ACCT 402 CH 5 HW Review Questions

13) Provide at least four examples of specialists whose findings might provide appropriate evidence for the independent auditors.

Among specialists whose findings might provide competent evidence for the independent auditors are (only four required): actuaries, appraisers, attorneys, engineers, environmental consultants, and geologists.

1) Describe the relationship between detection risk and audit risk.

Audit risk is the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. It is composed of the possibility that (1) a material misstatement in an assertion about an account has occurred (inherent risk and control risk), and (2) the auditors do not detect the misstatement (detection risk). Detection risk is this second component, the risk that the auditors' procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist. All other factors held constant, audit risk increases with increases in detection risk.

10) When in the course of an audit might the auditors find it useful to apply analytical procedures?

Auditors may find it useful to apply analytical procedures at several different times during the audit. These procedures must be applied during the risk assessment stage to enhance the auditors' understanding of the client's business, to direct the auditors' attention to higher risk areas, and to assist in the design of an effective audit program. Also, analytical procedures may be applied during field work as substantive procedures to provide evidence as to the reasonableness of specific account balances. Finally, the auditors are required to apply analytical procedures to the audited financial statements as a part of the final overview of the engagement.

20) What disclosures should be made in the financial statements regarding material related party transactions?

Disclosure requirements for related party transactions include: (1) A description of the transactions, including dollar amounts. (2) The relationship between the parties. (3) Amounts receivable from or owed to related parties at the balance sheet date. (4) The terms and manner of settlement.

27) Should the working trial balance prepared by the auditors include revenue and expense accounts if the balances of these accounts for the audit year have been closed into retained earnings prior to the auditors' arrival? Explain.

Even though the balances of the client's revenue and expense accounts have been closed to the Retained Earnings account prior to the auditors' arrival, the balances of revenue and expense accounts prior to their closing should be included in the auditors' working trial balance. Since the auditors ordinarily express an opinion on the income statement as well as the balance sheet, it is imperative that the audit working papers include full information on the revenue and expense accounts.

28) Why are the final figures from the prior year's audit included in a working trial balance or lead schedule?

Inclusion of the final figures from the prior year's audit in a working trial balance or lead schedules facilitates comparisons and focuses attention on any unusual changes; it also gives assurance that the correct starting figure is used if the auditors verify the year's transactions in a balance sheet account in order to determine the validity of the ending balance.

3) Define inherent risk. Can the auditors reduce inherent risk by performing audit procedures?

Inherent risk refers to the possibility of a material misstatement occurring in an assertion assuming no related internal controls. Accordingly, since it exists independently of the auditors, the auditors cannot "reduce" inherent risk. Rather, they gather evidence that allows them to make an accurate assessment of the existing inherent risk.

19) What are related party transactions?

Related party transactions, as the term would suggest, are those between related parties. Parties are considered to be "related" when one party has the ability to influence the other party to the extent that one of the transacting parties may not be pursuing its separate interest. Examples of parties related to the client entity include officers and directors (and their immediate family members) and affiliated companies. Routine transactions between related parties, such as normal compensation arrangements and expense accounts, are excluded from the definition of related party transactions.

31) List several rules to be observed in the preparation of working papers that reflect current professional practice.

Rules to be observed in the preparation of working papers include the following: (1) A separate working paper should be prepared for each topic. (2) Only one side of a sheet is used. (3) Proper identification of a working paper includes a heading with the name of the client company, a clear description of the information presented, and the applicable date or period covered. (4) Documents examined, employees interviewed, and sites visited should be completely identified. (5) Working papers should be dated and signed or initialed by the preparer, and signed or initialed by the senior, manager, or partner who reviewed the working paper. (6) All working papers should be indexed and should be cross-referenced to the working trial balance or lead schedules. (7) Where reference is needed between papers, there must be adequate cross-referencing. (8) The nature of verification work performed by the auditors should be indicated on each working paper. (9) The extent and scope of tests of controls and substantive procedures should be stated clearly in the working papers for every phase of the audit. (10) The working papers should include comments by the auditors indicating their conclusions on each aspect of the work. (11) The rewriting of working papers should be considered evidence of inefficiency and inadequate planning. (12) The purpose of each working paper and its relation to the audit objectives should be clear. (13) Working papers should be placed in the completed file as soon as they are finished.

29) Should the auditors prepare adjusting journal entries to correct all errors they discover in the accounting records for the year under audit? Explain.

The auditors should prepare adjusting journal entries for material items only. The auditors are concerned with the fairness, not the preciseness, of the client's financial statements; thus the auditors may ignore immaterial errors having no significant effect on the fairness of the financial statements. However, the auditors should consider the cumulative materiality of "passed" adjustments that appear to be immaterial when considered individually. Also, management must concur and represent that it believes that adjustments that are made are not material individually or in the aggregate.

