Audit Quiz 3

Substantive Procedures

- Audit procedures that produce appropriate evidence

An auditor is concerned about management override as a limitation of internal control. Which of the following tests would best assess the validity of the auditor's concern? A. Matching purchase orders to accounts payable. B. Verifying that approved spending limits are not exceeded C. Tracing sales orders to the revenue account. D. Reviewing minutes of board meetings.

. Answer (B) is correct. To determine whether management has overridden approvals, the auditor should compare actual expenditures with budgeted amounts.

3 Types of Fair Value (3 Levels)

1. Observed - Market prices for exact same item 2. Observed - Market prices for comparable item 3. Valuation Models - "Fabricated" prices (High RMM)

2 Types of Substantive Procedures

1. Tests of Details 2. Analytical Procedures

Basic Types of Audit Opinions

1. Unmodified - OK 2. Qualified - OK, "except for . . . " Scope Limitation - most common issue (Not enough info available) 3. Adverse - NOT OK 4. Disclaimed - NO Opinion offered

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. A regional state patent office. C. The patent inventor. D. The patent owner.

Answer (A) is correct. 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.

A service auditor's report on internal control may be issued on management's description of a service organization system and the suitability of the design of controls or management's description of a service organization system and the suitability and operating effectiveness of controls. Which of the following is true about a type 1 report? A. It should state that the auditor did not test the effectiveness of the controls. B. It should include an opinion about the design of internal control as well as conclusions about tests of controls. C. It will include a list of all fraud and error discovered. D. It need not be restricted in its use and may be made available to any third party.

Answer (A) is correct. A service auditor's type 1 report should contain a statement that the auditor did not test the effectiveness of the controls.

Analytical procedures are required for which of the following? A. Audit planning. B. Tests of balances. C. Client retention decision. D. Internal control evaluation.

Answer (A) is correct. An audit plan based on the audit strategy must be developed and documented for all audit engagements. It includes the nature, timing, and extent of procedures expected to reduce audit risk to an acceptably low level. Thus, the audit plan includes a description of risk assessment procedures. Risk assessment procedures are performed to obtain an understanding of the entity and its environment, including its internal control, to identify and assess the risks of material misstatement (RMMs) at the levels of (1) the financial statements as a whole and (2) relevant assertions. Risk assessment procedures include (1) inquiries of management and others within the entity, (2) analytical procedures, and (3) observation and inspection. The auditor also may perform other appropriate procedures, such as inquiring of external parties (e.g., legal counsel) or reviewing externally generated information (e.g., financial publications). Analytical procedures may be applied not only as risk assessment procedures (analytical procedures used to plan the audit) but also as substantive procedures. These are procedures (tests of details and analytical procedures) designed to detect material misstatements at the assertion level.

For a reporting entity that has participated in related party transactions that are material, disclosure in the GAAP-based financial statements should include A. The nature of the relationship and the terms and manner of settlement. B. Details of the transactions within major classifications. C. A statement to the effect that a transaction was consummated on terms equivalent to those that prevail in arm's-length transactions. D. A reference to deficiencies in the entity's internal control.

Answer (A) is correct. Disclosure in GAAP-based financial statements of a reporting entity that has participated in material related party transactions should include (1) the nature of the relationship; (2) a description of the transactions; (3) the dollar value of the transactions; (4) the amounts due from or to related parties; and (5) if not otherwise apparent, the terms and manner of settlement.

Early appointment of the auditor enables preliminary work to be performed by the auditor. This benefits the client because it permits the audit to be performed in A. A more efficient manner. B. A more thorough manner. C. Accordance with quality control standards. D. Accordance with generally accepted auditing standards.

Answer (A) is correct. Early appointment of the auditor is advantageous to both the auditor and the client. Early appointment aids the auditor in planning the work, especially that to be done before the end of the year. The client benefits from more efficient scheduling of the audit and an early completion of the work after the end of the fiscal year.

Which of the following procedures should an auditor most likely include in the planning of an audit of financial statements? A. Determining the need for specialized skills. B. Inquiring of the client's lawyer about litigation, claims, and assessments. C. Obtaining a written representation letter from management of the client. D. Determining whether necessary controls have been implemented.

Answer (A) is correct. If specialized skills are needed, the auditor determines whether a professional with such skills is on the audit staff or an external specialist must be hired. For this purpose, the auditor should be able to (1) communicate the objectives of the work of the other professional, (2) evaluate whether the procedures performed meet the audit objectives, and (3) evaluate the results of those procedures (AU-C 300).

A CPA is conducting the first audit of a nonissuer's financial statements. The CPA hopes to reduce the audit work by consulting with the predecessor auditor and reviewing the predecessor's audit documentation. This procedure is A. Acceptable if the client and the predecessor auditor agree to it. B. Acceptable if the CPA refers in the audit report to reliance upon the predecessor auditor's work as part of the basis for the CPA's own opinion. C. Required if the CPA is to express an unmodified opinion. D. Unacceptable because the CPA should bring an independent viewpoint to a new engagement.

