other answers offer less scope for creative accounting.
According to PCAOB auditing standards, a critical accounting estimate is best defined as an accounting estimate where the nature of the estimate is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change and
A. Due to qualitative considerations is judged by the auditor to be significant
B. The impact of the estimate on financial condition or operating performance is material
C. Other auditing procedures have identified the presence of bias in management’s estimate
D. The nature of the estimate usually requires the expertise of a specialist to determine it
B.
According to PCAOB auditing standards, a critical accounting estimate is an accounting estimate where (1) the nature of the estimate is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change and (2) the impact of the estimate on financial condition or operating performance is material.
The primary reason an auditor requests a letter of inquiry be sent to an entity’s legal counsel is to provide the auditor with
A. The probable outcome of asserted claims and pending or threatened litigation
B. Corroboration of the information furnished by management about litigation, claims, and assessments
C. Legal counsel’s opinion of the entity’s historical experiences in recent similar litigation
D. A description and evaluation of litigation, claims, and assessments that existed at the balance sheet date
B.
A letter of inquiry to the entity’s legal counsel is the auditor’s primary means of obtaining corroboration of the information provided by management concerning material litigation, claims, and assessments.
How should an auditor verify the valuation of marketable securities at the balance sheet date?
A. Confirm all securities with the related custodians and test interest income
B. Observe the inventory count of all securities at the balance sheet date
C. Compare the prices of the securities to published closing prices at the balance sheet date
D. Inquire of management that securities are valued at fair value
The correct answer is (C).
In order to verify the valuation of marketable securities at the balance sheet date, the auditor will compare the prices of securities to published closing prices at the balance sheet date. This will help us determine if the marketable securities are accurately valued or not.
Confirming all securities with the related custodians and test interest income and observing the inventory count of all securities at the balance sheet date will give comfort over existence. Inquiry of management that securities are valued at fair value would not be considered reliable as it is internal and oral evidence.
An auditor believes that there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. In evaluating the entity’s plans for dealing with the adverse effects of future conditions and events, the auditor most likely would consider, as a mitigating factor, the entity’s plans to
A. Repurchase the entity’s stock at a price below its book value
B. Issue stock options to key executives
C. Lease rather than purchase operating facilities
D. Accelerate the due date of an existing mortgage
C.
Possible plans to mitigate the adverse effects of future conditions and events may include: reducing or delaying expenditures such as leasing instead of purchasing operating facilities; increasing ownership equity; and borrowing money or restructuring debt. Issuing stock options would only cost the company money if they were exercised rather than mitigate the situation.
The scope of an audit is not restricted when an attorney’s response to an auditor as a result of a client’s letter of audit inquiry limits the response to
A. Matters to which the attorney has given substantive attention in the form of legal representation
B. An evaluation of the likelihood of an unfavorable outcome of the matters disclosed by the entity
C. The attorney’s opinion of the entity’s historical experience in recent similar litigation
D. The probable outcome of asserted claims and pending or threatened litigation.
A.
A lawyer may limit the response to matters to which the lawyer has given substantive attention in the form of legal consultation or representation. Answers b., c., and d. are sufficient to cause a scope limitation.
Which of the following procedures would an auditor most likely perform regarding litigation?
A. Confirm directly with the clerk of the court that the client’s litigation is properly disclosed.
B. Discuss with management its policies and procedures for identifying and evaluating litigation.
C. Inspect the legal documents in the client’s lawyer’s possession regarding pending litigation.
D. Confirm the details of pending litigation with the client’s adversaries’ legal representatives.
B.
The auditor’s procedures should include a discussion with management about the policies and procedures adopted for identifying ,evaluating,and accounting for litigation, claims, and assessments. The events or conditions that should be considered in the financial accounting for and reporting of litigation, claims, and assessments are matters within the direct knowledge and, often, control of management of an entity. Accordingly, management is the primary source of information about such matters. It is the auditor’s responsibility to conclude whether the client’s litigation is properly disclosed. The auditor requests the client’s attorney’s opinion on this, not the clerk of the court. The clerk of the court would not have the information needed. The auditor would examine documents in the client’s possession;not the lawyer’s possession. The auditor would not likely inspect documents in the client’s lawyer’s possession due to confidentiality considerations. If the attorney’s response does not provide enough information, the auditor would arrange a conference with the attorney rather than request documentation. It would not be appropriate for the auditor to contact the client’s adversaries’ legal representatives.
According to PCAOB auditing standards, a company’s critical accounting policies and practices are those that
A. Are both most important to the portrayal of the company’s financial condition and results, and require management’s most difficult, subjective, or complex judgments
B. Form the basis of a company’s accounting structure and thus, other accounting policies and practices are dependent on them for their execution
C. Form the basis of a company’s accounting structure and thus, remain critical from one year to the next
D. Have been identified in past audits as requiring special attention from the engagement partner
A.
According to PCAOB auditing standards, critical accounting policies and practices are a company’s accounting policies and practices that are both most important to the portrayal of the company’s financial condition and results, and require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.
Critical accounting policies and practices are tailored to specific events in the current year, and the accounting policies and practices that are considered critical might change from year to year.
