Chapter 4 - Auditing

CPA An auditor who performed analytical procedures that compared current-year financial information to the comparable prior period noted a significant increase in net income. Given this result, which of the following expectations of recorded amounts would be unreasonable? -A decrease in costs of goods sold as a percentage of sales -A decrease in accounts payable -A decrease in retained earnings -A decrease in notes payable

A decrease in retained earnings A significant increase in net income would result in an increase, not a decrease, in retained earnings

When gaining an understanding of the client, the auditor will consider: -Related party identification -The appropriateness of the client's system of internal controls to mitigate identified business risks -Controls over the technology used to process and store data electronically -All of these answer choices are correct

All of these answer choices are correct

Which factors would likely increase an auditor's concern pertaining to risk of fraudulent financial reporting? -An extremely confusing and overly complex institutional structure, with blurred lines of authority -Low profitability/growth with respect to competitors in the same industry -Excessive amount of liquid assets that would easily be converted to cash -Management participation in selection of accounting methods and principles.

An extremely confusing and overly complex institutional structure, with blurred lines of authority

CPA Analytical procedures used in planning an audit should focus on identifying -Material weaknesses in the internal control structure -The predictability of financial data from individual transactions -The various assertions that are embodied in the financial statements -Areas that may represent specific risks relevant to the audit

Areas that may represent specific risks relevant to the audit Analytical procedures utilize historical data and relationships to predict expected balances. Analytical procedures enable the auditor to gain an understanding of the client's business and raise questions when current balances differ from expected balances. In this manner, the auditor is able to identify specific areas of risk that will need to be addressed during the audit

CPA A primary objective of analytical procedures used in the final review stage of an audit is to -Identify account balances that represent specific risks relevant to the audit -Gather evidence from tests of details to corroborate financial statement assertions -Detect fraud that may cause the financial statements to be misstated -Assist the auditor in evaluating the overall financial statement presentation

Assist the auditor in evaluating the overall financial statement presentation Analytical procedures used in the overall review stage of an audit are intended to assist the auditor in assessing the conclusions reached and in evaluating the overall financial statement presentation

CPA Which of the following is an analytical procedure that an auditor most likely would perform when planning an audit? -Confirming a sample of accounts payable -Scanning payroll files for terminated employees -Comparing current-year balances to budgeted balances -Recalculating interest expense based on notes payable balances

Comparing current-year balances to budgeted balances In planning the audit engagement, an auditor likely would compare current-year balances with budgeted balances that would be useful in developing expectations

CPA Which of the following activities is an analytical procedure an auditor would perform in the final overall review stage of an audit to ensure that the financial statements are free from material misstatement? -Reading the minutes of the board of directors' meetings for the year under audit -Obtaining a letter concerning potential liabilities from the client's attorney -Comparing the current year's financial statements with those of the prior year -Ensuring that a representation letter signed by management is in the file

Comparing the current year's financial statements with those of the prior year Comparing the current and prior year's financial statements is a legitimate analytical procedure performed both in planning and as a final review

CPA After identifying related party transactions, an auditor most likely would -Substantiate that the transactions were consummated on terms equivalent to those prevailing in arms-length transactions -Discuss the implications of the transactions with third parties, such as the entity's attorneys and bankers -Determine whether the transactions were approved by the board of directors or other appropriate officials -Ascertain whether the transactions would have occurred if the parties had not been related

Determine whether the transactions were approved by the board of directors or other appropriate officials The auditor's primary concern with regard to related party transactions is disclosure. After identifying related party transactions, the auditor should examine the transactions in order to determine the purpose, nature, and extent of the transactions and their effects on the financial statements. In that process, the auditor would look to see if the transactions were properly authorized by the board of directors

What is the typical means by which an auditor outlines the details of the engagement, and communicates this to the client's management? -Engagement letter -Audit working papers -An audit plan -Risk assessment

Engagement letter

Auditing arrangements and procedures should be specified in the management letter sent to the client by the auditors. -True -Flase

