AUD 4
A corporate balance sheet indicates that one of the corporate assets is a patent. An auditor will most likely obtain evidence regarding the continuing validity and existence of this patent by obtaining a written representation from...? A) A patent attorney. B) The patent owner. C) The patent inventor. D) A regional state patent office.
A. A patent attorney. A patent is an intangible asset representing a governmental grant of rights to an invention for a specified time. The lack of physical substance makes verifying its existence and ownership difficult. To obtain evidence of the continuing validity and existence of a patent, the auditor should obtain a written representation from an auditor's specialist. A patent attorney is an auditor's external specialist who has expertise not normally possessed by auditors. The attorney can perform the necessary research and express an opinion on which the auditor may reasonably rely.
If the auditor considers an act of noncompliance with laws and regulations to be sufficiently serious to warrant withdrawing from the engagement, the auditor would likely...? A) Consult with legal counsel as to what other action, if any, should be taken. B) Return all incriminating evidence and working papers to the client's audit committee for follow-up. C) Contact the successor auditor to make the successor aware of the possible consequences of relying on management's representations. D) Notify all parties who may rely upon the company's financial statements of the company's illegal act.
A. Consult with legal counsel as to what other action, if any, should be taken. According to AU-C 250, the auditor should consider consulting legal counsel in these circumstances. Such consultation may be necessary in determining the effects of continued association with the client or whether the auditor may have a duty to notify parties outside the client that overrides his or her duty of confidentiality to the client. (B) The auditor has no responsibility to return all incriminating evidence and working papers to the client's audit committee for follow-up. (C) The successor auditor, with client approval, has the burden of initiating communication with the predecessor. (D) Notifying others is the responsibility of management.
An internal auditor would least likely provide direct assistance to the auditor in...? A) Evaluating accounting estimates. B) Performing substantive procedures. C) Performing tests of controls. D) Obtaining an understanding of internal control.
A. Evaluating accounting estimates. The auditor has the ultimate responsibility to express an opinion on the financial statements. Judgments about (1) assessments of the risks of material misstatement, (2) materiality of misstatements, (3) sufficiency of tests performed, (4) evaluation of significant accounting estimates, and (5) other matters affecting the auditor's report always should be those of the auditor.
Auditors should obtain and evaluate sufficient appropriate evidence to support significant accounting estimates. Differences between the estimates best supported by the evidence and those in the financial statements...? A) May be individually reasonable but collectively indicate possible bias. B) Should arouse concern only when estimates are based on hypothetical assumptions or subjective factors. C) May be individually unreasonable, but if they collectively indicate no bias, accumulation of the differences with other identified misstatements is not required. D) Are per se unreasonable and should be treated as material misstatements.
A. May be individually reasonable but collectively indicate possible bias. If the amount in the financial statements is not reasonable, it should be treated as fraud or error and accumulated with other identified misstatements. If the differences between the best estimates and those in the financial statements are individually reasonable but collectively indicate possible bias (for example, when the effect of each difference is to increase income), the auditor should reconsider the estimates as a whole. (C) An unreasonable difference should be considered an identified misstatement and accumulated. (D) No estimate is considered accurate with certainty. Hence, differences may be reasonable and not considered to be identified material misstatements.
Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions? a) Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date. B) Inspecting communications with law firms for evidence of unreported contingent liabilities. C) Sending second requests for unanswered positive confirmations of accounts receivable. D) Retesting ineffective internal control procedures previously reported to the audit committee.
A. Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date. Related party transactions may involve window dressing at the end of the period. For example, a shareholder may repay a loan just before the balance sheet date, and the entity may then lend the same amount to the same party after the beginning of the next period (AU-C 550). (B) Inspecting communications with law firms for evidence of unreported contingent liabilities identifies potential litigation, claims, and assessments requiring disclosure in financial statements. (C) Confirmations may not provide effective evidence about related party transactions because the related parties may not cooperate. (D) Retesting ineffective control procedures is not an effective use of audit resources.
