Audit Chapter 14

Management letter

A letter from the auditor to the client identifying any problems and suggested solutions that may help management improve its effec-tiveness or efficiency.19455_ch14_hr_734-793.indd 7771/22/18 7:22 PM

Letter of audit inquiry

A letter that the auditor asks the client to send to its legal counsel to gather corroborative evidence concerning litigation, claims, and assessments.

14-14 The legal implications of a client's noncompliance with laws and regulations are ultimately a matter for the auditor to resolve before the auditor can issue the audit opinion. (T/F)

False

14-22 Auditors should not issue a going-concern audit opinion if it would be a self-fulfilling prophecy that the company will, indeed, go bankrupt. (T/F)

False

14-26 An example of a Type I subsequent event would be when a significant lawsuit is initiated relating to an incident that occurred after the balance sheet date. (T/F)

False

14-29 The management letter confirms management responses obtained by the auditor earlier in the audit and the con-tinuing appropriateness of those responses. (T/F)

False

14-38 One of the issues that the auditor is required to commu-nicate to the audit committee is the competence, train-ing, and industry specialization of each of the highest ranking members of the engagement team (the partner, manager, and audit senior). (T/F)

False

Noncompliance

This involves acts of omission or commission by the entity, either intentional or unintentional, which are contrary to the prevailing laws or regulations.

14-10 OAO Gazprom is a natural gas producer in Russia; top management used their power to siphon profits out of Gazprom and into their own pockets. In its filings, the company did not disclose many specific details about its related party transactions. (T/F)

True

14-13 Auditing standards recognize that there are inherent limi-tations in an auditor's ability to detect material misstate-ments relating to an organization's compliance with laws and regulations. (T/F)

True

14-17 Review analytics should corroborate conclusions formed during the audit, thereby enabling the audi-tor to draw conclusions upon which to base the audit opinion. (T/F)

True

14-18 The auditor's expectations when performing review analytical review can be less precise than those for substantive analytics. (T/F)

True

14-2 Even if immaterial, an intentional misstatement may cause serious difficulties in the audit, and for the client. (T/F)

True

14-21 The going-concern evaluation is based on information obtained from typical audit procedures performed to test management's assertions; no separate procedures are required, unless the auditor believes that there is substantial doubt about the client's ability to continue as a going concern. (T/F)

True

14-25 Type I subsequent events provide evidence about condi-tions that existed at the balance sheet date, while Type II subsequent events provide evidence about conditions that did not exist at the balance sheet date, but that may require disclosure. (T/F)

True

14-30 The management letter is not required, but auditors use it to make significant operational or control recommen-dations to the client. (T/F)

True

14-33 The terms engagement quality review and concurring partner review are synonymous. (T/F)

True

14-34 An engagement quality review is required for publicly traded companies, and is optional for privately held company audits. (T/ F)

True

14-37 Objective criteria for evaluating the quality of the client's accounting policies is not available; assessing the quality, not just the acceptability of the significant accounting policies is a matter or professional judgment. (T/F)

True

14-9 Management can provide disclosures on the face of the financial statements, or in the notes to the financial statements. (T/F)

True

14-24 The Altman Z-Score is a model used to help assess the likelihood that a company will go bankrupt. Which of the following ratios is included in the model?a. Working capital to total assets.b. Working capital to total sales.c. Sales to total debt.d. Sales to total accounts receivable.

A

14-36 Which of the following is not a procedure that an engagement quality reviewer would perform? a. Evaluating whether or not to continue providing audit services to the client in the subsequent year, based on information gained during the current-period audit. b. Discussing significant matters related to the finan-cial statements and internal controls. c. Evaluating judgments about materiality and the disposition of corrected and uncorrected identified misstatements. d. Reviewing the engagement team's evaluation of the firm's independence in relation to the engagement.

A

14-40 With regard to discussing significant audit adjustments with the audit committee, which of the following state-ments is false?a. Significant audit adjustments reflect a lack of independence between the auditor and client management.b. Significant audit adjustments may reflect on the stewardship and accountability of management.c. The audit committee should be made aware of significant audit adjustments, even if management readily agrees to make them.d. Significant adjustments, by definition, suggest that there have been internal control failures that must be communicated to the audit committee.e. Two of the above (a-d).