Answer (A) is correct. In an initial audit, the auditor should ask management to permit the predecessor auditor to (1) respond fully to inquiries and (2) allow a review of his or her audit documentation. In accordance with the ethical requirement for AICPA members to cooperate with each other, the predecessor auditor ordinarily agrees to these requests (AU-C 510).

Which of the following most likely would not be considered an inherent limitation of the potential effectiveness of an entity's internal control? A. Incompatible duties. B. Management override. C. Faulty judgment. D. Collusion among employees.

Answer (A) is correct. Internal control has inherent limitations. The performance of incompatible duties, however, is a failure to assign different people the functions of authorization, recording, and asset custody, not an inevitable limitation of internal control. Segregation of duties is a category of control activities.

Payroll Data Co. (PDC) processes payroll transactions for a retailer. Cook, CPA, is engaged to issue a report on PDC's internal controls implemented as of a specific date. These controls are relevant to the retailer's internal control, so Cook's report may be useful in providing the retailer's independent auditor with information necessary to plan a financial statement audit. Cook's report should A. Contain a disclaimer of opinion on the operating effectiveness of PDC's controls. B. State whether PDC's controls were suitably designed to achieve the retailer's objectives. C. Identify PDC's controls relevant to specific financial statement assertions. D. Disclose Cook's assessed risks of material misstatement for PDC.

Answer (A) is correct. Service auditors may report (1) on the fairness of management's description of the controls and whether the controls have been implemented and are suitably designed (type 1 report) or (2) additionally on operating effectiveness (type 2 report). The type 1 report should include a disclaimer of opinion related to operating effectiveness of the controls.

An issuer client who disagrees with the independent auditor on a significant matter affecting its financial statements has several courses of action. Which of the following courses of action would be inappropriate? A. Appeal to the FASB to review the significant matter. B. Modify the financial statements by expressing in the notes its viewpoint with regard to the significant matter. C. Ask the auditor to refer in the auditor's report to a client note in the financial statements that discusses the client point of view with regard to the significant matter. D. Engage another independent auditor.

Answer (A) is correct. The FASB does not provide services for the settlement of disputes between clients and CPAs.

Which of the following is an aspect of scheduling and controlling the audit engagement? A. Include in the audit plan a column for estimated and actual time. B. Perform audit work only after the client's books of account have been closed for the period under examination. C. Write a conclusion in the audit documentation indicating how the results of the audit will affect the auditor's report. D. Include in the engagement letter an estimate of the minimum and maximum audit fee.

Answer (A) is correct. The audit plan is a tool for scheduling and controlling the audit. It should contain a detailed set of procedures for accomplishing audit objectives, estimated times for each step, and the personnel required. Thus, it can be used to document the progress of the audit and the auditor's compliance with requirements for planning and supervision.

The audit plan usually cannot be finalized until the A. Understanding of the entity and its environment has been completed. B. Engagement letter has been signed by the auditor and the client. C. Control deficiencies have been communicated to those charged with governance. D. Search for unrecorded liabilities has been performed and documented.

Answer (A) is correct. The auditor must obtain an understanding of the entity and its environment, including internal control, to assess the risks of material misstatement of the financial statements, whether due to fraud or error.

Which of the following matters generally is included in an auditor's engagement letter? A. Management's responsibility for the entity's compliance with laws and regulations. B. The factors to be considered in setting preliminary judgments about materiality. C. Management's vicarious liability for illegal acts committed by its employees. D. The auditor's acceptance of the responsibility to search for significant internal control deficiencies.

Answer (A) is correct. The primary purpose of an engagement letter is to provide written record of the agreement with the client as to the services to be provided by the auditor. The terms of the engagement should be documented in an engagement letter that states the following: (1) objective and scope of the audit, (2) responsibilities of the auditor and management, (3) inherent limitations of the audit and internal control, (4) the financial reporting framework, and (5) the expected form and content of audit reports. Management's responsibility for compliance with laws and regulations applicable to its activities should be included in the agreement.

Computer Services Company (CSC) processes payroll transactions for schools. Drake, CPA, is engaged to report on CSC's controls implemented as of a specific date. These controls are relevant to the schools' internal control, so Drake's report will be useful in providing the schools' independent auditors with information necessary to plan their audits. Drake's report expressing an opinion on CSC's controls implemented as of a specific date should contain a(n) A. Description of the scope and nature of Drake's procedures. B. Statement that CSC's management has disclosed to Drake all design deficiencies of which it is aware. C. Opinion on the operating effectiveness of CSC's controls. D. Paragraph indicating the basis for Drake's assessment of the risks of material misstatement.

