A4

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?

"I believe that the plaintiff will have problems establishing any liability." The lawyer's comment that the plaintiff "will have problems establishing any liability" is vague...it does not provide an evaluation of the likelihood of an unfavorable outcome. Does "will have problems" mean a loss is probable, reasonably possible, or remote? The auditor would likely want to request clarification to ensure that the situation has been properly accounted for and disclosed.

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?

"We believe that the action can be settled for less than the damages claimed." This statement seems to give some indication that the lawyer believes that there is at least some likelihood that there may be a known or estimable amount and that the case may actually result in a liability.

Which of the following does not demonstrate an inappropriate segregation of duties?

A billing clerk prepares invoices and records the resulting increase in accounts receivable. Preparing invoices and recording the related receivables are both recordkeeping functions that would not be inconsistent with each other.

Which of the following internal control activities is not usually performed in the vouchers payable department?

Accounting for unused prenumbered purchase orders and receiving reports. Accounting for unused prenumbered purchase orders and receiving reports is an effective control, but it would not typically be performed in the vouchers payable department.

In performing a count of negotiable securities, an auditor records the details of the count on a security count worksheet. What other information is usually included on this worksheet?

An acknowledgment by a client representative that the securities were returned intact. After performing a count of negotiable securities, the auditor would generally obtain an acknowledgment from the client that the securities were returned intact. This helps maintain accountability for the securities, and reduces the likelihood of employee misappropriation (e.g., if a client employee were to steal a security and blame the auditor).

When would the auditor's analytical procedures be facilitated by the entity?

An auditor's analytical procedures are facilitated when an entity uses a standard cost system with variance reports because the comparison of actual to budget will already have been performed. In addition, it is likely that management will already be aware of significant variations from budget and will be better able to address any questions the auditor may have.

An auditor's analytical procedures indicate a lower than expected return on an equity method investment. This situation most likely could have been caused by:

An error in recording amortization of the excess of the investor's cost over the investment's underlying book value. Under equity method accounting, the amortization of the excess of the investor's cost over the investment's underlying book value reduces the investor's income from the equity method investment. If amortization is calculated incorrectly (i.e., the amortization is too high), this could lower the return on the investment.

A client is a defendant in a patent infringement lawsuit against a major competitor. Which of the following items would least likely be included in the attorney's response to the auditor's letter of inquiry?

An evaluation of the ability of the client to continue as a going concern if the verdict is unfavorable and maximum damages are awarded. It is the auditor's responsibility to evaluate the ability of the client to continue as a going concern. The attorney would not make such an evaluation.

An auditor's tests of controls for completeness for the revenue cycle usually include determining whether:

An invoice is prepared for each shipping document. The auditor often traces a sample of shipping documents to sales invoices to test completeness of sales.

Which of the following questions would an auditor least likely include on an internal control questionnaire concerning the initiation and execution of equipment transactions?

Are procedures in place to monitor and properly restrict access to equipment? Questions relating to access controls for assets would not normally be a part of a questionnaire related to controls over the initiation and execution of equipment purchases.

"In connection with an audit of our financial statements, management has prepared, and furnished to our auditors a description and evaluation of certain contingencies." The foregoing passage most likely is from a(an):

Audit inquiry letter to legal counsel. Legal counsel is best able to corroborate the description and evaluation of contingencies provided by management.

The usefulness of the standard bank confirmation request may be limited because the bank employee who completes the form may:

Be unaware of all the financial relationships that the bank has with the client. A bank employee may not have access to all information about transactions with the audit client and thus may be unaware of all the financial relationships the bank has with the client.

An auditor suspects that certain client employees are ordering merchandise for themselves over the Internet without recording the purchase or receipt of the merchandise. When vendors' invoices arrive, one of the employees approves the invoices for payment. After the invoices are paid, the employee destroys the invoices and the related vouchers. In gathering evidence regarding the fraud, the auditor most likely would select items for testing from the file of all:

Cash disbursements. Because the employee is destroying the invoices and related vouchers, the most obvious documentation remaining would be the file of all cash disbursements. The auditor would select items from this file and then attempt to trace from specific cash disbursements to the related invoices and approved vouchers. Missing documentation might be indicative of fraud.

What sets of information does an auditor usually confirm on one form?

Cash in bank and collateral for loans. The standard AICPA bank confirmation form includes spaces for the bank to confirm both cash balances on deposit at the bank and collateral pledged on loans originating from the bank.

An auditor most likely would limit substantive audit tests of sales transactions when control risk is assessed as low for the occurrence assertion concerning sales transactions and the auditor has already gathered evidence supporting:

Cash receipts and accounts receivable. Examination of accounts receivable and cash receipts provides the auditor with evidence with respect to both the completeness and the occurrence of sales transactions, thus limiting the need to test sales transactions.