False

When the auditor is engaged at the risk assessment stage of the audit, analytical procedures are rarely used because these would represent substantive procedures. -True -False

False

Which of the following refers to measurement, agreed to beforehand, that can be quantified and reflected the success factors of an organization? -Key Performance Indicators -Current ratio -Acid-test ratio -Price-earnings ratio

Key Performance Indicators

CPA After determining that a related party transaction has, in fact, occurred, an auditor should -Add a separate paragraph to the auditor's standard report to explain the transaction -Perform analytical procedures to verify whether similar transactions occurred, but were not recorded -Obtain an understanding of the business purpose of the transaction -Substantiate that the transaction was consummated on terms equivalent to an arm's-length transaction

Obtain an understanding of the business purpose of the transaction After determining that a related party transaction has occurred, the auditor should obtain an understanding of the business purpose of the transaction. The auditor should apply the procedures considered necessary to determine the purpose, nature, and extent of the related party transactions and their effects on the financial statements

CPA An auditor's decision either to apply analytical procedures as substantive tests or to perform tests of transactions and account balances usually is determined by the -Availability of data aggregated at a high level -Relative effectiveness and efficiency of the tests -Timing of tests performed after the balance sheet date -Auditor's familiarity with industry trends

Relative effectiveness and efficiency of the tests Evidence may be gathered by means of analytical tests (performed as substantive tests), tests of transactions, and tests of details of balances. The decisions as to which means to employ is based on the auditor's judgment of the expected effectiveness and efficiency of the available procedures.

CPA Which of the following auditing procedures would be most likely to assist an auditor in identifying related party transactions? -Inspecting correspondence with lawyers for evidence of unreported contingent liabilities -Vouching accounting records for recurring transactions recorded just after the balance sheet date -Reviewing confirmations of loans receivable and payable for indications of guarantees -Performing analytical procedures to seek indications of possible financial difficulties

Reviewing confirmations of loans receivable and payable for indications of guarantees Reviewing confirmations of loans receivable and payable for indications of guarantees is one of the auditing procedures that will assist the auditor in identifying related party transactions

CPA Which of the following events most likely indicated the existence of related parties? -Borrowing a large sum of money at a variable rate of interest -Selling real estate at a price that differs significantly from its market value -Making a loan with scheduled terms for repayment of the funds -Discussing merger terms with a company that is a major competitor

Selling real estate at a price that differs significantly from its market value Transactions considered to indicate the existence of related parties include making loans with no scheduled terms for repayment of the funds. Such terms, of the lack thereof, appear more favorable than loans made independently between unrelated parties. Making a loan with specific scheduled terms for repayment would not be indicative of a related party transaction.

CPA In auditing related-party transactions, an auditor ordinarily places primary emphasis on -The probability that related-party transaction will recur -Confirming the existence of the related parties -Verifying the valuation of the related-party transactions -The adequacy of the disclosure of the related-party transactions

The adequacy of the disclosure of the related-party transactions GAAP focuses on providing full disclosure of related-party issues, so the auditor places primary emphasis on evaluating the adequacy of disclosure of such transactions

CPA Which of the following comparisons would an auditor most likely make in evaluating an entity's costs and expenses? -The current year's accounts receivable with the prior year's accounts receivable -The current year's payroll expense with the prior year's payroll expense -The budgeted current year's sales with the prior year's sales -The budgeted current year's warranty expense with the current year's contingent liabilities

The current year's payroll expense with the prior year's payroll expense The auditor evaluates an entity's costs and expenses to try to detect any material misstatements present. The best comparison would be current-year and prior-year payroll expense as they are likely to be related to each other. Thus, prior-year expense can be used to predict likely current-year expense. If the numbers are materially different, it could indicate the existence of a material misstatement

CPA Which of the following most likely would cause an auditor to consider whether a client's financial statements contain material misstatements? -Management did not disclose to the auditor that it consulted with other accountants about significant accounting matters -The chief financial officer will not sign the management representation letter until the last day of the auditor's fieldwork -Audit trails of computer-generated transactions exist only for a short time -The results of an analytical procedure disclose unexpected differences