Answer (A) is correct. The report expressing an opinion on the description of controls implemented and their design (type 1 report) includes (1) a title that includes the word independent; (2) an addressee; (3) identification of management's description of the system; (4) a reference to management's assertion and a statement of management's responsibility for the controls; (5) a statement that the service auditor's responsibility is to express an opinion on the fairness of management's description of the system and the suitability of the design of the controls in meeting the objectives; (6) a statement that the report was conducted in accordance with the AICPA attestation standards; (7) a statement that the service auditor did not test the effectiveness of the controls; (8) statements about the scope of the service auditor's procedures; (9) a statement about the inherent limitations of controls; (10) an opinion on whether, in all material respects, management's description of the system is fairly stated and whether the controls are suitably designed; (11) a statement restricting the use of the report to management of the service organization and user entities; (12) the date of the report; and (13) the name, city, and state of the service auditor.

Green, CPA, is auditing the financial statements of Ajax Co. Ajax uses the DP Service Center to process its payroll. DP's financial statements are audited by Blue, CPA, who recently issued a report on DP's policies and procedures regarding the processing of other entities' transactions. In considering whether Blue's report is satisfactory for Green's purposes, Green should A. Make inquiries about Blue's professional reputation. B. Not rely on DP's controls. C. Review the audit plan followed by Blue. D. Perform tests of controls at the DP Service Center.

Answer (A) is correct. The user auditor should be satisfied about (1) the service auditor's professional competence and (2) the adequacy of the standards governing the type 1 or type 2 report.

If the predecessor auditor refuses to give the current auditor of a nonissuer access to the documentation, what should the current auditor do? A. Review the risk assessment of the opening balances of the financial statements. B. Withdraw from the engagement. C. Disclaim an opinion due to a scope limitation. D. Discuss the matter with the client's legal counsel.

Answer (A) is correct. When the prior period statements were audited by a predecessor auditor, the auditor should request management to authorize the predecessor to (1) allow a review of audit documentation and (2) respond fully to inquiries by the auditor. Thus, the auditor is provided with information to assist in planning and performing the engagement. The predecessor ordinarily permits the auditor to review audit documentation, including documentation of (1) planning, (2) risk assessment procedures, (3) further audit procedures, (4) audit results, and (5) other matters of continuing accounting and auditing significance. But the predecessor's denial or limitation of access may affect (1) the auditor's assessment of risk regarding the opening balances or (2) the nature, timing, and extent of the auditor's procedures with respect to the opening balances and consistency of accounting principles.

U-C 402, Audit Considerations Relating to an Entity Using a Service Organization, applies to a financial statement audit of an entity that uses services of another organization as part of its information system. For this purpose, the user auditor may need to obtain a service auditor's report. Which of the following is a true statement about a service auditor's report? A. It provides the user auditor with assurance regarding whether control procedures have been implemented at the user organization. B. It should include an opinion. C. If it proves to be inappropriate for the user auditor's purposes, (s)he must personally perform procedures at the service organization. D. A user auditor need not be concerned about the service auditor's professional competence.

Answer (B) is correct. A service auditor's report should be helpful in providing a sufficient understanding to plan the audit of the user organization. The service auditor's report may express an opinion on the fairness of the description of the controls implemented at the service organization and whether they were suitably designed. If the service auditor also has tested controls, the report may express an opinion on the operating effectiveness of the controls.

An auditor who uses the work of an auditor's external specialist may refer to the specialist in the auditor's report if the A. Specialist's findings provide the auditor greater assurance of reliability about management's representations. B. Reference is needed for an understanding of a modification of the opinion. C. Auditor's use of the specialist's findings is different from that of prior years. D. The specialist's findings fully corroborate management's financial statement assertions.

Answer (B) is correct. The auditor may refer to an auditor's external specialist only if the opinion is modified. A modified opinion is a qualified opinion, adverse opinion, or a disclaimer of opinion. The reference is made because it is relevant to understanding the modification. An auditor's report with such a reference should state that it does not reduce the auditor's responsibility (AU-C 620).

Which of the following ultimately determines the specific audit procedures necessary to provide an independent auditor with a reasonable basis for the expression of an opinion? A. The audit plan. B. The auditor's judgment. C. Auditing standards. D. Audit documentation

Answer (B) is correct. The auditor's professional judgment must determine the necessary audit plans and the specific audit procedures that will gather sufficient appropriate evidence to reduce audit risk to an acceptably low level and enable the auditor to draw reasonable conclusions on which to base the opinion.

Which of the following factors most likely would cause an auditor to question the integrity of management? A. Management has an aggressive attitude toward financial reporting and meeting profit goals. B. Audit tests detect material fraud that was known to management, but not disclosed to the auditor. C. Managerial decisions are dominated by one person who is also a stockholder. D. Weaknesses in internal control reported to the audit committee are not corrected by management.

Answer (B) is correct. The auditors request written representations from management. These include disclosures of fraud or suspected fraud affecting the entity involving (1) management, (2) employees who participate significantly in internal control, and (3) others if the fraud is material. If management fails to provide written representations about such matters, the auditor should (1) reevaluate management's integrity, (2) determine the possible effect on the opinion, and (3) withdraw from the engagement in appropriate circumstances (AU-C 580).