A

Disclosure checklist

A decision aid that the auditor uses to serve as a cue to guiding audit planning around management's assertions in various disclosures.

Restatement

A financial reporting disclosure that occurs when and if a material misstatement is ultimately discovered; at that point, management will have to issue revised financial statements with the misstatement corrected.

14-8 In completing the audit, the auditor obtains a letter of audit inquiry. Which of the following is an accurate description of a letter of audit inquiry?a. A letter that is the primary source of corroborative evi-dence concerning litigation, claims, and assessments, which is received from the client's legal counsel.b. A letter that is the primary source of corrobora-tive evidence concerning cash valuation, which is received from the client's bank.c. A letter that is the primary source of corroborative evidence concerning accounts receivable valuation, which is received from the client's customer.d. A letter that is the primary source of corroborative evidence concerning inventory valuation, which is received from the client's supplier.

A

Management representation letter

A letter to the auditors that the client's chief executive and chief financial officers are required to sign that speci-fies management's responsibility for the financial statements and confirms oral responses given to the auditor during the audit.

Iron curtain method

A method of misstatement correction that focuses on assuring that the year-end balance sheet is correct; this method does not consider the impact of prior-year uncorrected misstatements reversing in later years.

Rollover method

A method of misstatement correction that focuses on the materiality of the current-year misstatements and the reversing effect of prior-year misstatements on the income statement, thereby allowing misstatements to accumulate on the balance sheet.

Judgmental misstatement

A misstatement that arises from differences in judgments of management concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate.

Known misstatement

A misstatement that has been specifically identified; known misstatements are also referred to as factual misstatements.

Projected misstatement

A misstatement that is the auditor's best estimate of the misstatement in a given population, and that is a projection of the mis-statement identified in an audit sample to the entire population from which the sample was drawn.

Reasonable period of time

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

Corruption perception index

A ranking put forth by Transparency Inter-national that ranks countries according to the extent to which people believe corruption exists; the ranking includes about 200 countries and ranks them on a scale from 0 to 10 (0highcorruption5; 10lowcorruption5).

Engagement quality review

A review at the end of each audit conducted by an experienced auditor, usually a partner, who was not a part of the audit team, but who has appropriate competence, independence, integrity, and objec-tivity. The purpose of this review is to help make sure that the audit and audit documentation are complete and support the audit opinion on the financial state-ments and, for public companies, on the client's internal controls.

Subsequent events review

A review of events occurring in the period between the balance sheet date and the audit report date to determine their pos-sible effect on the financial statements.

Altman Z-score

A series of ratios that have predictive power in indicating the likelihood of bankruptcy. This score is named for the person who first intro-duced the concept and associated measurement.

Summary of unadjusted audit differences

A summary of unadjusted audit differences that is communicated to the audit committee is described in the management representation letter, and that is evaluated individually and in the aggregate for determining whether the financial statements are materially correct.

Going-concern assumption

An accounting guideline which assumes that the company will continue on long enough to carry out its objectives and commitments. In other words, there is belief that the company will not liquidate in the near future.

Dual approach

An approach to considering uncorrected misstatements that requires the simultaneous application of both the rollover method and the iron curtain method.

14-39 Which of the following is not a typical communication between the auditor and the audit committee at the end of an audit engagement?a. Discussion of the auditor's responsibility.b. Discussion of the client continuance decision.c. Discussion about auditor independence.d. Discussion about management judgments and accounting estimates.

B

Busy season

An intensive time of the year during which the auditor faces the greatest deadline pressure and work volume based upon the need to provide assurance over the client's financial reports.

14-12 Which of the following statements is false?a. Disclosure checklists are a convenient documenta-tion format for evidence that the auditor adequately evaluated management's assertions about the adequacy of its disclosures.b. The auditor's report, and assurance therein, covers mandatory disclosures in the basic financial state-ments and the related notes, along with voluntary disclosures in the MD&A.c. When assessing the adequacy of disclosures, the auditor should have reasonable assurance that the disclosures are understandable to users.d. Disclosure checklists tend to be industry-specific.e. All of the above are false.