The results of an analytical procedure disclose unexpected differences Analytical procedures are a category of "substantive" audit procedures, and unexpected differences relative to the auditor's expectations may direct the auditor's attention to the possibility of a material misstatement

CPA Which of the following statements is correct concerning analytical procedures used in planning an audit engagement? -They often replace the tests of controls that are performed to assess control risk -They usually use financial and nonfinancial data aggregated at a high level -They usually involve the comparison of assertions developed by management to ratios calculated by an auditor -They are often used to develop an auditor's preliminary judgement about materiality

They usually use financial and nonfinancial data aggregated at a high level Analytical procedures used in planning often use data aggregated at a high level

CPA What is the primary purpose of reviewing conflict-of-interest statements signed by members of management? -To obtain an understanding of business processes -To identify transactions with related parties -To assess control risk -To consider limitations of internal control

To identify transactions with related parties Reviewing conflict-of-interest statements signed by management would provide the auditor with information about potential relationships with related parties that might warrant additional disclosure in the financial statements

If an auditor is considering accepting a client in an industry that is unfamiliar to the auditor, the auditor should ____ -issue a disclaimer of opinion -not accept the engagement -rely on the opinion of specialists the auditor hires -attempt to learn all matters that would materially pertain to the entity's business

attempt to learn all matters that would materially pertain to the entity's business

When gaining an understanding of the client's sources of financing, the auditor: -determines if the client is writing off uncollectible accounts receivable -determines if the client is meeting principal and interest payments when they are due -is not interested in debt covenants because most debt contracts are the same -ignores the relative reliance on debt versus equity funding because that is a management decision, not an audit issue

determines if the client is meeting principal and interest payments when they are due

If the management of an entity is close to breaching a debt covenant that requires maintaining a certain current ratio, management may have an incentive to ____ -either overstate current assets or understate current liabilities -overstate either current assets or current liabilities -understate either current assets or current liabilities -either understate current assets or overstate current liabilities

either overstate current assets or understate current liabilities

CPA When auditing related party transactions, an auditor places primary emphasis on -confirming the existence of the related parties -verifying the valuation of the related party transactions -evaluating the disclosure of the related party transactions -ascertaining the rights and obligations of the related parties

evaluating the disclosure of the related party transactions When auditing related party transactions, the auditor is primarily concerned with the adequacy of disclosure

Risks of material misstatement that are associated with a client's IT system include all of the following except: -failure to accrue for a contingent liability -no schedule for backing up data -a terminated employee who is still able to log on to the client's IT system -the installation of new software that still needs modifications to operate as needed

failure to accrue for a contingent liability

When the economy is poor, a fall in profits can easily be explained to shareholders when most companies in the industry are also experiencing a decline in earnings; therefore, therefore when the economy is poor there is a tendency within an entity to ____ -minimize revenues -minimize profits -maximize profits -maximize write-offs

maximize write-offs

An audit committee of a publicly traded company should be composed of: -the CFO and two other board members who are also shareholders -executive and non-executive members of the board of directors -the audit partner, the CFO, and a shareholder -members of the board of directors who are independent directors

members of the board of directors who are independent directors

Analytical procedures: -are only useful if the client's variation from budget is low -are not affected by different accounting methods between the client and other members of the industry -cannot be performed on interim data -must take into account seasonal variation in the client's business

must take into account seasonal variation in the client's business

Which of the following statements is false regarding related parties? -the presence of related parties is considered a fraud risk factor -a subsidiary company is considered a related party -management should have controls in place for identifying related parties -related party transactions do not have to be disclosed if they are conducted at "arm's length"

related party transactions do not have to be disclosed if they are conducted at "arm's length"

Common uses of analytical procedures include all of the following except: -test of internal controls -testing account balances derived from estimates during the risk response stage -overall assessment of financial statements at the final review stage of the audit -risk identification during the risk assessment stage

test of internal controls