Audit plans are modified to suit the circumstances of particular engagements. A complete audit plan for an engagement usually should be developed A. Prior to beginning the actual audit work. B. After the auditor has obtained an understanding of existing internal control. C. After reviewing the activities of the board of directors. D. When the audit engagement letter is prepared.

Answer (B) is correct. The effectiveness of a client's internal control has an inverse relationship with the evidence that must be gathered to support an opinion. Only after the understanding of the entity and its environment, including its internal control, is obtained and the risks of material misstatement have been assessed can the auditor determine the nature, timing, and extent of further audit procedures (AU-C 315).

Which of the following auditor concerns usually is so serious that the auditor might conclude that a financial statement audit cannot be conducted? A. The entity has no formal written code of conduct. B. The integrity of the entity's management is suspect. C. Procedures requiring separation of duties are subject to management override. D. Management fails to modify prescribed controls for changes in conditions.

Answer (B) is correct. The financial statements contain assertions by management, so the integrity of management is crucial to the auditor's evaluation of the (1) sufficiency and (2) appropriateness (relevance and reliability) of the evidence obtained to support those assertions. Thus, if the integrity of management is suspect, the auditor may be unable to obtain sufficient appropriate evidence to support an opinion.

An auditor is required to establish an understanding in writing with a client regarding the services to be performed for each engagement. This understanding generally includes A. Management's responsibility for errors and the illegal activities of employees that may cause material misstatement. B. The auditor's responsibility for ensuring that the audit committee is aware of any significant deficiencies or material weaknesses in control that come to the auditor's attention. C. Management's responsibility for providing the auditor with an assessment of the risk of material misstatement due to fraud. D. The auditor's responsibility for determining preliminary judgments about materiality and audit risk factors.

Answer (B) is correct. The understanding with the client regarding services to be performed is typically documented in an engagement letter. An engagement letter should indicate that a traditional financial statement audit is not designed to provide assurance on internal control. However, the auditor is responsible for ensuring that those charged with governance are aware of any significant deficiencies or material weaknesses in control, that come to his or her attention.

Hill Corporation has hired Jones, a CPA, to audit its financial statements for year end. Jones, when searching for related party transactions, should seek information to obtain an understanding about each of Hill's subsidiary's relationships because A. Some of these transactions may not have taken place if the parties had not been related. B. Hill's business structure might be designed in such a way as to deliberately obscure related party transactions. C. This would permit the audit of Hill's interentity account balances to be performed as of concurrent dates. D. Intercompany transactions may have been consummated on terms equivalent to arm's-length transactions.

Answer (B) is correct. Under U.S. GAAP, transactions between a parent and its subsidiaries are related party transactions. Thus, Jones should obtain an understanding of Hill's subsidiary relationships to assess whether Hill's ownership and governance structures were designed to obscure related party transactions. The auditor's risk assessment procedures should inquire about (1) the identity of related parties, (2) the relationship of the entity with each party, (3) whether transactions with them have occurred, and (4) the nature and purpose of the transactions. Jones also should be aware that business structure and operating style are occasionally deliberately designed to obscure related party transactions.

In an audit based on International Standards on Auditing (ISAs), a successor auditor would normally become satisfied with opening balances by A. Auditing the prior year's financial statements. B. Reviewing the predecessor's working papers. C. Interviewing the client. D. Performing analytical procedures.

Answer (B) is correct. Under the ISAs, an auditor may obtain sufficient appropriate evidence about opening balances by reviewing the predecessor's working papers. In this case, the auditor should consider the competence and independence of the predecessor.

Although substantive tests may support the accuracy of underlying information used in monitoring, these tests may provide no affirmative evidence of the effectiveness of monitoring controls because A. Substantive tests rarely guarantee the accuracy of information used in monitoring if only a sample has been tested. B. The information used in monitoring may be accurate even though it is subject to ineffective control. C. Substantive tests relate to the entire period under audit, but tests of controls ordinarily are confined to the period during which the auditor is on the client's premises. D. When procedures are computerized and leave no audit trail to indicate who performed them, substantive tests may necessarily be limited to inquiries and observation.

Answer (B) is correct. When obtaining an understanding of each of the five components of internal control (including monitoring), the auditor must perform procedures to understand the design of relevant controls and must determine whether controls have been implemented. If (s)he intends to rely on the controls, (s)he must also determine their effectiveness. However, when controls based on monitoring leave no audit trail, for example, documentation of design or operation, evidence about effectiveness of design or operation may be obtained only by inquiries, observations, and computer-assisted audit methods. Moreover, substantive procedures likewise may provide no affirmative evidence of the effectiveness of monitoring controls because the information may be accurate even though controls over its creation are ineffective. Thus, the ineffectiveness of monitoring would not be revealed by substantive procedures unless the detection of material misstatements resulted in performance of additional audit procedures directed at the controls.