During an audit of an entity's stockholders' equity accounts, the auditor determines whether there are restrictions on retained earnings resulting from loans, agreements, or state law. This audit procedure most likely is intended to verify management's assertions related to:

Classification and understandability. Restrictions on retained earnings are for contractual or legal appropriation of retained earnings. The purpose is to restrict dividends, and such restrictions should be disclosed in the financial statements.

When an auditor decides to confirm accounts receivable balances rather than individual invoices, it most likely would be beneficial to include with the confirmations:

Client-prepared statements of account that show the details of the account balances. When confirming the total accounts receivable balance, it is beneficial to include a client-prepared statement of account that shows the details of the account balances so that the confirmation recipients can more easily verify the receivable balance.

Which of the following internal controls most likely would assure that all billed sales are correctly posted to the accounts receivable ledger?

Comparison of daily sales summaries to daily postings to the accounts receivable ledger would ensure the completeness of the accounts receivable ledger.

In establishing the existence and ownership of a long-term investment in the form of publicly-traded stock, an auditor should inspect the securities or:

Confirm the number of shares owned that are held by an independent custodian The auditor would confirm the number of shares held by an independent custodian to establish the existence and ownership of a long-term investment in publicly traded securities.

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:

Confirm the number of shares owned that are held by an independent custodian. Confirmations should be requested from the custodian for securities that are in the possession of third parties.

Which of the following procedures would an auditor least likely perform before the balance sheet date?

Confirmation of accounts payable. The auditor should consider whether the year-end balances of the particular asset or liability accounts that might be selected for interim examination are reasonably predictable with respect to amount, relative significance, and composition. Accounts payable is relatively difficult to predict because it may fluctuate at management's discretion.

An insignificant portion of a client's inventory is in public warehouses. Evidence of the existence of this merchandise can most efficiently be acquired through which of the following methods?

Confirmation. The auditor should observe the physical inventory count of goods held in public warehouses if the inventory held therein is significant; otherwise, confirmation of such inventory is sufficient.

Which audit procedure is most likely related to the classification and understandability of the financial statements with respect to inventory?

Confirming inventories pledged under loan agreements. The pledge or assignment of any inventories should be appropriately disclosed in the financial statements.

Analytical procedures performed in the final review stage of an audit generally would include:

Considering the adequacy of the evidence gathered in response to unexpected balances identified in planning. Analytical procedures applied during the final review stage should be used to determine whether adequate evidence has been gathered in response to unusual or unexpected balances identified during the audit.

In auditing an entity's computerized payroll transactions, an auditor would be least likely to use test data to test controls concerning:

Control and distribution of unclaimed checks. In auditing an entity's computerized payroll transactions, an auditor would be least likely to use test data to test controls concerning control and distribution of unclaimed checks, since these sorts of controls are typically not automated. Controls surrounding unclaimed checks typically rely on proper segregation of duties, which is best evaluated through the auditor's direct observation.

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

Corroboration of the information furnished by management about litigation, claims, and assessments. A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished by management concerning litigation, claims, and assessments.

An auditor suspects that a client's cashier is misappropriating cash receipts for personal use by lapping customer checks received in the mail. In attempting to uncover this embezzlement scheme, the auditor most likely would compare the:

Dates checks are deposited per bank statements with the dates remittance credits are recorded. When lapping occurs, an employee uses current remittances to conceal remittances that have been stolen previously. Thus, a lag will exist from the time that this current payment is deposited until the current customer's account is actually credited. (The current payment is applied to the previous customer's account).

An auditor traced a sample of purchase orders and the related receiving reports to the purchases journal and the cash disbursements journal. The purpose of this substantive audit procedure most likely was to:

Determine that purchases were properly recorded. In general, an audit procedure can be restated as the question to be answered. In this case, tracing a sample of purchase orders and related receiving reports to the purchases journal and the cash disbursements journal seeks to answer the question, "Were all purchases properly recorded?" (the completeness assertion).

When a client engages in transactions involving derivatives, the auditor should:

Develop an understanding of the economic substance of each derivative. In auditing investments in securities and derivatives, the auditor must assess the reasonableness and appropriateness of assumptions, market variables, and valuation models. In order to do this, the auditor must consider whether the substance of transactions or events differs materially from their form. Remember that generally accepted accounting principles require transactions and events to be reported in accordance with their economic substance, even if this differs from their form

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:

Examine the contracts for possible risk exposure and the need to recognize losses. 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 strategies most likely could improve the response rate of the confirmations of accounts receivable?