An auditor concludes that a client has failed to comply with a law that has not been properly accounted for or disclosed. The auditor should withdraw from the engagement if the...? A) The effect of the noncompliance on the financial statements is material, and the client refuses to accept the auditor's report as modified for the noncompliance. B) Noncompliance has an effect on the financial statements that is both material and direct. C) Auditor cannot reasonably estimate the effect of the noncompliance on the financial statements. D) Auditor is precluded from obtaining sufficient appropriate evidence about the noncompliance.
A. The effect of the noncompliance on the financial statements is material, and the client refuses to accept the auditor's report as modified for the noncompliance. When an auditor concludes that a client has failed to comply with a law that has not been properly accounted for or disclosed, the effect of the noncompliance on the financial statements is material, and the client refuses to accept the auditor's report as modified, the auditor should withdraw from the engagement and indicate the reasons for withdrawal in writing to the audit committee or board of directors (AU-C 250). (B) The auditor should express a qualified or adverse opinion if financial statements are not fairly presented. (C) If an auditor cannot reasonably estimate the effect of noncompliance on the financial statements but no scope limitation or departure from GAAP exists, (s)he should consider either disclaiming an opinion or including an explanatory paragraph in a report expressing an unmodified opinion. (D) If the auditor is precluded from obtaining sufficient appropriate evidence about noncompliance, a disclaimer should be issued.
The company being audited has an internal auditor that is both competent and objective. The auditor wants to assign tasks for the internal auditor to perform. Under these circumstances, the auditor may...? A) Not assign any task to the internal auditor because of the internal auditor's lack of independence. B) Allow the internal auditor to perform tests of internal controls. C) Allow the internal auditor to audit a major subsidiary of the company. D) Allow the internal auditor to perform analytical procedures but not be involved with any tests of details.
B. Allow the internal auditor to perform tests of internal controls. The auditor may request direct assistance from the internal auditor when performing the audit. Thus, the auditor may appropriately request the internal auditor's assistance in obtaining the understanding of internal control, performing tests of controls, or performing substantive procedures. The internal auditor may provide assistance in all phases of the audit if (1) the internal auditor's competence and objectivity have been assessed, and (2) the auditor supervises, reviews, evaluates, and tests the work performed by the internal auditor to the extent appropriate. (A) The internal auditor may provide assistance in all phases of the audit if certain conditions are met. (C) A group auditor may decide not to assume responsibility for the work of a component auditor by referring to the audit of the component auditor in the report on the group statements. However, an internal auditor must not be allowed to audit a major subsidiary. This service requires an exercise of professional judgment that the auditor must not delegate to an auditor who lacks independence. (D) The internal auditor may assist in the performance of substantive procedures if certain conditions are met.
Which of the following most likely would indicate the existence of related parties? A) Depending on a single product for the success of the entity. B) Failing to correct previously identified internal control deficiencies. C) Borrowing money at an interest rate significantly below the market rate. D) Writing down obsolete inventory just before year end.
C. Borrowing money at an interest rate significantly below the market rate. The following suggest possible related party transactions: (1) exchanging property for similar property in a nonmonetary transaction, (2) borrowing or lending at rates significantly above or below market rates, (3) selling realty at a price materially different from its appraised value, and (4) making loans with no scheduled repayment terms. (A) Dependence on one product is not a transaction that, by its nature, suggests the existence of related parties. However, AU-C 550 cites it as a possible condition motivating related party transactions. (B) The cost of correction may exceed the benefits. (D) Under U.S. GAAP, inventory is customarily written down to lower of cost or market at year end.
Which of the following steps should an auditor perform first to determine the existence of related parties? A) Examine invoices, contracts, and purchasing orders. B) Review the company's business structure. C) Inquire about the existence of related parties from management. D) Review proxy and other materials filed with the SEC.
C. Inquire about the existence of related parties from management. When obtaining an understanding of the entity's related party relationships and transactions, the auditor should inquire of management regarding (1) the identity of the entity's related parties, including changes from the prior period; (2) the relationships of the entity with those parties; and (3) the types and purposes of transactions with them. (A) The auditor should be aware of the possibility of related parties when examining invoices, contracts, and purchasing orders. However, the first step should be to request a list from management. (B) The business structure can provide the auditor with expectations about the likelihood of related parties. However, the auditor should first request a list from management. (D) The auditor may review proxy and other materials filed with the SEC for possible related parties. However, the auditor should first request a list from management.
