AC 523 Ch. 3 Questions

Materiality is assessed in terms of potential effect of a misstatement on decisions made by ______.

a reasonable user of financial statements

In practice, auditors commonly set tolerable misstatement for each account at ______.

between 50% and 75% of overall materiality

Based on an understanding of the entity and environment, the auditor identifies those _______________ risks that may result in material misstatements.

business

When a prospective client refuses to permit the predecessor auditor to respond, the successor auditor should ______.

have reservations about accepting the client

Violations of laws or regulations are referred to as

illegal acts

Information about an auditor's financial or business relationships with the firm's clients is documented by having all personnel complete an annual

independence questionnaire

When an entity operates in a highly regulated industry, the auditor would choose a _____ percentage in deciding the appropriate percentage to apply to a selected materiality benchmark.

lower

The maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decision of users is overall

materiality

Auditor risk assessment procedures are used to ______.

obtain an understanding of the entity and its environment

Auditors can reduce audit risk to an acceptably low level by ______.

obtaining an understanding of the entity and its environment.

Auditors should attempt to identify all related parties during the ______ phase of the audit.

planning

When a client has multiple locations, the auditor determines which locations or business units to audit and the extent of audit procedures to be performed during the ______ process.

planning

The auditor's consideration of materiality on an audit is a matter of ______.

professional judgment

Auditors should establish an understanding with the entity about the terms of the engagement to ______.

reduce the risk of misinterpretation between the two parties

Materiality is a(n) __ concept.

relative

When auditing a company with multiple locations, the amount of audit attention devoted to various locations depends upon the ______.

risk of material misstatement

The purpose of setting ___________ __________ is to establish a scope for the audit procedures for the individual account balance or disclosures.

tolerable misstatement

A public accounting firm may disassociate itself from an auditing client due to ______.

- accounting issues. - disputes over fees. - auditing issues.

Risk assessment procedures include ______.

- observation and inspection. - preliminary analytical procedures. - inquiries of management and others.

Which of the following best describes an audit committee?

An audit committee is a subcommittee of the board of directors that is responsible for the financial reporting and disclosure process.

True or false: The extent of effort that goes into evaluating a new client is normally much less than the decision to continue with an existing client.

False

Which of the follow is not an inquiry that a successor auditor should make to a predecessor auditor?

The predecessor auditor's fee charged for audit work.

The first phase of the audit process that relates to audit planning is ______.

client acceptance and continuance

Ideally, the head of of internal auditing (chief audit executive) should ______.

report functionally to the audit committee and administratively to senior management

Operating effectiveness is checked using ______.

tests of controls only

The amount of overall materiality used to plan and perform audit procedures at the account or disclosure level is called

tolerable misstatement

If a company has income before taxes of $15,000,000 and the auditor decides that 7% of that amount would be material, what would be the overall materiality for the audit engagement.

$15,000,000 / 7% = $1,050,000

For public companies, a relative percentage for establishing overall materiality is typically __.

3% to 5% of income before taxes

True or false: In some cases, fraud may consist of illegal acts.

True

Substantive tests of transactions test for ____________ or _____________ in individual transactions.

error fraud

Which of the following statements are correct in regards to audit planning?

- Overall financial statement materiality serves as a safety net. - The lower the tolerable misstatement, the more extensive the required audit testing. - Audits must be completed in a reasonable length of time at reasonable cost.

An auditor may not accept a prospective client because the ______.

- client refuses to allow contact with the predecessor auditor. - entity has unusual business risks.

Engagement team members performing supervisory activities should ______.

- review the work of engagement team members. - inform engagement team members of their responsibilities.

In establishing an understanding about the terms of the engagement with potential clients, ______ should be discussed.

- using the work of internal auditors. - the engagement letter. - the role of the client's audit committee.

When should the audit committee meet with external auditors to discuss the auditor's responsibilities and significant accounting policies?

Before the engagement starts

Which of the following is not a factor that auditors should consider when evaluating the reliability of the internal audit function?

Composition

A significant aspect of most audit engagements is the use of a(n) ______ specialist.

IT

True or false: A public accounting firm should investigate a prospective client prior to accepting the engagement.

True. The investigation should include inquiries of the predecessor auditor.

When the aggregated misstatement are greater than overall materiality the auditor should

ask the entity to adjust the financial statements

Once the audit strategy has been established, the auditor develops a more detailed

audit plan

Serving as a contract, the ______ outlines responsibilities and prevents misunderstandings between the auditor and client.

engagement letter

If the entity's management does not provide satisfactory information about possible illegal acts, the auditor should consult with the ______.

entity's legal counsel

When the aggregated misstatements are less than the overall materiality, the auditor can conclude that the financial statements are presented ______.

fairly

It is generally ______ for the auditor to simply subdivide materiality proportionally to each account

inefficient. Otherwise, this would result in unnecessarily low tolerable misstatement levels..

Auditors should attempt to identify all _____________ ______________ because transactions with them may not be at "arm's length."

related parties

An amount or amounts that reduce to an appropriately low level the probability that the total of uncorrected and undetected misstatements that would result in material misstatement of the financial statements is

tolerable misstatement

Risk assessment, benchmarking and recommendations based on the assessment of business risk are all examples of ____________ _____________ services

value added

The consideration of materiality is a matter of ______.

professional judgment

When should the evaluation of client continuance take place?

- At or near the completion of the audit. - When a significant event occurs.

Which of the following statements are correct in relation to duel-purpose tests?

- Dual-purpose tests can improve audit efficiency. - Tests of controls check the operating effectiveness of controls. - Substantive tests of transactions are concerned with monetary misstatements.