Include a list of items or invoices that constitute the customers' account balances. The auditor should consider the types of information respondents will be readily able to confirm. For instance, some accounting systems facilitate the confirmation of single transactions rather than entire balances. In such cases, the auditor might consider including a client-prepared statement of account showing details of the customer's account balance being confirmed. By making it easier for customers to determine which items are included in the balance being confirmed, the auditor also makes it more likely that those customers will respond.

What type of account yields the highest level of evidence?

Income statement accounts tend to be more predictable than balance sheet accounts, and therefore interest expense would likely yield a higher level of evidence than the allowance for doubtful accounts, accounts receivable, or accounts payable.

To gain assurance that all inventory items in a client's inventory listing schedule are valid, an auditor most likely would trace:

Items listed in the inventory-listing schedule to inventory tags and the auditor's recorded count sheets. Tracing from the inventory schedule to the inventory tags and the auditor's recorded count sheets verifies the validity (existence) of the items. Note that the correct term for the directional test for existence is "vouch." However, in practice (and on the CPA Exam), the term trace is sometime used interchangeably with the term vouch.

In determining the effectiveness of an entity's internal controls relating to the occurrence assertion for payroll transactions, an auditor most likely would inquire about and:

Observe the segregation of duties concerning personnel responsibilities and payroll disbursement The occurrence assertion as it relates to payroll transactions would correspond to an audit objective to determine that payroll transactions actually occurred (i.e., that all payroll checks were issued to valid employees for hours actually worked). Segregation of duties between personnel and payroll departments is an important control to ensure that only valid employees receive paychecks.

Which of the following procedures should an auditor perform concerning litigation, claims, and assessments?

Obtain assurance from management that it has disclosed all unasserted claims that its lawyer has advised are probable of assertion. The auditor should obtain assurance from management that it has disclosed all unasserted claims that its lawyer has advised are probable of assertion.

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

Performing cutoff procedures for shipping and receiving. Performing cutoff procedures provides assurance that goods in transit (shipped or received) are appropriately included or excluded from inventory and this procedure is most appropriate for testing the completeness assertion.

Sound internal control dictates that, immediately upon receiving checks from customers by mail, a responsible employee should:

Prepare a duplicate listing of checks received. Upon receipt of cash, a remittance listing should be prepared.

TRANSACTION CYCLE BEGINNING: On receiving a client's bank cutoff statement, an auditor most likely would trace...

Prior-year checks listed in the cutoff statement to the year-end outstanding checklist. The auditor should obtain bank cutoff statements that include transactions for 10 to 15 days after year-end. The outstanding checks and deposits in transit at year-end on the bank reconciliation should agree with the information in the bank cutoff statement.

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:

Records produced by investment services. Investment income from dividends is generally recalculated by comparing recorded income with dividend record books produced by investment advisory services such as "Moody's Dividend Record." These books state the dividend that was declared and paid by the investee.

Which of the following payroll control activities would most effectively ensure that payment is made only for work performed?

Require employees to have their direct supervisors approve their time cards. A direct supervisor's approval of the time cards most effectively ensures that payment is paid for work performed as the supervisor observes the employees and determines whether employees are present and working.

Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions?

Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date. Unusual nonrecurring transactions near year-end are characteristic of related party transactions. Since related party transactions are not at arm's-length, management may use such transactions to bolster sales or assets.

After making inquiries about credit granting policies, an auditor selects a sample of sales transactions and examines evidence of credit approval. This test of controls most likely supports management's financial statement assertion(s) of:

Rights and obligation: No Allocation and valuation: Yes By ensuring that credit approval is obtained before goods are shipped to customers, the auditor is testing management's assertion that accounts receivable are collectible (allocation and valuation). Ensuring that credit approval is obtained before goods are shipped does not support the rights and obligations assertion.

Which of the following best represents a key control for ensuring sales are properly authorized when assessing control risks for sales?

Sales orders are sent to the credit department for approval. Proper authorization for sales involves obtaining credit approval before filling the order.

While observing a client's annual physical inventory, an auditor recorded test counts for several items and noticed that certain test counts were higher than the recorded quantities in the client's perpetual records. This situation could be the result of the client's failure to record:

Sales returns. Failure to record sales returns would result in actual inventory quantities being greater than those recorded in the perpetual inventory records.

A weakness in internal control over recording retirements of equipment may cause an auditor to:

Select certain items of equipment from the accounting records and locate them in the plant. Testing to see whether equipment listed in the accounting records is physically present in the plant and still in service is an effective way to test whether unrecorded disposals occurred.

To provide assurance that each voucher is submitted and paid only once, an auditor most likely would examine a sample of paid vouchers and determine whether each voucher is:

Stamped "paid" by the check signer. To provide assurance that each voucher is submitted and paid only once, an auditor should verify that each voucher was stamped "paid" by the check signer.