Transactions indicative of the existence of related parties include all of the following except...? A) Selling real estate at a price significantly different from the appraised value. B) Making loans with no scheduled terms for repayment. C) Selling real estate at a price significantly different from the carrying amount. D) Borrowing or lending interest-free or at a rate significantly different from prevailing market rates at the time of the transaction.
C. Selling real estate at a price significantly different from the carrying amount. Real estate's fair value is normally significantly higher than its carrying amount. The longer that real estate is held, the more likely that its fair value differs from its carrying amount. A difference between the carrying amount and fair value does not indicate the existence of related parties. It is an occurrence in the normal course of business.
When a management's specialist has assumed full responsibility for taking the client's physical inventory, reliance on the specialist's work is acceptable if...? A) Circumstances made it impracticable or impossible for the auditor to test the work done by the specialist. B) The auditor's report contains a reference to the assumption of full responsibility by the specialist. C) The auditor conducted the same audit tests and procedures as would have been applicable if the client employees took the physical inventory. D) The auditor is satisfied with the competence of the specialist.
C. The auditor conducted the same audit tests and procedures as would have been applicable if the client employees took the physical inventory. The auditor is responsible for the observation of inventories. The auditor performs this procedure whether the client or an external specialist takes the physical inventory. The auditor should (1) examine the specialist's program, (2) observe its procedures and controls, (3) make or observe some physical counts, (4) recompute calculations, and (5) test intervening transactions. (A) The auditor usually cannot express an unmodified opinion unless (s)he has made or observed some physical counts. (B) The auditor cannot assign responsibility to a specialist. (D) Although the auditor is concerned with the competence of the specialist, (s)he still should become satisfied as to the existence of the inventory.
Which of the following must an auditor document with respect to the consideration of fraud in a financial statement audit? A) Instances of the auditor's exercise of professional skepticism during the consideration of fraud. B) Reasons for not identifying management override as a fraud risk. C) Reasons for not identifying improper revenue recognition as a fraud risk. D) Reasons for not identifying collusion as a fraud risk.
C. The auditor presumes the existence of a risk of material misstatement due to fraud related to revenue recognition. If the auditor concludes that the presumption is overcome in the circumstances of the engagement, the auditor should document the reasons for the conclusion (AU-C 240). (A) The auditor should approach every aspect of the audit with professional skepticism. Hence, specific, separate documentation of its exercise is not required. (B) Management override is always a fraud risk because it is an inherent limitation of internal control. Thus, the results of procedures designed to address management override should be documented. (D) The inherent limitations of an audit include the nature of auditing. For example, audit procedures for gathering evidence may not detect an intentional misstatement involving collusion. Thus, collusion is always a fraud risk.
Which of the following statements concerning the auditor's use of the work of an auditor's external specialist is true? A) If the auditor believes that the determinations made by the auditor's specialist are unreasonable, only a qualified opinion may be expressed. B) The auditor's specialist may be identified in the auditor's report only when the auditor expresses an unmodified opinion. C) The auditor's specialist should observe the same confidentiality requirements as the auditor. D) The auditor's specialist need not have an understanding of the extent of the auditor's use of the specialist's work.
C. The auditor's specialist should observe the same confidentiality requirements as the auditor. An agreement between the auditor and the auditor's external specialist generally is documented in an engagement letter. A matter that should be included is the need for the confidentiality provisions of the relevant ethical requirements that apply to the auditor to also apply to the specialist. For example, a member of the AICPA may use a third-party service provider to render professional services to clients. The member should have a contract with the third-party service provider to maintain the confidentiality of the information (Ethics Ruling). Other requirements may be imposed by law or regulation. (A) If the auditor determines that the work of the auditor's specialist is not adequate, the auditor (or the specialist or another specialist) should perform additional procedures. If they do not resolve the matter, the opinion may need to be modified. An adverse opinion may be expressed if the auditor concludes that the financial statements are materially misstated. (B) The auditor may refer to an auditor's external specialist only when the opinion is modified. (D) The auditor should agree, in writing if appropriate, with the auditor's specialist regarding the arrangements for the services, including objectives, roles, communications, and confidentiality requirements. Certain factors indicate that the agreement needs to be more detailed or in writing. One such factor is that the auditor's use of the work of the auditor's specialist (and its significance for the audit) is extensive.
