Audit 4 - Audit Evidence - Part 2

The current file of an auditor's working papers most likely would include a copy of the

Bank reconciliation. A copy of the bank reconciliation is part of the current year's work and would be found in a current file. The permanent file contains documents and information that are useful for current and future audits such as contractual arrangements (e.g. debt and lease agreements), articles of incorporation, and the documentation of the auditor's understanding of internal controls.

Which of the following procedures would an auditor most likely perform for year-end accounts receivable confirmations when the auditor did not receive replies to second requests?

Inspect the shipping records documenting the merchandise sold to the debtors. When the auditor does not receive a reply from a confirmation, the existence of accounts receivable must still be established. Therefore, the auditor would perform alternative procedures, which include reviewing cash received after (not prior to) year-end and the related shipping documentation to verify the goods were sold before year-end.

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." An indication that a case can be settled for less than the amount claimed is vague and does not give the auditor sufficient information to make certain that the contingency is properly accounted for and disclosed. If the liability will be nominal, if the case is without merit, or if the company will be able to defend the action successfully, the company would not incur a liability and no further clarification would be required.

Which of the following cannot be determined by performing analytical procedures involving the quick ratio?

A collection of a payment on account from one of the entity's regular customers was never recorded. If a collection on account was never recorded, accounts receivable will be overstated and cash will be understated. The quick ratio, however, which is the ratio of quick assets, which includes both cash and accounts receivable, to total current liabilities would not be affected. If a collection of a receivable is recorded with a credit to accounts payable, both accounts receivable and accounts payable will be overstated, which will affect the quick ratio. If the current portion of long-term debt is too high due to a lack of adjustment, current liabilities will be overstated resulting in a reduction of the quick ratio. If a payment on account is recognized as a cash sale instead of a reduction to accounts receivable, accounts receivable will be overstated, affecting the quick ratio.

In the audit of a nonissuer, which of the following statements is correct regarding the use of external confirmations to obtain audit evidence?

A factor for an auditor to consider when designing confirmation requests is the assertion being tested. When evaluating whether or not to use external confirmations, the auditor will consider the assertion begin tested so that the confirmation request can be designed to provide information that will support or refute that assertion. Refusal to allow the auditor to perform confirmation procedures is a potential scope limitation that may affect the auditor's ability to express an opinion but is not related to GAAP. Negative confirmations provide less reliable evidence than positive confirmations since a confirmation not returned may be due to the third party's indifference or neglect, rather than the lack of an exception, and would be used when the expected exception rate is low.

Which of the following situations most likely represents the highest risk of a misstatement arising from misappropriations of assets?

A large number of bearer bonds on hand. Bearer bonds can be converted into cash by anyone possessing them and, as a result, they pose a significant risk of misappropriation. Low sales prices do not make inventory items more or less susceptible to misappropriation. Access to assets, not processing of transactions provides an opportunity for misappropriation. Fixed assets with easily identifiable serial numbers would be more difficult to misappropriate and more readily recovered if stolen.

If the objective of a test of details is to detect overstatements of sales, the auditor should trace transactions from the

Accounting records to the source documents. Sales might be overstated due to recording sales that did not occur or due to recording sales in amounts that are greater than the actual transaction amounts. Either of these misstatements can be detected by tracing the recorded sales to source documents. If a sale did not occur, some or all source documents will be missing. If sales are recorded in incorrect amounts, the source documents will not agree with the recorded amounts. Tracing transactions from cash receipts to sales simply verifies that amounts collected were recorded as sales. Tracing transactions from the sales journal to the cash receipts journal will indicate whether or not recorded sales were collected but will not reveal overstatements. Tracing source documents to the accounting records will indicate whether legitimate sales were recorded.

For the fiscal year ending December 31, previous year and the current year, Justin Co. has net sales of $1,000,000 and $2,000,000; average gross receivables of $100,000 and $300,000; and allowance for uncollectible accounts receivable of $30,000 and $50,000, respectively. If the accounts receivable turnover and the ratio of allowance for uncollectible accounts receivable to gross accounts receivable are calculated, which of the following best represents the conclusions to be drawn?