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. Inquire about the existence of related parties from management. C. Review the company's business structure. D. Review proxy and other materials filed with the SEC.

Answer (B) is correct. 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.

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. Determine whether the transactions were approved by the board of directors or other appropriate officials. D. Ascertain whether the transactions would have occurred if the parties had not been related.

Answer (C) is correct. 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).

Which of the following procedures would most likely assist an auditor in identifying related party transactions? A. Evaluate the reasonableness of management's accounting estimates that are subject to bias. B. Retest ineffective internal control activities for evidence of management override. C. Review the minutes of the meetings of the board of directors and its committees. D. Send second requests for unanswered positive confirmations of accounts receivable.

Answer (C) is correct. Among the procedures for identifying related party transactions are reviews of (1) the minutes of the meetings of the board of directors and its committees; (2) filings with regulators; (3) conflict-of-interest statements; (4) transactions with major customers, suppliers, lenders, and borrowers; (5) accounting records for large, unusual, or nonrecurring transactions or balances; (6) invoices of law firms; and (7) confirmations of compensating balance arrangements.

An auditor is evaluating a client's internal controls. Which of the following situations would be the most difficult internal control issue for an auditor to detect? A. The accounting staff neglects the control due to increased transactions to be processed. B. The technology department writes a program that does not properly implement the control due to a lack of understanding. C. Two employees, who work in different departments, are circumventing an internal control. D. Someone erroneously disables edit checks in a software program designed to identify control exceptions.

Answer (C) is correct. Because of its inherent limitations, internal control can provide only reasonable assurance that the entity's objectives are met. Thus, manual or automated controls can be circumvented by collusion of two or more people or by management override (AU-C 315). Fraud perpetrated by collusion may be difficult to detect because of schemes designed to conceal it.

An auditor (the user auditor) may decide to make use of another auditor's (the service auditor's) report on internal control at a service organization that provides certain services to the user auditor's client. When the client's transactions flow through the service organization's accounting system, consideration of internal control may be necessary. The most efficient approach is often to obtain a service auditor's report. Which of the following is a true statement about the relationship of the user and service auditors? A. A user auditor cannot treat a service auditor's report as evidence if the period it covers does not coincide with that of the financial statements the user auditor has been engaged to audit. B. It is inappropriate for the user auditor to discuss with the service auditor the scope and results of the work. C. When reporting on an audit of financial statements, the user auditor should not refer to the service auditor's report if the opinion is unmodified. D. The user auditor need not be concerned about fraud or noncompliance with laws and regulations at the service organization.

Answer (C) is correct. Because the service auditor is not responsible for auditing any portion of the financial statements being reported on by the user auditor, the service auditor should not be referred to in the user auditor's report if the opinion is unmodified. But if the user auditor modifies the opinion because of a modified opinion by the service auditor, the user auditor may refer to the service auditor.

Audit planning for an initial audit most likely includes A. Determining the opinion to be expressed. B. Obtaining an engagement letter prepared by the auditee. C. Performing procedures involving opening balances. D. Selecting a sample of invoices for comparison with shipping reports.

Answer (C) is correct. First-year audits involve additional planning considerations. Examples are (1) communication with the predecessor auditor, (2) audit procedures regarding opening balances, (3) assignment of firm personnel with appropriate qualifications, and (4) procedures required by the firm's system of quality control for initial engagements.

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.

Answer (C) is correct. 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.

Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions? A. Retesting ineffective internal control procedures previously reported to the audit committee. B. Sending second requests for unanswered positive confirmations of accounts receivable. C. Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date. D. Inspecting communications with law firms for evidence of unreported contingent liabilities.

Answer (C) is correct. 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).

Which of the following is an auditor least likely to perform in planning a financial statement audit? A. Coordinating the assistance of entity personnel in data preparation. B. Discussing matters that may affect the audit with firm personnel responsible for non-audit services to the entity. C. Selecting a sample of vendors' invoices for comparison with receiving reports. D. Reading the current year's interim financial statements.

Answer (C) is correct. Selecting a sample of vendors' invoices for comparison with receiving reports is a test of details (a substantive procedure). It is a further audit procedure performed to test relevant assertions.

When one auditor succeeds another, the auditor should request the A. Client to instruct its lawyer to send a letter of audit inquiry concerning the status of the prior year's litigation, claims, and assessments. B. Predecessor auditor to submit a list of internal control related matters noted in an audit but have not been corrected. C. Client to authorize the predecessor auditor to allow a review of the predecessor auditor's audit documentation. D. Predecessor auditor to update the prior year's report to the date of the change of auditors.