Which of the following audit procedures is an auditor most likely not to perform related to newly identified related party transactions outside the normal course of business? A) Verify the terms and conditions of the transactions. B) Analyze accounting records for transactions. C) Understand the controls over authorization and approval of such transactions. D) Evaluate the business purpose of the transactions.
C. Understand the controls over authorization and approval of such transactions. Significant transactions outside the normal course of business most likely have a high assessed risk of material misstatement because normal controls do not typically apply. Thus, the focus should be on substantive testing of the transactions. (A) The auditor should verify the terms and conditions and evaluate the accounting and disclosure. (B) The auditor should analyze the accounting records, for example, by using computer-assisted audit procedures. (D) The auditor should evaluate whether the business purposes (or the lack of a purpose) of the transactions indicates fraud or misappropriation of assets.
When auditing related party transactions, an auditor places primary emphasis on...? A) Confirming the existence of the related parties. B) Ascertaining the rights and obligations of the related parties. C) Verifying the valuation of the related party transactions. D) Assessing the risks of material misstatement of related party transactions.
D. Assessing the risks of material misstatement of related party transactions. The auditor has a responsibility to perform audit procedures to identify, assess, and respond to the risks of material misstatement arising from the entity's failure to appropriately account for or disclose related party relationships, transactions, or balances.
An internal auditor's work would most likely affect the nature, timing, and extent of an independent auditor's auditing procedures when the internal auditor's work relates to assertions about the...? A) Valuation of related party transactions. B) Existence of contingencies. C) Valuation of intangible assets. D) Existence of fixed asset additions.
D. Existence of fixed asset additions. Assertions may relate to material financial statement amounts for which the risks of material misstatement or the degree of subjectivity involved in the evaluation of the audit evidence is high. In these cases, reliance on the internal auditor is less effective. However, certain assertions may relate to less material financial statement amounts for which the risks of material misstatement or the degree of subjectivity involved is low. For example, the auditor may be able to rely on the internal auditor's work regarding assertions about the existence of cash, prepaid assets, and fixed asset additions. (A) The auditor is less likely to rely on the internal auditor's work regarding subjective issues such as valuation of related party transactions. (B) The auditor is less likely to rely on the internal auditor's work regarding subjective issues such as existence of contingencies. (C) The auditor is less likely to rely on the internal auditor's work regarding subjective issues such as valuation of intangible assets.
In which of the following circumstances is an auditor most likely to rely on work done by internal auditors? A) If financial statement amounts are material and the degree of subjectivity in evaluating the audit evidence is high. B) For financial statement amounts determined largely or entirely on the basis of estimates made by management. C) If the internal auditors have concluded that the risk of material misstatement at the overall financial level is negligible. D) For financial statement amounts judged by the auditor to require little or no subjectively evaluated audit evidence.
D. For financial statement amounts judged by the auditor to require little or no subjectively evaluated audit evidence. The auditor should make all significant judgments. Thus, (s)he should use less of the internal auditors' work and perform more work directly in the following circumstances: (1) the more judgment is involved in planning and performing audit procedures or evaluating evidence, (2) the higher the assessed risk of material misstatement at the assertion level, (3) the less the internal auditors' organizational status and relevant policies and procedures support their objectivity, and (4) the lower their competence. Accordingly, the auditor is most likely to rely on the work of the internal audit function when little or no judgment is required to evaluate audit evidence. (A) The more judgment is required to evaluate audit evidence, the less likely is reliance on the work of the internal audit function. (B) Only the external auditor can make significant judgments about the evaluation of accounting estimates. (C) Only the external auditor can make significant judgments.
Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions? A) Vouching accounting records for recurring transactions recorded just after the balance sheet date. B) Performing analytical procedures for indications of possible financial difficulties. C) Inspecting correspondence with lawyers for evidence of unreported contingent liabilities. D) Reviewing confirmations of loans receivable and payable.
