Auditing and Assurance - Chapter 8

What are analytical procedures?

...

main benefit of APs?

...

3 primary reasons why adequate planning is beneficial/essential

1. It's required by GAAS 2. It helps evidence gathering efforts (and keep audit costs reasonable). 3. It helps client relationships (and to avoid misunderstandings with the client).

what are the (4) reasons to possibly reject a new client or drop an existing one?

1. client lacks integrity (collusion, scope limitations, FFR, etc.) 2. client is difficult to work with (scope limitation ->disclaimer opinion) 3. auditor lacks industry knowledge 4. clients in a risky industry with bankruptcy/lawsuits

what should the engagement letter include (8)?

1. engagement objectives 2. responsibilities of the auditor and management 3. engagement limitations 4. anticipated fees 5. deadlines for completing the audit 6. when the audit report will be ready 7. assistance to be provided by client personnel 8. any other fees like tax to be provided

Which of the following would most likely not be classified as a related-party transaction? A) An advance of one week's salary to an employee B) Sales of merchandise between affiliated companies C) Loans or credit sales to the principal owner of the client company D) Exchanges of equipment between two companies owned by the same person

A) An advance of one week's salary to an employee

Which of the following best describes the corporate minutes of an entity? A) Official record of the meetings of the board of directors and the stockholders B) Unofficial record of the meeting of the board of directors C) Official record of management meeting with investors and creditors of the company D) Unofficial record of the board of directors meetings

A) Official record of the meetings of the board of directors and the stockholders

The major concern when using nonfinancial data in analytical procedures is the: A) accuracy of the nonfinancial data. B) source of the nonfinancial data. C) type of nonfinancial data. D) presence of multiple sources of nonfinancial data.

A) accuracy of the nonfinancial data.

An auditor has accessed client business risk and the risk of material misstatements to the clients financial statements. These are done in order to: A) apply the audit risk model to determine the appropriate extent of audit evidence. B) determine the reliance on the company's internal control systems for financial reporting. C) determine the test of balances to be performed by the audit team. D) assure the CPA firm that they can perform the audit effectively and efficiently.

A) apply the audit risk model to determine the appropriate extent of audit evidence.

When performing planning analytical procedures for a client the auditor detected that the gross profit percentage had declined by 50% from the previous year to the year currently under audit. The auditor should: A) investigate the possibility the client may have made an error in their cost of goods sold computation. B) assist management in developing greater cost efficiencies in their product line. C) prepare a going concern opinion for the client. D) advise the client to have extensive disclosure to alleviate investor concerns.

A) investigate the possibility the client may have made an error in their cost of goods sold computation.

A related party transaction may be indicated when another company: A) subsidizes certain operating expenses of the company. B) purchases its securities at their fair value. C) loans to company at market rates. D) has had a distributor relationship with the company for 10 years.

A) subsidizes certain operating expenses of the company.

Which of the following statements is not correct with respect to analytical procedures? A) Auditing standards emphasize the need for auditors to develop and use expectations. B) Analytical procedures must be performed throughout the audit. C) Analytical procedures may be performed at any time during the audit. D) Analytical procedures use comparisons and relationships to assess whether account balances appear reasonable.

B) Analytical procedures must be performed throughout the audit.

Which is a liquidity activity ratio? A) Profit margin B) Inventory turnover C) Return on assets D) Times interest earned

B) Inventory turnover

The audit team gathers information about a new client's business and industry in order to obtain: A) an understanding of the clients internal control system for financial reporting. B) an understanding of how economic events and transactions have an effect on the company's financial statements. C) information about control risk. D) information regarding whether the company is engaging in financial statement fraud

B) an understanding of how economic events and transactions have an effect on the company's financial statements.

Related party: A) transactions must be disclosed in the footnotes even if the amounts are immaterial. B) disclosures include the nature of the related party relationship and a description of the transaction. C) transactions are considered arms-length transactions. D) disclosures are required only for public companies

B) disclosures include the nature of the related party relationship and a description of the transaction.

An auditor who accepts an audit engagement and does not possess the industry expertise of the business entity should: A) engage financial experts familiar with the nature of the business entity. B) obtain a knowledge of matters that relate to the nature of the entity's business. C) refer a substantial portion of the audit to another CPA who will act as the principal auditor. D) first inform management that an unqualified opinion cannot be issued.

B) obtain a knowledge of matters that relate to the nature of the entity's business.

Most auditors assess inherent risk as high for related parties and related-party transactions because: A) of the unique classification of related-party transactions required on the balance sheet. B) of the lack of independence between the parties. C) of the unique classification of related-party transactions required on the income statement. D) it is required by generally accepted accounting principles.

B) of the lack of independence between the parties.