Answer (C) is correct. The Code of Professional Conduct protects the confidentiality of client information. Hence, the auditor should seek the client's specific consent for the predecessor auditor to respond fully to the auditor's inquiries. The auditor should communicate with the predecessor to determine whether to accept the engagement (AU-C 210). If the engagement is accepted, the audit may be facilitated by making specific inquiries of the predecessor and by reviewing the predecessor's audit documentation. The auditor also should request the client to authorize this review.

In using the work of an auditor's external specialist, an agreement should exist between the auditor and the specialist as to the nature of the specialist's work. This agreement most likely should include A. A statement that the specialist assumes no responsibility to update the specialist's report for future events or circumstances. B. The conditions under which a division of responsibility may be necessary. C. The applicability of the same confidentiality requirements to the auditor and the specialist. D. The auditor's disclaimer as to whether the specialist's findings corroborate the representations in the financial statements.

Answer (C) is correct. The agreement should be documented and should cover (1) the nature, objectives, and scope of the work; (2) the roles of the auditor and specialist; (3) the nature, timing, and extent of communications between the auditor and specialist; and (4) the need for the specialist to observe confidentiality requirements. The 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 also to 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.

An audit client has substantial assets held in a trust that is managed by the trust department of a bank. Which of the following actions by the auditor is the most efficient way to obtain information about the trust department's internal controls? A. Perform a review or compilation of the trust department. B. Perform tests of controls on a sample of the client's transactions with the trust department. C. Rely on the trust department's audit report on internal controls placed in operation and their operating effectiveness. D. Ask management of the trust department to complete a questionnaire about internal controls and provide flowcharts for related processes.

Answer (C) is correct. The audit client is a user entity that uses a service organization (the trust department of a bank) to provide services relevant to the user entity's internal control over financial reporting. The user auditor could perform procedures at the service organization. But the most efficient way to obtain information about the trust department's internal controls is to read an independent service auditor's report. A type 1 report addresses management's description of the service organization's system and the suitability of the design of controls. A type 2 report addresses (1) these matters and (2) the operating effectiveness of the controls. If the user auditor's risk assessment includes an expectation that the service organization's controls are operating effectively, (s)he requires a type 2 report, assuming (s)he does not (1) test the service organization's controls or (2) use another auditor to do so.

Which of the following procedures most likely could assist an auditor in identifying related party transactions? A. Performing tests of controls concerning the segregation of duties. B. Evaluating the reasonableness of management's accounting estimates. C. Reviewing confirmations of compensating balance arrangements. D. Scanning the accounting records for recurring transactions.

Answer (C) is correct. The auditor performs procedures to identify material transactions that may be indicative of previously undetermined relationships. These procedures include reviewing confirmations of compensating balance arrangements for indications that balances are or were maintained for or by related parties (AU-C 550 and AS 2410).

After identifying a significant related party transaction outside the entity's normal course of business, an auditor should A. Add an emphasis-of-matter paragraph to the auditor's report to explain the transaction. B. Perform analytical procedures to identify similar transactions that were not recorded. C. Evaluate the business purpose of the transaction. D. Substantiate that the transaction was consummated on terms equivalent to those of an arm's-length transaction.

Answer (C) is correct. The auditor should inspect any contracts or agreements to evaluate whether (1) the business purpose (or lack of a business purpose) implies that the transaction's intent was fraudulent, (2) the terms are consistent with management's explanations, and (3) the accounting and disclosure are appropriate. The auditor also should obtain evidence of appropriate authorization and approval.

An auditor most likely modifies the opinion if the entity's financial statements include a note on related party transactions A. Disclosing loans to related parties at interest rates significantly below prevailing market rates. B. Describing an exchange of real estate for similar property in a nonmonetary related party transaction. C. Stating without substantiation that a particular related party transaction occurred on terms equivalent to those that would have prevailed in an arm's-length transaction. D. Presenting the dollar volume of related party transactions and the effects of any change from prior periods in the method of establishing terms.

Answer (C) is correct. The auditor should obtain sufficient appropriate evidence about a management assertion that related party transactions were conducted on terms equivalent to those that prevail in arm's-length transactions. Management is responsible for substantiating the assertion. The auditor evaluates management's support for the assertion.

Internal control can provide only reasonable assurance of achieving an entity's control objectives. The likelihood of achieving those objectives is affected by which limitation inherent to internal control? A. The auditor's primary responsibility is the detection of fraud. B. The board of directors is active and independent. C. The cost of internal control should not exceed its benefits. D. Management monitors internal control.

Answer (C) is correct. The cost of an entity's internal control should not exceed the benefits that are expected to be derived. Although the cost-benefit relationship is a primary criterion that should be considered in designing internal control, the precise measurement of costs and benefits usually is not possible.

Which of the following events most likely indicates the existence of related parties? A. Borrowing a large sum of money at a variable rate of interest. B. Selling real estate at a price that differs significantly from its carrying amount. C. Making a loan without scheduled terms for repayment of the funds. D. Discussing merger terms with a company that is a major competitor.

Answer (C) is correct. 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.