Accounts receivable turnovers are 10.0 and 6.6 and the ratios of uncollectible accounts receivable to gross accounts receivable are 0.30 and 0.16, respectively. Examine allowance for possible understatement of the allowance. Accounts receivable turnover is net sales, divided by average accounts receivable. This will be $1,000,000/$100,000 in the previous year or 10.0 and $2,000,000/$300,000 in the current year or 6.6. A decrease in the allowance as a percentage of gross accounts receivable from .3 to .16 may bear an indication of an understatement of the allowance.

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. To determine if cash payments were made for legitimate purposes, the auditor would select from the population of payments, from the cash disbursements journal, and trace them to supporting documents. The auditor would not find these fraudulent transactions selecting from a population of approved vouchers receiving reports, or vendors' invoices since all of them have been destroyed.

Which of the following procedures would an auditor most likely perform in obtaining evidence about subsequent events?

Compare the latest available interim financial information with the financial statements being reported upon. By comparing interim financial statements with those reported on, the auditor can identify any significant changes in financial position that would not be explained by normal operations, indicating the possibility of subsequent events that should be evaluated. The auditor would not be concerned about securities purchased after year end as their value would not affect the audited financial statements. Testing balance sheet accounts would not provide information about subsequent events, nor would inquiries about paychecks recorded before year end as neither relates to events occurring after year-end.

An auditor observes the mailing of monthly statement to a client's customers and reviews evidence of follow-up on errors reported by the customers. This test of controls most likely is performed to support management's financial statement assertion(s) of

Completeness (No) Existence (Yes) Observing the mailing of monthly statements and reviewing evidence of follow-up on errors reported will provide the auditor with evidence about whether the receivables actually exist. To obtain evidence supporting the assertion of completeness, the auditor would trace transactions from shipping documents to accounts receivable to make certain that all transactions have been recorded.

A letter from the client's attorney:

Corroborates evidence already obtained through the client. The primary source of evidence about litigation, claims, and assessments results from inquiries made of the client. A letter to the client's attorney identifies the information provided by management and requests the attorney's corroboration. While the client generally initiates the request for the letter, it is mailed directly to the auditor and is not obtained by the client on the auditor's behalf. An attorney's letter is not required if, as a result of audit procedures already applied, including inquiries of management, the auditor has concluded that there are no actual or potential litigation, claims, or assessments.

The permanent file of an auditor's working papers most likely would include copies of the

Debts agreements Permanent files in an auditor's documentation will include items that will have ongoing significance, such as debt agreements where the debt will relate to more than one period. Current files will include items that relate to the current period such as lead schedules, attorneys' letters, and bank statements.

An auditor most likely would apply analytical procedures in the overall review stage of an audit to

Determine whether additional audit evidence may be needed. Analytical procedures applied in the overall review of an audit are designed to give the auditor to determine if there is sufficient appropriate audit evidence to support the opinion. They involve comparing the information on the financial statements to the auditor's perceptions of the entity to determine if they seem to fairly reflect financial position, results of operations, and cash flows. As a result, the auditor may determine that additional evidence is necessary. Analytical procedures are not effective at evaluating subsequent events. A review of working papers, not analytical procedures, will inform the auditor if necessary procedures were omitted. The effectiveness of control activities is evaluated through the performance of tests of controls, not analytical procedures. In addition, it is done early in the engagement, not during the overall review stage.

Which of the following procedures would be most appropriate when obtaining evidence to support management's valuation and allocation assertion in relation to derivatives?

Estimating the market value of stock options using the Black-Scholes-Merton model. Since derivatives are required to be reported at fair value, using the Black-Scholes-Merton model to measure the fair value of stock options, which are derivatives, and comparing them to their carrying values would provide evidence about management's assertion related to valuation and allocation. Confirming terms of an interest rate swap, a form of derivative, would provide evidence of existence and rights and obligations, but not about valuation and allocation. Marketable securities are not necessarily derivatives and observing a physical count provides evidence about existence, not about valuation and allocation. Evaluating management's documentation measuring the effectiveness of cash flow hedges will support whether changes in value are properly classified as a component of income or other comprehensive income, related to management's classification assertion.

Which of the following procedures would an auditor most likely perform to assist in the evaluation of loss contingencies?