To provide assurance that each voucher is submitted and paid only once, an auditor most likely would examine a sample of paid vouchers and determine whether each voucher is:

Stamped "paid" by the check signer. By stamping the voucher "paid," the check signer cancels the voucher so it cannot be resubmitted for payment.

When there are numerous property and equipment transactions during the year, an auditor who plans to assess control risk at a low level usually performs:

Tests of controls and limited tests of current year property and equipment transactions. Since control risk is assessed at a low level, tests of controls would be required to evaluate the effectiveness of the internal controls to support that assessed level. Assuming controls are operating effectively, only limited substantive testing would be performed.

Which of the following controls should prevent an invoice for the purchase of merchandise from being paid twice?

The check signer reviews and cancels the voucher packets. Having the check signer review and cancel the voucher packet is a preventive control to ensure the same voucher is not presented and paid a second time. Additionally, because this control is implemented prior to processing (paying for) the original invoice, it functions as a preventive control of avoiding duplicate payments.

An independent auditor asked a client's internal auditor to assist in preparing a standard financial institution confirmation request for a payroll account that had been closed during the year under audit. After the internal auditor prepared the form, the controller signed it and mailed it to the bank. What was the major flaw in this procedure?

The form was mailed by the controller. The auditor should control the mailing of independent confirmations.

The objective of auditing procedures applied to segment information is to provide the auditor with a reasonable basis for concluding whether:

The information is presented in conformity with the GAAP rules on segment information. The auditor's objective is to provide a reasonable basis for concluding whether segment information is presented in conformity with GAAP.

What comparison would an auditor make in auditing cost and expenses?

The most likely analytical review procedure involving costs and expenses would be to compare the current year's payroll expense (average amount per employee) to the prior year, taking into consideration an average increase in wage rates. This is a very effective technique in auditing payroll expense.

Which of the following procedures represents a weakness in internal controls for payroll?

The payroll clerk distributes signed payroll checks. Undistributed checks are returned to the payroll department. Unclaimed payroll checks should be returned to an independent party for follow up. Returning such checks (assets) to the payroll department (recordkeeping) represents an inadequate segregation of duties.

Which of the following circumstances most likely would cause an auditor to suspect an employee payroll fraud scheme?

There are significant unexplained variances between standard and actual labor cost. Significant unexplained variances between standard and actual labor costs may cause the auditor to suspect an employee payroll fraud scheme.

What ratio would an engagement partner most likely calculate when reviewing the balance sheet in the overall review stage of an audit?

Total debt/total assets During the final review stage of an audit, the auditor focuses on the overall presentation of the financial statements. Total debt/total assets indicates the portion of assets financed by creditors, which is a meaningful ratio to calculate during the final audit review.

When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud most likely would be reduced if the:

Trust company has no direct contact with the entity employees responsible for maintaining investment accounting records. When an entity uses a trust company as custodian of its marketable securities, the possibility of concealing fraud would be reduced if the trust company deals only with the person reconciling the accounts, and not with the employees responsible for maintaining investment records.

Which of the following controls would a company most likely use to safeguard marketable securities when an independent trust agent is not employed?

Two company officials have joint control of marketable securities, which are kept in a bank safe-deposit box. Joint custody by two company officials over assets like cash and marketable securities helps safeguard the assets. Under joint custody, collusion is required for a defalcation to occur.

An auditor compares annual revenues and expenses with similar amounts from the prior year and investigates all changes exceeding 10%. This procedures could most likely indicate that...

Unrealized gains on available-for-sale securities should properly be recorded in other comprehensive income. If such gains were erroneously recorded in the income account for trading securities, this might be discovered through comparison of the current year and prior year revenues and expenses (assuming the error occurred only in the current year, and not in the prior year).

Which of the following internal controls most likely would prevent direct labor hours from being charged to manufacturing overhead?

Use of time tickets to record actual labor worked on production orders. The use of time tickets to record actual labor worked on production orders is the best way to prevent direct labor from being charged to manufacturing overhead.

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

Valuation and allocation. By ensuring that credit approval is obtained before goods are shipped to customers, the auditor is testing management's assertion that accounts receivable are collectible (valuation or allocation).

Why are relationships among I/S accounts more predictable than B/S accounts?

because they represent transactions over a period of time rather than at one point in time. In addition, relationships involving transactions subject to management discretion (travel and entertainment) are less predictable. As a result, analytical procedures are more appropriate for operating expense accounts.

What does the auditor's risk assessment affect?

the NET of audit procedures, but it does not determine the relevance of audit evidence