Prior to the audit, an auditor usually discusses the general audit strategy with the client's management. Which of the following details do management and the auditor usually agree upon at this time? A. The specific matters to be included in the communication with the audit committee. B. The minimum amount of misstatements that may be considered to be material. C. The schedules and analyses that the client's staff should prepare. D. The effects that inadequate controls may have over the safeguarding of assets.

Answer (C) is correct. The terms of the engagement should be documented in an engagement letter that states the following: (1) objective and scope of the audit, (2) responsibilities of the auditor and management, (3) inherent limitations of the audit and internal control, (4) the financial reporting framework, and (5) the expected form and content of audit reports. The engagement letter also includes other relevant information, such as fees, billings, and assistance to be provided by the client's staff.

Which of the following factors does a CPA ordinarily consider in the planning stage of an audit engagement? I. Financial statement accounts likely to contain a misstatement. II. Conditions that require extension of audit tests. A. I only. B. II only. C. Both I and II. D. Neither I nor II.

Answer (C) is correct. When planning an audit, the auditor should consider, among other things, the financial statement accounts likely to require adjustment and the conditions that require extension or modification of audit procedures (e.g., risk of material misstatement).

Related Party Transactions must be examined 1. Desired transactions:

Arms-Length

Estimates Primary goal:

Assure "Reasonableness

Internal audit assesses...?

Competence & Objectivity 1. Competence - Professional certifications, etc. 2. Objectivity - Reporting order, policies, limitations

In developing an audit plan, an auditor should A. Determine whether the allowance for sampling risk exceeds the achieved upper precision limit. B. Evaluate findings from substantive procedures performed at interim dates. C. Consider whether the inquiry of the client's attorney identifies any litigation, claims, or assessments not disclosed in the financial statements. D. Perform risk assessment procedures.

D

Prior to the audit, an auditor usually discusses the overall audit strategy with the client's management. Which of the following matters do the auditor and management agree upon at this time? A. The appropriateness of the entity's plans for dealing with adverse economic conditions. B. The determination of the fraud risk factors that exist within the client's operations. C. The control weaknesses to be included in the communication with those charged with governance. D. The coordination of the assistance of the client's personnel in data preparation.

D

Which of the following is a basic tool used by the auditor to control the audit work and review the progress of the audit? A. Time and expense summary. B. Engagement letter. C. Progress flowchart. D. Audit plan.

D

Which of the following is correct regarding the communication between successor and predecessor auditors? A. The successor and predecessor auditors should communicate with each other in writing regarding potential problems. B. The successor auditor should contact the predecessor auditor prior to proposing an audit engagement. C. The client should be present during the communications between the predecessor auditor and the successor auditor. D. The successor auditor should request permission from the prospective client to make an inquiry of the predecessor auditor.

D

Which of the following procedures would an auditor most likely include in the initial planning of a financial statement audit? A. Obtaining a written representation letter from the client's management. B. Examining documents to detect noncompliance with laws and regulations having a material effect on the financial statements. C. Considering whether the client's accounting estimates are reasonable in the circumstances. D. Determining the extent of involvement of the client's internal auditors.

D

With respect to the auditor's planning of a year-end audit, which of the following statements is always true? A. An engagement should not be accepted after the fiscal year-end. B. An inventory count must be observed at the balance sheet date. C. Those charged with governance should not be told of the specific audit procedures that were performed. D. It is an acceptable practice to carry out part of the audit at interim dates.

D

planning meeting must be ...

Documented & notes must be included in the audit file

Auditor's Report

NEVER refers to management's specialist

Nature - Timing - Extent of Audit Procedures

Nature - Not all procedures are alike Some are better suited to produce specific evidence Timing - Risk affects when certain procedures are done Extent - More risk = more procedures

Auditors are required to have a

Planning Meeting to discuss how to conduct the audit

Internal Audit

Provides evidence re Internal Control

2 types of specialists

auditor's speciaist management's specialist

An auditor referred to the findings of an auditor's external specialist in the auditor's report. This may be an appropriate reporting practice if the A. Auditor is not familiar with the professional certification, personal reputation, or particular competence of the specialist. B. Auditor, as a result of the specialist's findings, adds a paragraph emphasizing a matter regarding the financial statements. C. Auditor's report contains a qualified opinion. D. Auditor, as a result of the specialist's findings, decides to indicate a division of responsibility with the specialist for the audit opinion.

c

A management's specialist most likely is useful to A. Assist the auditor in collecting sufficient appropriate audit evidence. B. Provide the auditor advice on technical accounting issues. C. Add credibility to the financial statements. D. Assist the client in preparing the financial statements.

d

An auditor uses the knowledge provided by the understanding of internal control and the assessed risks of material misstatement primarily to A. Determine whether procedures and records concerning the safeguarding of assets are reliable. B. Determine whether the opportunities to allow any person to both perpetrate and conceal fraud are minimized. C. Modify the initial assessments of inherent risk and judgments about materiality levels for planning purposes. D. Determine the nature, timing, and extent of substantive procedures for financial statement assertions.