Obtaining a letter of audit inquiry from the client's lawyer One of the auditor's more significant procedures related to loss contingencies is to obtain a letter from the client's attorney providing information about existing litigation, claims, and assessments, and the attorney's opinion as to their probabilities of success. Checking the arithmetic accuracy of the accounting records will not provide information about loss contingencies. Performing analytical procedures will only provide information about liabilities recorded, not about contingencies, which are not necessarily subject to the development of meaningful expectations. Reading the financial statements and disclosures will provide information about recorded liabilities, but not about contingencies.

An opportunity for fraud involving lapping of accounts receivable is more likely when which two duties involving accounts receivable are not segregated?

Opening the mail and recording. Lapping occurs when receipts are misappropriated, resulting in the overstatement of one customer's account. Subsequent collections are applied to the overstated account, moving the overstatement to another account, with the action repeated such that the overstatement moves from one customer's account to another. To accomplish a lapping scheme, the same party would need access to the cash receipts in order to misappropriate them, such as when the person is responsible for opening the mail, and the ability to affect the recording of cash receipts so that subsequent receipts will be applied to the desired accounts. Being responsible for authorization and reconciliation would enable a party to authorize a transaction and then, for example, write-off the receivable as a result of a collusive relationship with the other party. The same would be true of someone responsible for recording and reconciliation. Responsibility for receipt of returned goods and recording would enable a party to misappropriate goods as they are returned without recording the return in the accounting records.

An auditor scans a client's investment records for the period just before and just after the year end to determine that any transfers between categories of investments have been properly recorded. The primary purpose of this procedure is to obtain evidence about management's financial statement assertions of

Presentation and disclosure, and valuation or allocation A test to make certain that transfers of investments have been properly recorded would provide the auditor with evidence that the investments are properly presented and that the amount is correct, supporting the assertions of presentation and disclosure and valuation or allocation. Rights and obligations are tested by either observing the securities or confirming them with a custodian. The same is true for existence or occurrence.

Which of the following would not be considered an analytical procedure?

Projecting a deviation rate by comparing the results of a statistical sample with the actual population characteristics. An analytical procedure involves establishing an expectation and comparing the client's data to it to determine if the client's data is within an acceptable range. This would be appropriate for comparing client data to industry averages, comparing net sales to expected amounts based on industry trends, or estimating expenses based on budgeted amounts. Although expected deviation rates are estimated when performing a test of controls using sampling, it is for the purpose of determining if a control is operating effectively, not for the purpose of determining if an amount is reasonable, which is the basis of analytical procedures.

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?

Reading the minutes of meetings of the stockholders and the board of directors. When there is substantial doubt about an entity's ability to continue as a going concern, it is likely that related matters will be discussed in stockholder and board meetings and review minutes would be a good potential source of information. The ability to continue as a going concern is a function of the entity to meet its short-term obligations. Information about the value of property would not provide the auditor would not provide an indication. Whether or not leases are capitalized does not affect the cash flows related to the leases and would not affect the ability to continue as a going concern. Likewise, whether or not assets are pledged as collateral will not provide information about the entity's ability to meet its obligations and continue as a going concern.

Which of the following procedures would an auditor most likely perform prior to the balance sheet date?

Review detail and test significant travel and entertainment expense Auditing significant travel and entertainment expenses can be performed at an interim period, applying procedures to transactions occurring between the testing and the end of the period, as appropriate. Since subsequent events relate to events occurring after the financial statement date, a review would be performed at or after the end of the period. A search for unrecorded liabilities is designed to identify liabilities that are not on the balance sheet as of the end of the period and would be tested at that time. An inquiry letter to the client's legal counsel is designed to obtain information about matters still pending as of the end of the period and would not be relevant at an interim date.

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?

Review the lawyer's letter for information about litigation. The lawyer's letter may provide information resulting in the accrual of a contingency, which would involve developing an estimate. Related party transactions are recorded at actual amounts, not estimates. Determining if accounting estimates deviate from historical patterns only deals with estimates reported and does not address whether there might be unrecorded estimates. Confirmations of inventory provide actual data, not estimates.

Which of the following procedures would not be effective for obtaining evidence of the accuracy of the amount recorded as interest expense?