B

14-19 Which of the following statements concerning review analytical procedures is false?a. Review analytical procedures help auditors assess the overall presentation of the financial statements.b. The auditor's expectations in review analytical procedures should be more precise than those for substantive analytics.c. Auditing standards require the use of review ana-lytical procedures to assist in identifying ending account relationships that are unusual.d. Ratio analysis, common-size analysis, and analysis of the dollar and percentage changes in each income statement item over the previous year are useful for performing review analytical procedures.

B

14-28 After the report release date, the auditor may become aware of facts that may have affected the financial statements and auditor's report, had the auditor known the facts at the time of issuance. With regard to this situation, which of the following statements is true?a. Because such facts become known after the report release date, the auditor cannot reasonably be held accountable for these issues; no action is required on the part of the auditor.b. If the auditor decides that steps should be taken to prevent further reliance on the financial state-ments and audit report, the client is advised to make appropriate and timely disclosure of these new facts.c. If such facts would have been investigated had they been known at the report date, the auditor should determine whether engagement personnel are competent and qualified to perform audits; action is required on the part of the auditor to assess whether engagement personnel should be retained to work on the engagement in the subsequent year.d. If the auditor decides that steps should be taken to prevent further reliance on the financial statements and audit report, the auditor should notify the audit committee immediately; no action beyond this is required on the part of the auditor because of confidentiality concerns.

B

14-4 Which of the following statements is false?a. Management's incentives may bias their willingness to book, or correct, detected misstatements.b. Known misstatements are those that arise from differences in judgments of management concern-ing accounting estimates that the auditor consid-ers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate.c. Section 10A(b) of the Exchange Act requires auditors to take action upon discovery of an illegal act even if it does not have a material effect on the financial statements, including alerting management and the audit committee.d. The auditor evaluates the misstatements that have been posted to the summary of unadjusted audit dif-ferences (SUAD) to determine whether uncorrected misstatements are material—either individually or in combination with other misstatements.

B

Report release date

The date the auditor grants the entity permission to use the auditor's report in connection with the financial statements.

14-16 Which of the following is an important provision of the Foreign Corrupt Practices Act?a. Auditors of clients operating in foreign countries must hire a joint auditor in the foreign country to provide assurance that laws and regulations have been followed by the client.b. Auditors of clients operating in foreign countries must provide reasonable assurance that any inven-tory observations that occur in the foreign country are observed by at least some audit personnel from the U.S.; this requirement is in place because fraud often occurs in inventory accounts.c. Companies that have securities listed on U.S. markets must make and keep financial records that accurately and fairly reflect the transactions of the company and must design and maintain an adequate system of internal accounting controls.d. Companies that have securities listed on U.S. markets must adhere to the internal control requirements of both the U.S. and the applicable foreign country.

C

14-31 In completing the audit, the auditor communicates with management via the management letter. Which of the following statements is false about management letters?a. The management letter is used to make signifi-cant operational or control recommendations to management.b. Many audit firms consider management's inatten-tion to addressing comments in the letter to be an important risk factor in subsequent-year audits.c. The management letter is required for publicly traded companies in the United States, but not pri-vately held companies.d. All of the above are false.

C

14-35 Which of the following statements is false concerning engagement quality reviews? a. The purpose of the engagement quality review is to provide reasonable assurance that the audit and audit documentation are complete and that they support the audit opinion on the financial statements. b. The engagement quality review must be documented, and the documentation should include who per-formed the review, which documents were reviewed, and the date the engagement quality reviewer pro-vided approval of the issuance of the audit opinion. c. Engagement quality reviews are required for both publicly traded companies and private companies in the United States. d. One of the procedures that would be performed during the engagement quality review is to deter-mine if appropriate consultations have taken place on difficult or contentious matters.

C

14-11 In completing the audit, the auditor should review the adequacy of the disclosures in the financial statements. When assessing the disclosures, the auditor should have reasonable assurance about which of the following?a. The disclosed events and transactions have occurred and pertain to the entity.b. All the disclosures that should have been included are included.c. The disclosures are understandable to users.d. All of the above.