Which of the following audit procedures most likely would assist an auditor in identifying conditions and events that may indicate substantial doubt about an entity’s ability to continue as a going concern?
A. Reading the minutes of meetings of the stockholders and the board of directors
B. Comparing the market value of property to amounts owed on the property
C. Reviewing lease agreements to determine whether leased assets should be capitalized
D. Inspecting title documents to verify whether any assets are pledged as collateral
A.
The minutes of meetings of stockholders and the board of directors are likely to contain clear indications of doubts about the entity’s ability to continue as a going concern. Comparisons of market value of property and related loans don’t focus on the financial condition of the entity as a whole; many assets—such as relationships with customers and suppliers—are very valuable, and yet do not appear on the balance sheet. Lease agreements rarely highlight financial distress. Assets often are pledged as collateral by entities in strong financial condition.
Which of the following statements in an attorney’s legal letter requires further investigation?
A. “We believe that the plaintiff’s case against the company is without merit.”
B. “We are of the opinion that this action will not result in any liability to the company.”
C. “It is our opinion that the company will be able to assert meritorious defenses to this action.”
D. “It is our opinion that the possible liability to the company in this proceeding is nominal in amount.”
The correct answer is (C).
If the attorney’s letter is clear that chances of an unfavorable outcome is “remote”, no further action is required by the auditor. The following statements in an attorney’s legal letter provide sufficient clarity:
- “We are of the opinion that this action will not result in any liability to the company.”
- “It is our opinion that the possible liability to the company in this proceeding is nominal in amount.”
- “We believe the company will be able to defend this action successfully.”
- “We believe that the plaintiff’s case against the company is without merit.”
- “Based on the facts known to us, after a full investigation, it is our opinion that no liability will be established against the company in these suits.”
However, if the attorney’s letter is uncertain regarding outcome because of inherent uncertainties, further investigation is required by the auditor. The following statements in the attorney’s legal letter will indicate uncertainty:
- “We believe that the plaintiff will have serious problems establishing the company’s liability under the act; nevertheless, if the plaintiff is successful, the award may be substantial.”
- “It is our opinion that the company will be able to assert meritorious defenses to this action.” The term “meritorious defenses” implies that the company’s defenses will not be summarily dismissed by the court but it does not necessarily indicate counsel’s opinion that the company will win the litigation.
- “We believe the action can be settled for less than the damages claimed.”
- “We are unable to express an opinion as to the merits of the litigation at this time.
- “In our opinion, the company has a substantial chance of prevailing in this action.”
Which of the following procedures most likely would assist an auditor in identifying conditions and events that may indicate substantial doubt about an entity’s ability to continue as a going concern?
A. Performing cutoff tests of sales transactions with customers with long-standing receivable balances
B. Evaluating the entity’s procedures for identifying and recording related-party transactions
C. Inspecting title documents to verify whether any real property is pledged as collateral
D. Inquiring of the entity’s legal counsel about litigation, claims, and assessments
D.
The entity’s legal counsel may provide information about the probability of litigation, claims, and assessments that could possibly cause the company to cease to exist. The procedures in the other answer alternatives. would not provide evidence of an entity’s inability to continue as a going concern. Performing cutoff tests provides evidence about whether account balances are stated accurately. Evaluating procedures concerning related-party transactions would provide evidence of proper disclosure of such transactions. Real property pledged as collateral does not necessarily indicate a cause for concern.
Which of the following procedures most likely would assist an auditor in determining whether management has identified all accounting estimates that could be material to the financial statements?
A. Inquire about the existence of related party transactions
B. Determine whether accounting estimates deviate from historical patterns
C. Confirm inventories at locations outside the entity
D. Review the letter of inquiry to legal counsel for information about litigation
D.
Inquiries about related-party transactions and inventories at external locations are not focused on accounting estimates. Accounting estimates appropriately change with changes in circumstances; further, determining deviation from historical patterns doesn’t indicate that all accounting estimates are identified. Unresolved litigation is a frequent reason for accounting estimates, due to the uncertainty in the litigation outcome.
Which of the following statements is correct with respect to the auditor’s consideration of an entity’s ability to continue as a going concern?
A. The auditor’s workpapers must include audit evidence which provides assurance that the entity will continue as a going concern.
B. If there is absence of reference to substantial doubt in the auditor’s report, this should be viewed as assurance as to an entity’s ability to continue as a going concern.
C. It is not necessary for the auditor to design audit procedures solely to identify conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
D. The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed the date of the financial statements being audited.
C.
It is not necessary to design audit procedures solely to identify conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time. The results of auditing procedures designed and performed to achieve other audit objectives should be sufficient for that purpose. There is no requirement that the auditor’s work papers include evidence which provides assurance that the entity will continue as a going concern. The fact that the entity may cease to exist as a going concern subsequent to receiving a report from the auditor that does not refer to substantial doubt, even within one year following the date of the financial statements, does not, in itself, indicate inadequate performance by the auditor. Accordingly, the absence of reference to substantial doubt in an auditor’s report should not be viewed as providing assurance as to an entity’s ability to continue as a going concern. (The auditor is not responsible for predicting future conditions or events.) A reasonable period of time is defined as not to exceed one year beyond the date of the financial statements.