Reviewing minutes of meetings of the board of directors. Reviewing minutes of meetings of the board of directors will provide evidence as to when loans are approved by the board, which can be used to support the completeness of recorded amounts, but will not provide evidence about interest expense. Performing an interest reasonableness test, comparing auditor expectations to recorded amounts is often the most effective means of testing interest expense. Confirmations to creditors may provide information about interest paid to a creditor for the period and will provide evidence about interest expense. Reviewing original loan documents will allow the auditor to understand the terms of notes and loans payable, enabling the auditor to establish an expectation to be used in analytical procedures.

Which of the following most likely would cause an auditor to consider whether a client's financial statements contain material misstatements?

The results of an analytical procedure disclose unexpected differences. When results of analytical procedures disclose unexpected differences, it can only mean that the auditor's expectations were erroneous, the client's data is erroneous, or the client's data is fraudulently misstated. A client may consult with other accountants regarding accounting matters without disclosing it to the auditor for a variety of reasons that would not be indicative of fraud. The letter of representation is generally signed as of the date of the report, which is the last day of the auditor's field work. The fact that electronic audit trails may have short lives are an inherent limitation of the way of doing business but not indicative of fraud.

An auditor is concerned that costs that should be recognized as repairs and maintenance expense have been inappropriately capitalized and are reported as assets. Which of the following procedures would not be effective in determining whether or not this is the case?

Tracing amounts recorded as repairs and maintenance expense to supporting documentation To determine if amounts that should have been recognized as repairs and maintenance expense were incorrectly capitalized and reported as assets, the auditor will test from a population of items that were capitalized and reported as assets to determine if any should have been recognized as expense. This can be accomplished by physically inspecting acquisitions for the period, which draws from a population of amounts capitalized and determines if they are legitimate. Comparing repairs and maintenance expense to budgeted amounts will alert the auditor that amounts may have been inappropriately capitalized if there is a favorable variance caused by underspending. Likewise, comparing asset acquisitions to budgets for capital expenditures will alert the auditor that amounts may have been inappropriately capitalized if actual acquisitions exceed budgeted amounts. Tracing amounts recorded as expense to supporting documents provides the auditor with evidence that recorded transactions did occur and were reported properly but would not provide evidence about items that were not recorded in repairs and maintenance expense that should have been.

An auditor's purpose in reviewing credit ratings of customers with delinquent accounts receivable is most likely to obtain evidence concerning management's assertions about

Valuation and allocation. By evaluating the credit ratings of customers with delinquent accounts, the auditor can evaluate the collectability of the account, which is necessary in determining the reasonableness of the net realizable value of accounts receivable. This supports the valuation and allocation assertion.

Inquiries of warehouse personnel concerning possible obsolete or slow-moving inventory items provide assurance about management's assertion of

Valuation and allocation. The auditor would make inquiries concerning possible obsolete or slow-moving inventory to provide assurance as to management's assertion that inventory is properly valued.

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

Valuation or allocation. Approving credit before goods are shipped reduces the likelihood that customers will default on their account with the entity. Assessing this control is part of the auditor's evaluation of the valuation of accounts receivable at its net realizable value. Credit approval has no relationship to the completeness, existence, or rights and obligation assertions.

Which of the following relates to the sufficiency of audit evidence?

When no exceptions were discovered in a preliminary sample, the auditor decided that no further testing was necessary. The sufficiency of audit evidence relates to the quantity of evidence obtained. This would include decisions related to how much testing was necessary or the size of samples used in audit tests. Decisions regarding whether reconciliation to records is adequate in place of observation, whether to use positive or negative confirmations, and what types of supporting documentation are necessary to examine all relate to the appropriateness of audit evidence, not the sufficiency.

Which of the following events least likely would indicate the existence of related party transactions?

Writing off obsolete inventory to net realizable value just before year end Obsolete inventory should be written down to net realizable value and doing so is not an indication of related party transactions. A related party may make a loan with no scheduled due date or at an unusually low interest rate due to the relationship. Maintaining compensating balances for the benefit of a principal stockholder is an indication that the entity is indebted to that stockholder, directly or indirectly, an indication of a related party transaction.