An auditor should examine minutes of the board of directors' meetings: A) through the date of the financial statements. B) through the date of the audit report. C) only at the beginning of the audit. D) on a test basis.

B) through the date of the audit report.

Which of the following is a correct statement regarding analytical procedures? A) A major strength in using industry ratios for auditing is the difference between the nature of the client's financial information and that of the firms making up the industry totals. B) Common-size financial statements display all items as a percentage change from a base year. C) Auditors should investigate the most significant differences between budgeted and actual results. D) In order to look for a misstatement in the allowance for bad debts, the auditor should divide gross sales by sales returns and allowances.

C) Auditors should investigate the most significant differences between budgeted and actual results.

Which of the following is not a primary reason for obtaining a good understanding of the client's industry and external environment? A) Risk associated with a specific industry may affect the auditor's assessment of client business risk. B) Risk associated with a specific industry may affect the auditor's assessment of acceptable audit risk. C) Risk associated with a specific industry may affect the auditor's assessment of acceptable control risk. D) Many control risks are common to all clients in certain industries.

C) Risk associated with a specific industry may affect the auditor's assessment of acceptable control risk.

The auditor determines that Mathews Company occupies the 3rd floor of an office tower for which it pays no rent. The most likely explanation is: A) they got lucky the landlord hasn't noticed the lack of payments. B) landlord has weak internal controls over billings. C) a related party transaction in which a major shareholder owns the office tower. D) Matthews Company is engaging in fraudulent activities.

C) a related party transaction in which a major shareholder owns the office tower.

Business risk: A) is the risk after considering the effectiveness of top management controls. B) is the risk that the client's internal controls will fail. C) can include a new technology which threatens to erode a company's competitive advantage. D) cannot be mitigated by management.

C) can include a new technology which threatens to erode a company's competitive advantage.

An official record of meetings of the board of directors and stockholders is included in the corporate: A) bylaws. B) charter. C) minutes. D) license.

C) minutes.

In making client acceptance decisions, the audit firm will consider: A) inherent and control risk of the client. B) audit risk to the CPA Firm. C) the client's business risk and the risk of material misstatements in the financial statements. D) CPA Firm's potential ongoing revenue from the audit client.

C) the client's business risk and the risk of material misstatements in the financial statements.

Which of the following is most correct with respect to the use of analytical procedures? A) Analytical procedures may be used in evaluating balances in the testing phase as long as the auditor also uses them in assessing the going concern assumption. B) Analytical procedures must be used throughout the audit. C) Analytical procedures used in the testing phase of the audit are primarily used to direct an auditor's attention so that the auditor's understanding of the business is improved. D) Analytical procedures are performed by studying plausible relationships between financial and nonfinancial data.

D) Analytical procedures are performed by studying plausible relationships between financial and nonfinancial data.

Which of the following would not be classified as an analytical procedure? A) Benchmarking the company's profitability ratios against others in the industry B) Variance analysis of actual versus budgeted amounts for production C) Reperforming the client's depreciation expense using the client's accounting policies for capital expenditures made during the year D) Reconciling fixed asset dispositions with the fixed asset ledger

D) Reconciling fixed asset dispositions with the fixed asset ledger

When are auditors likely to encounter judgment problems in the use of analytical procedures? A) Whenever the auditor places reliance on management's explanations for unusual fluctuations in account balances without first developing independent expectations B) Whenever the auditor allows unaudited balances to unduly influence his/her expectations of current balances C) Whenever the auditor fails to consider the pattern reflected by several unusual fluctuations when trying to explain what caused them D) The auditor is likely to encounter judgment problems in each of the above instances

D) The auditor is likely to encounter judgment problems in each of the above instances

During audit planning, the auditor uses analytical procedures primarily to: A) identify weaknesses in internal control. B) determine if the company's financial statements appear reasonable and are free of material misstatement. C) determine the correspondence of the company's financial statements to the valuation and accuracy audit objectives. D) determine the nature, extent, and timing of audit procedures

D) determine the nature, extent, and timing of audit procedures

Analytical procedures: A) are not a type of audit evidence. B) are not required during the completion phase of the audit. C) performed during the planning phase of the audit are used as a substantive test in support of account balances. D) performed in the completion phase serve as a final review for material misstatements or financial problems.