D

14-15 The auditor has responsibility regarding a client's noncom-pliance with laws and regulations. Management may try to hide acts involving noncompliance, which limits the auditor's ability to detect such acts. Which of the follow-ing are inherent limitations that affect the auditor's ability to detect acts involving noncompliance?a. Laws and regulations often relate to operational issues within the entity that do not necessarily relate to the financial statements, so the informa-tion systems relating to financial reporting may not capture noncompliance.b. Management may act to conceal noncompliance, or override controls, or intentionally misrepresent facts to the auditor.c. The legal implications of noncompliance are ultimately a matter for legal authorities to resolve and are not a matter about which the auditor can resolve.d. All of the above.

D

14-20 The analytical procedures of the financial statements of Koss Corporation that are depicted in Exhibit 14.3 reveal which of the following indicators of the fraud? a. Cash balances had declined to their lowest level since FYE 2004.b. Cost of goods sold as a percentage of sales had risen sharply over the period, with a particularly significant increase from FYE 2008 to 2009.c. Net income as a percentage of sales had decreased sharply over the period, with a particularly signifi-cant decrease from FYE 2008 to 2009.d. All of the above.e. Two of the above (a-c).

D

14-23 In evaluating whether the client is a going concern, which of the following questions should the auditor ask?a. Are there indicators of going-concern problems?b. Is it likely that management can mitigate any identi-fied going-concern problems?c. Are disclosures about the going-concern problems adequate?d. All of the above.

D

14-27 Which of the following is an example of a Type II subsequent event?a. The client settles a lawsuit for a different amount than was accrued at the balance sheet date.b. A sale of inventory below carrying value provides evidence that the net realizable value was less than cost at year-end.c. Information becomes available that provides evidence about the valuation of an estimate or reserve that had been accrued at year-end.d. None of the above.

D

14-3 The auditor discovers various errors in the client's financial statements during the audit. At the end of the audit, the auditor analyzes these misstatements to determine if the client needs to correct them. In which of the following situations could management and the auditor decide not to correct the misstatement? a. If, by correcting the misstatements, net income would increase rather than decrease.b. If, by correcting the misstatements, net income would decrease rather than increase.c. If the misstatements, in the aggregate, are material.d. If the misstatements, in the aggregate, are immaterial.

D

14-32 In Exhibit 14-8 which of the following items is not present in the management letter?a. The auditor's observations and recommendations to management.b. Management's response.c. The issue of whether or how management responded to the management letter related to the prior year's audit.d. What actions the auditor will take in the subsequent-year audit to help management address the identified weaknesses.

D

14-7 In obtaining evidence about loss contingencies, which of the following are sources of evidence that the auditor should obtain from management?a. A description and evaluation of contingencies that existed at the balance sheet date.b. Assurance that the accounting and disclosure requirements concerning contingent liabilities have been met.c. Documentation of communication with internal and external legal counsel of the client.d. All of the above.

D

Subsequent events

Events occurring between the date of the financial statements and the date of the auditor's report.

Type II subsequent events

Events that did not exist at the balance sheet date, but that may require disclosure.

Type I subsequent events

Events that existed at the balance sheet date.

14-5 The auditor is responsible for designing and maintain-ing policies and procedures to identify, evaluate, and account for loss contingencies; management is respon-sible for determining that the auditor has properly identified, accounted for, and disclosed material loss contingencies. (T/F)

False

14-6 One important primary source of evidence concerning loss contingencies is the client's management; a primary source of corroborative evidence concerning contin-gencies is the client's legal counsel, which provides the management representation letter. (T/F)

False

14-1 Known misstatements are those that the auditor has spe-cifically identified and about which there is no doubt; they are also known as factual misstatements. (T/F)

TRUE

Support letter

Written evidence from management to the auditor providing assurance that the entity has received a commitment of necessary financial sup-port to ensure that the entity remains a going concern.

Factual misstatement

a misstatement about which there is no doubt.