Suppose that you are the auditor of a major retail client who has reported the following income before taxes (IBT) for the first two quarters of the year: 1st quarter = $1,200,000 and 2nd quarter = $1,500,000. You are in the process of establishing overall materiality for the client, who is also a public company. Based on prior years, the client has a 10% decline in IBT from the 2nd quarter to the 3rd quarter. You also know that IBT in the 4th quarter increases by 25% over the 3rd quarter.

1Q = $1,200,000 2Q = $1,500,000 3Q = (1,500,000 * (100% - 10%) = $1,350,000 4Q = (1,350,000 * (100% + 25%) = $1,687,500 Estimated income before taxes = $5,737,500 * 5% = 287,000

True or false: The audit team a public accounting firm uses for an engagement does not tend to vary from client to client.

False. Public accounting firms need to ensure that engagements are completed by auditors having the proper degree of technical training and proficiency given the circumstances of the entity.

When determining whether to use the work of the entity's internal auditors, the external auditor must obtain ______.

an understanding of the internal audit function

The arrangements reached between the auditor and the entity are formalized in a(n)

engagement letter

Ensuring that members of the audit team meet independence requirements generally take place as part of ______.

preliminary engagement activities

To detect material misstatements in a class of transactions, account balance and disclosure component of the financial statements, the auditor designs

substantive procedures

Tests of controls are performed to ______.

test the operating effectiveness of controls

Auditing standards distinguish between illegal acts that have _________ and material effects on the financial statements and those that have ___________ but ___________ effects

Auditing standards distinguish between illegal acts that have *direct* and material effects on the financial statements and those that have *material* but *indirect* effects.

True or false: If current year pretax income is not stable, auditors should not base materiality on income.

False. While another benchmark (total assets or total revenue) may be preferable, normalized earnings may still be used.

Which of the following best describes why audit committees are formed?

Audit committees are formed to satisfy the shareholders' need for assurance that directors are exercising due care in the performance of their duties.

Select all of the following that are functions of the audit committee:

- Selection of the independent auditor, discussion of audit fee with the auditor, and review of the auditor's engagement letter. - Review of the independent auditor's overall audit plan (scope, purpose, and general audit procedures). - Review of the annual financial statements before submission to the full board of directors for approval. - Review of the results of the auditor's examination including experiences, restrictions, cooperation received, findings, and recommendations. Matters that the auditor believes should be brought to the attention of the directors or shareholders should be considered. - Review of the independent auditor's evaluation of the company's internal control systems. - Review of the company's accounting, financial, and operating controls. - Review of the reports of internal audit staff. - Review of interim financial reports to shareholders before the board of directors approves them.

An auditor's independence would be considered impaired if the ______.

- client owes money to the auditor that has the characteristics of a loan. - spouse of the auditor is an accounting supervisor for the entity.

The nature and extent of planning activities that are necessary depend on the ______ the entity

- complexity of. - size of. - auditor's previous experience with.

Factors that should be considered in the determination of staffing requirements for an audit include ______.

- engagement complexity. - engagement size. - personnel availability. - timing of the work.

During the documenting stage, the auditor ______.

- ensures that the identified risks have been addressed. - complies his or her knowledge about the entity's business objectives and strategies. - records how the entity is managing its risks.

Generally, the three preliminary engagement activities are ______.

- ensuring the audit team and firm are in compliance with ethical and independence requirements. - determining the audit engagement team requirements. - establishing an understanding with the entity.

In deciding the appropriate percentage to apply to a selected materiality benchmark, the auditor would choose a lower percentage within the range for qualitative factors such as ______.

- high risk of fraud. - material misstatements in prior years. - the entity is close to violating a covenant in a loan agreement.

Factors that would cause the auditor to use a lower percentage for tolerable misstatement include a ______.

- history of material weaknesses in internal control. - high risk of misstatement within the account balance.

Under Section 301 of the Sarbanes-Oxley Act, the audit committee of a public company ______.

- is directly responsible for the hiring, paying and oversight of the public accounting firm employed by the company. - must have the authority to engage independent counsel to carry out duties as necessary. - must preapprove all audit and nonaudit services provided by the auditors.

When net income is fluctuating, the auditor should consider basing materiality on ______

- normalized earnings for the past three years. - a benchmark other than net income.

Examples of tests of controls include ______.

- observation of the application of specific controls. - reperformance of the application of the control. - inquiries of management, supervisory and staff personnel. - inspecting documents, reports and electronic files.

Traditionally, value added services have included ______.

- tax planning. - internal reporting processes. - system design and integration.

The categories of substantive procedures are ______.

- test of details. - substantive analytical procedures.

When an auditor becomes aware of significant illegal acts, the auditor should make sure that ______ (is) are adequately informed.

- those charged with governance. - the audit committee.

In documenting the overall audit strategy and audit plan, auditors should document the ______.

- timing of audit tests. - extent of audit tests. - nature of audit tests.

Auditors consider materiality from a reasonable user perspective and communicate to users that "the financial statements present fairly in ______ material respects.

all

Many public accounting firms adopt a policy of not completing the current audit until ______ fees have been paid.

all of the prior year's

An individual or organization possessing expertise in a field other than accounting or auditing whose work is used to assist the auditor in obtaining sufficient, appropriate evidence is defined by auditing standards as a(n)

auditor's specialist

Auditors should consider laws and regulations that are generally recognized as having ______ effects on the determination of financial statement amounts.

direct and material

Tests of details of account balances and disclosures focus on the items that are contained in the ______ financial statement account balances and disclosures.

ending

Overall responsibility for an audit engagement rests with the ______.

engagement partner