D) performed in the completion phase serve as a final review for material misstatements or financial problems.

if AAR is set at a high level, does this mean more evidence will be collected or less evidence will be collected?

a higher AAR would need less evidence

acceptable audit risk

a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.

inherent risk

a measure of the auditor's assessment of the likelihood that there are material misstatements in an account balance before considering the effectiveness of internal control.

written communication that the auditor will provide reasonable assurance for the detection of fraud is found in: a. engagement letter b. representation letter c. responsibility letter d. client letter

a. engagement letter

which of the following normally signs the engagement letter for an audit of a private company: a. management b. board of directors representative c. audit committee representative d. corporate treasurer

a. management

what is the engagement letter?

an agreement between the CPA firm and the client concerning the conduct of the audit and related services. the new auditor is required by auditing standards to document the client's understanding of terms in the engagement letter.

what is a related party?

any transaction that is affiliated with another company (e.g. through subsidiary, common ownership

when should the auditor inquire about related party transactions?

at the beginning (planning)

in what order should the following steps occur? a. assess client business risk b. understand the client's business and industry c. perform preliminary analytical procedures d. assess acceptable audit risk

b, a, c, d

the purpose of the engagement letter is to: a. document the CPA firm's ability to external users of the audited financial statements b. document the terms of the engagement c. notify the audit staff of an upcoming engagement so that personnel scheduling can be facilitated d. emphasize management's responsibility for approving the audit program

b. document the terms of the engagement

a written understanding detailing what the auditors will do in determining if the financial statements are fair representations of the company's financial statements and what the auditor expects from the client in performing an audit will normally be expressed in the: a. management letter requested by the auditor b. engagement letter c. audit plan d. audit strategy for the client

b. engagement letter

the preliminary audit strategy: a. is set up before the auditor understands the client's reason for the audit b. guides the development of the audit plan c. is determined after the engagement staffing is set d. is the detailed steps to be followed for the substantive audit tests

b. guides the development of the audit plan

the purpose of the requirement in having communication between the predecessor and successor auditor is to: a. allow the predecessor to evaluate whether to accept the engagement b. help the successor auditor to evaluate whether to accept the engagement c. help the client by facilitating the change of auditors d. ensure the predecessor collects all unpaid fees prior to a change in auditor

b. help the successor auditor to evaluate whether to accept the engagement

initial audit planning involves four matters. which of the following is not one of these? a. develop an overall audit strategy b. request that bank balances be confirmed c. schedule engagement staff and audit specialists d. identify the client's reason for the audit

b. request that bank balances be confirmed

which of the following statements are true regarding the communication between predecessor and successor: a. the burden of initiating the communication rests with the predecessor b. the predecessor's response can be limited to stating that no information will be provided c. the predecessor should communicate with the successor only if the client is public d. the predecessor auditor of a public company does not need permission from the client before communicating with the successor auditor

b. the predecessor's response can be limited to stating that no information will be provided

which of the following best expresses the understanding of the terms of the engagement that exist between the client and the CPA firm? a. management asserts there are no errors, material or immaterial, in the general ledger b. auditors assert that the primary goal is audit efficiency c. auditors assert that their primary responsibility is to plan and perform the audit in order to provide reasonable assurance as to the detection of material misstatement due to error or fraud d. management asserts that they will provide the auditor with a risk assessment as to material misstatements due to errors or fraud in the company's financial statements

c. auditors assert that their primary responsibility is to plan and perform the audit in order to provide reasonable assurance as to the detection of material misstatement due to error or fraud

an engagement letter sent to a publicly held audit client usually would NOT include a: a. reference to the auditor's responsibility for the detection of errors or irregularities b. estimation of the time to be spent on the audit work by the audit staff and management c. statement that management advisory services would be made available upon request d. reference to management's responsibility for the financial statements

c. statement that management advisory services would be made available upon request

a new client's refusal to allow the new auditor permission to communicate with the predecessor auditor would impact the new auditor's decision, including: a. the auditor's ability to design audit tests b. possible scope exception due to lack of access c. the desirability of accepting the engagement d. a violation of GAAP rules concerning consistency and comparability of financial information

c. the desirability of accepting the engagement

the two major factors affecting acceptable audit risk are: a. IR and the intended uses of the financial statements b. control risk and the intended uses of the financial statements c. the likely statement users and the intended uses of the financial statement d. the audit firm and the intended uses of the statement

c. the likely statement users and the intended uses of the financial statement

the predecessor auditor is required to respond to the request of the successor auditor for information, but the response can be limited to stating that no information will be provided when: a. the predecessor auditor has poor relations with the successor auditor b. the client is dissatisfied with the predecessor's work c. there are actual or potential legal problems between the client and predecessor d. the predecessor believes that the client lacks integrity

c. there are actual or potential legal problems between the client and predecessor

the auditor uses knowledge gained from the understanding of the client's business and industry to assess what kind of risk?

client business risk

what (5) comparisons are useful when performing preliminary analytical procedures?