14) What are the major purposes of obtaining representation letters from audit clients?

The major purposes of obtaining a client representation letter include: (a) to remind the client officers of their primary responsibility for the financial statements, (b) to document in the audit working papers the client's responses to many questions asked by the auditors during the engagement, and (c) to provide evidence in areas where accounting presentation may be dependent upon management's future intentions.

30) Explain the meaning of the term permanent file as used in connection with audit working papers. What kinds of information are usually included in the permanent file?

The permanent file consists of working papers that are of use in the audits of multiple succeeding years. Such papers are reviewed and brought up to date in each succeeding audit and, therefore, may be contrasted with the file of current year's working papers which relate only to a single year's audit. Typical of the papers to be placed in the permanent file are copies of the articles of incorporation or partnership agreement, long-term construction contracts, description of the history and policies of the company, and schedules or analyses of such accounts as capital stock, land, and buildings which often show little or no change over a period of years.

22) What are the major functions of audit working papers?

The primary functions of audit working papers are to provide (1) evidence of the auditor's basis for concluding on the achievement of the audit's overall objectives and (2) evidence that the audit was planned and performed in accordance with GAAS. Secondary functions include (1) assisting the audit team in planning and performing the work, (2) serving as a record of matters of continuing significance for future audits, (3) assisting audit team members responsible for supervising and reviewing the work, (4) demonstrating accountability of the various audit team members for the work performed, and (5) assisting firm reviewers, inspection and review individuals, and successor auditors with performing their roles.

23) Why are the prior year's audit working papers a useful reference to staff assistants during the current audit?

The prior year's audit working papers are a useful guide to staff assistants because the audit procedures performed in the prior year usually are similar to those of the current year. By referring to last year's working papers, the assistant can see how the procedures were documented and is given a possible format for organizing the current year's working paper. In addition, exceptions noted in last year's working papers may alert the assistant to possible problems in the current year. Finally, the prior year's working papers contain information substantiating the beginning balances for the current year.

12) "Use of data analytics is likely to increase the use of sampling and eliminate the audit of all items in a population." Comment on the accuracy of this quotation.

The statement is inaccurate in that in many areas of the audit the use of data analytics may lead to auditing entire populations (e.g., authorization of sales, authorization of warranty work) more frequently than had been done in the past.

6) In a conversation with you, Mark Rogers, CPA, claims that both the sufficiency and the appropriateness of audit evidence are a matter of judgement in every audit. Do you agree? Explain.

The sufficiency of audit evidence is a matter of judgment on every audit, because there are no firm guidelines on the quantity of evidence necessary in a specific audit. The strength of the client's internal control, the inherent risk of the audit, the levels of materiality for the audit, and the existence of related-party transactions are among the factors influencing the auditors' judgment on the sufficiency of audit evidence. In addition, the quantity of evidence needed to support the auditors' opinion varies inversely with the quality of the available evidence. Appropriateness is the measure of the quality of audit evidence—both its relevance and reliability. The reliability of audit evidence depends on its source, rather than wholly on the judgment of the auditors. For example, documentary evidence created outside the client organization and transmitted directly to the auditors is normally of higher quality than documentary evidence created and held within the client organization.

26) Describe a situation in which a set of audit working papers might be used by third parties to support a charge of gross negligence against the auditors.

The third parties who are likely to charge the auditors with negligence are bankers, creditors, stockholders, or other persons who invest money in a business in reliance upon audited financial statements and subsequently sustain losses. If events subsequent to the audit show that the audited statements did not provide a fair picture of financial position, operating results, or cash flows, the injured third parties are likely to attempt to recover their losses from the auditors on grounds that they were negligent in conducting the examination. During court cases, the auditors' working papers are produced; the plaintiffs are given an opportunity to point out any conflicting statements or other evidence in the papers that tend to substantiate their charges.

2) Identify and describe the two components of the risk of material misstatement.

The two components of the risk of material misstatement include inherent risk and control risk. Inherent risk is the risk of material misstatement of an assertion about an account, class of transaction, or disclosure without considering internal control, and control risk is the risk that internal control will fail to prevent or detect and correct the material misstatement.

16) List and briefly describe the three approaches to auditing accounting estimates tha are included in a client's financial statements.

Three approaches for auditing estimates are: (1) Review and test management's process of developing the estimate. Using this approach an auditor will in essence follow the procedures performed by management and consider their accuracy, whether they follow GAAP, and their reasonableness. (2) Independently develop an estimate of the amount to compare to management's estimate. Here, for example, if management has estimated the allowance for doubtful accounts using an estimated percentage of credit sales, the auditors might choose to estimate the allowance by aging receivables. (3) Review subsequent events or transactions bearing on the estimate. For example, collection of a receivable after year-end provides evidence relevant to the valuation of the account at year-end.