D. Reviewing confirmations of loans receivable and payable. An auditor should be alert during the audit for related party information. Thus, the auditor should inspect records and documents, especially (1) bank and legal confirmations, (2) minutes of meetings of shareholders and directors, and (3) any other records or documents considered necessary. Other records and documents may include third-party confirmations. (A) Recurring transactions recorded after the balance sheet are in the normal course of business, for example, sales transactions. (B) Analytical procedures may disclose financial difficulties but not related party transactions. (C) The question indicates that the auditor is concerned about identifying related party transactions, not unreported contingent liabilities.
Which of the following events most likely would indicate the existence of related parties? A) High turnover of senior management and members of the board of directors. B) Failure to correct internal control weaknesses on a timely basis. C) Granting stock options to key executives at favorable prices. D) Selling real estate at a price significantly different from appraised value.
D. Selling real estate at a price significantly different from appraised value. The following suggest the existence of related party transactions: (1) exchanging property for similar property in a nonmonetary transaction, (2) borrowing or lending at rates significantly above or below market rates, (3) selling realty at a price materially different from its appraised value, and (4) making loans with no scheduled repayment terms. (A) Turnover of managers and directors is often substantial. (B) Failure to correct internal control weaknesses on a timely basis is more likely a fraud risk factor. (C) Compensatory share option plans by definition are at favorable prices.
In auditing related party transactions, an auditor ordinarily places primary emphasis on... A) The probability that related party transactions will recur. B) Confirming the existence of the related parties. C) Verifying the valuation of the related party transactions. D) The adequacy of the disclosure of the related party transactions.
D. The adequacy of the disclosure of the related party transactions. Accounting principles ordinarily do not require transactions with related parties to be accounted for differently from those with unrelated parties. Primary emphasis should be on the adequacy of disclosure.
After identifying related party transactions, an auditor most likely would...? A) Substantiate that the transactions were consummated on terms equivalent to those prevailing in arm's-length transactions. B) Discuss the implications of the transactions with third parties, such as the entity's attorneys and bankers. C) Ascertain whether the transactions would have occurred if the parties had not been related. D) Determine whether the transactions were approved by the board of directors or other appropriate officials.
D. Determine whether the transactions were approved by the board of directors or other appropriate officials. After identifying significant related party transactions outside the normal course of business, an auditor should obtain evidence that they have been appropriately authorized and approved by management, those charged with governance, or (in a proper case) the shareholders. Appropriate authorization and approval reduce but do not eliminate the risks of material misstatement due to fraud or error (AU-C 550). (A) The transactions need not be equivalent to arm's-length transactions. Moreover, substantiation in these circumstances is difficult. (B) Discussion with third parties should be considered only when necessary to understand the transactions fully. (C) Ascertaining whether the transactions would have occurred if the parties were unrelated is ordinarily not possible unless they are routine.
The work of internal auditors may affect the independent auditor's which of the following? I. Procedures performed in obtaining an understanding of internal control. II. Procedures performed in assessing the risks of material misstatement. III. Substantive procedures performed in gathering direct evidence.
I, II, and III. The internal audit function is part of the client's internal control. The auditor should obtain an understanding of this function when obtaining an understanding of internal control. The auditor also may use the internal auditors to provide direct assistance under certain conditions. A primary purpose of internal auditors is to review, assess, and monitor internal control. Thus, their work is relevant to the understanding of internal control and the assessment of risk. Moreover, some procedures performed by internal auditors, such as confirmations, may provide direct evidence about material misstatements.
For which of the following judgments may an independent auditor share responsibility with an entity's internal auditor who is assessed to be both competent and objective? - Materiality of Misstatements (Y/N) - Evaluation of Significant Accounting Estimates (Y/N)
Materiality of Misstatements: NO. Evaluation of Significant Accounting Estimates: NO. The responsibility to report on financial statements is solely the auditor's. It cannot be shared with internal auditors. Because the auditor has the ultimate responsibility to express an opinion on the financial statements, judgments about (1) assessments of RMMs, (2) materiality of misstatements, (3) sufficiency of tests performed, (4) evaluation of significant accounting estimates, and (5) other matters affecting the auditor's report always should be those of the auditor.