client data (this years' financial statement data) and: industry data similar period data client-determined expected results auditor-determined expected results expected results (using non-financial data)

when dealing with audit risk: a. audit risk should not be a factor when determining if a new client should be accepted b. audits with a low acceptable audit risk generally result in lower audit fees c. if management of a company has a reputation of integrity, but it is also known to take aggressive financial risks, they should not be accepted as a new client d. if the auditor concludes that AAR is low, but the client is still acceptable, the auditor may still accept the engagement but increase the audit fee

d. if the auditor concludes that AAR is low, but the client is still acceptable, the auditor may still accept the engagement but increase the audit fee

When selecting staff for the audit engagement: a. only staff members who are CPAs should be assigned to the audit b. only managers and above need to have appropriate competence and capabilities to perform the audit c. continuity of staff members from year to year should not be a factor. d. staff assigned to the audit must be knowledgeable about the client's industry.

d. staff assigned to the audit must be knowledgeable about the client's industry.

if an auditor is requested to perform non-audit services for a public company audit client, who is responsible for agreeing to those services with the audit firm? a. the client's management b. the client's CEO c. the client's CFO d. the client's audit committee

d. the client's audit committee

when are analytical procedures required by GAAS?

during the 1. planning phase (to assist the auditor in determining the nature, extent, and timing of work to be performed, and to help identify accounts and classes of transactions where misstatements are likely) and 2. the completion phase as a review for material misstatements or financial problems

theoretically, information on related party should be founds where?

footnotes of the financial statements

does the contra-asset account, allowance for doubtful accounts, generally have a high or low IR?

high IR - based on estimates made by management

does the cash account generally have a high inherent or low inherent risk?

high IR - cash is very susceptible to fraud

under a defined pension plan, does the pension expense and related pension liability account generally have high IR or low IR?

high IR - complexity is high

does the valuation of a foreign subsidary generally have a high or low AR?

high IR - remoteness of location

possible tools/options to understand client's business and industry and client business risk

industry journals, industry benchmarks and financial ratios, client org chart, tour client operations, inquiry of related parties, read minutes of corporate meeting

will AAR be set higher for a long term or a brand new audit client?

long-term client (due to e.g. history with client, familiarity with client's systems)

does the valuation of office furniture account generally have a high or low IR?

low IR - very simple, not subject to fraud

what is the auditor's first duty with respect to related party transactions?

make sure they are properly disclosed

are related party transactions illegal?

no

which is usually included in the engagement letter? list of audit procedures to be used in inventory observation (yes or no) the auditors' assessment of audit risk

no no

which is usually included in the engagement letter? the projected type of opinion on the financials statement to be audited (yes or no) name of the client personnel responsible for supplying the auditor information (yes or no)

no no

when inherent risk is high, there will need to be: a lower assessment of audit risk? (yes or no) more evidence accumulated by the auditor? (yes or no)

no yes

which is usually included in an engagement letter? estimate of hours required to complete audit (yes or no) dollar estimate of fees to be billed to the client (yes or no)

no yes

who sets the level of AAR? on what basis is this determined?

the auditing firm (partners, managers) this could be determined by: firm policy, history with audit client, personality of partner/manager

what's the concern with related party transactions?

there is a possibility that it might distort the economic reality of what is really going on

auditors assign IRs to each balance sheet account 5 different ways. how can this be?

there is one IR for each audit objective (e.g. existence, completeness, valuation and allocation, rights and obligations)

why is the new successor auditor required to contact the old predecessor auditor?

this enables the new auditor to obtain information about the client for evaluation in whether to accept the engagement. permission must be obtained from the client first. the predecessor is required to respond to the successor's request, however, the response may be limited to " no information will be given". also they can figure out if the client is "opinion shopping".

when may the auditor refer to a specialist in the audit report? only if the specialist's report results in a modification of the audit opinion (yes or no) only if the specialist assisted in the audit of an account material to the financial statements (yes or no)

yes no

which is usually included in an engagement letter? the financial statements are the responsibility of the company's management (yes or no) ratios to be used by the auditor in the planning phase (yes or no)

yes no

Whenever an auditor compares client data to client-prepared budgets, there are two special concerns. Indicate if the two items below are concerns. Assessing whether the budgets were realistic plans (yes or no) Client data may have been altered to conform to the budget (yes or no)

yes yes

a successor auditor may perform which of the following for a new audit client: speak to local attorneys, banks, and other business regarding the company's reputation (yes or no) speak to predecessor auditors about disagreements they had with management (yes or no)

yes yes

the auditor is likely to accumulate more evidence when the audit is for a company that: has large amounts of debt (yes or no) is going to be sold in the near future (yes or no)

yes yes

which is usually included in an engagement letter? a reference to the standards acceptable in the USA (yes or no) a reference to GAAS (yes or no)

yes yes