d

Lake, CPA, is auditing the financial statements of Gill Co. Gill uses the EDP Service Center, Inc., to process its payroll transactions. EDP's financial statements are audited by Cope, CPA, who recently issued a report on EDP's internal control. Lake is considering Cope's report on EDP's internal control in assessing control risk on the Gill engagement. What is Lake's responsibility concerning making reference to Cope as a basis, in part, for Lake's own unmodified opinion? A. Lake may refer to Cope only if Lake is satisfied as to Cope's professional reputation and independence. B. Lake may refer to Cope only if Lake relies on Cope's report in restricting the extent of substantive procedures. C. Lake may refer to Cope only if Lake's report indicates the division of responsibility. D. Lake may not refer to Cope under the circumstances above.

d

The activities of the user entity and the service organization have a high degree of interaction. The user auditor A. Is not required to evaluate the service organization's controls. B. Should obtain absolute assurance that the service organization's internal control will prevent or detect fraud or error. C. Should not consider weaknesses in the service organization's internal control to be weaknesses in the user entity's system. D. Need not test the service organization's internal control if the user entity has effective controls related to service organization processing.

d

The element of the audit-planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the A. Evidence to be gathered to provide a sufficient basis for the auditor's opinion. B. Procedures to be undertaken to discover litigation, claims, and assessments. C. Pending legal matters to be included in the inquiry of the client's attorney. D. Timing of inventory observation procedures to be performed.

d

Which of the following circumstances would permit an independent auditor to accept an engagement after the close of the fiscal year? A. Issuance of a disclaimer of opinion as a result of inability to conduct certain tests required by generally accepted auditing standards due to the timing of the acceptance of the engagement. B. An expectation of the effectiveness of internal control. C. Receipt of an assertion from the preceding auditor that the entity will be able to continue as a going concern. D. Remedy of limitations resulting from accepting the engagement after the close of the end of the year, such as those relating to the existence of physical inventory.

d

Which of the following events least likely would indicate the existence of related party transactions? A. Making a loan with no scheduled date for the funds to be repaid. B. Exchanging property for the benefit of a principal shareholder. C. Borrowing funds at an interest rate significantly below prevailing market rates. D. Writing off obsolete inventory to net realizable value just before year end.

d

Which of the following events most likely would indicate the existence of related parties? A. Granting stock options to key executives at favorable prices. B. High turnover of senior management and members of the board of directors. C. Failure to correct internal control weaknesses on a timely basis. D. Selling real estate at a price significantly different from appraised value.

d

Which of the following factors most likely would cause a CPA to decline to accept a new audit engagement? A. The CPA does not understand the entity's operations and industry. B. Management acknowledges that the entity has had recurring operating losses. C. The CPA is unable to review the predecessor auditor's working papers. D. Management is unwilling to permit inquiry of its legal counsel.

d

Which of the following most likely would indicate the existence of related parties? A. Writing down obsolete inventory just before year end. B. Failing to correct previously identified internal control deficiencies. C. Depending on a single product for the success of the entity. D. Borrowing money at an interest rate significantly below the market rate.

d

Which of the following statements is true about related party transactions? A. In the absence of evidence to the contrary, related party transactions should be assumed to be outside the ordinary course of business. B. An auditor should determine whether a particular transaction would have occurred if the parties had not been related. C. An auditor should substantiate that related party transactions were consummated on terms equivalent to those that prevail in arm's-length transactions. D. The auditor should consider whether an identified related party transaction outside the normal course of business is appropriately accounted for and disclosed.

d

Which of the following statements is true about the use of the work of an auditor's specialist? A. The specialist need not agree to the auditor's use of the specialist's findings. B. The auditor is required to perform substantive procedures to verify the specialist's assumptions and findings. C. The auditor must keep client information confidential, but the specialist is not obligated to do so. D. The auditor should obtain an understanding of the methods and assumptions used by the specialist.

d

Which of the following statements would least likely appear in an auditor's engagement letter? A. Fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses. B. Management is responsible for making all financial records and related information available to us. C. Our engagement is subject to the risk that material fraud or errors, if they exist, will not be detected. D. After performing our preliminary analytical procedures, we will discuss with you the other procedures we consider necessary to complete the engagement.

d

Which of the following would a successor auditor ask the predecessor auditor to provide after accepting an audit engagement? A. Disagreements between the predecessor auditor and management about significant accounting policies and principles. B. The predecessor auditor's understanding of the reasons for the change of auditors. C. Facts known to the predecessor auditor that might bear on the integrity of management. D. Matters that may facilitate the evaluation of financial reporting consistency between the current and prior years.

d

Planning Meetings..?

discuss how to conduct the audit

Preliminary Risk Assessment

informs planning regarding Nature - Timing - Extent of Audit Procedures