Auditing Chapter 4

An audit strategy memorandum contains a. Specifications of procedures the auditors believe appropriate for the financial statements under audit. b. Specifications of auditing standards relevant to the financial statements being audited. c. Reconciliation of the account balances in the financial statements with the account balances in the client's general ledger. d. Documentation of the assertions under audit, the evidence obtained, and the conclusions reached.

A. An audit strategy contains specifications of procedures the auditors believe appropriate for the financial statements under audit.

Analytical procedures are generally used to produce evidence from a. Relationships among current financial balances and prior balances, forecasts, and nonfinancial data. b. Detailed examination of external, external-internal, and internal documents. c. Confirmations mailed directly to the auditors by client customers. d. Physical observation of inventories.

A. Analytical procedures incorporate information from a variety of sources.

Enterprise risk management is the responsibility of: a. Company management. b. The external auditors. c. The company's insurance providers. d. All of the other answers are correct.

A. ERM is the responsibility of company management.

When auditors become aware of noncompliance with a law or regulation committed by client personnel, the primary reason that the auditors should obtain a better understanding of the nature of the act is to a. Evaluate the effect of the noncompliance on the financial statements. b. Recommend remedial actions to the audit committee. c. Determine whether to contact law enforcement officials. d. Determine whether other similar acts could have occurred.

A. The audit team's first concern is the effect of the noncompliance on the financial statements.

Which of the following risk types increase when an auditor performs substantive analytical audit procedures for financial statement accounts at an interim date? a. Detection. b. Control. c. Sampling. d. Inherent.

A. The decision to perform substantive analytical procedures (as compared to a test of details) at interim (as compared to the balance sheet date) would increase detection risk.

When a company that sells its products with a positive gross profit increases its sales by 15 percent and its cost of goods sold by 7 percent, the cost of goods sold ratio will a. Decrease. b. Increase. c. Remain unchanged. d. Not be able to be determined with the information provided.

A. The numerator (cost of goods sold) increases relatively less than the denominator (sales) increases.

An auditor's analytical procedures indicate a lower than expected return on an equity method investment. This situation most likely could have been caused by a. An error in recording amortization of the excess of the investor's cost over the investment's underlying book value. b. An error in recording the unrealized gain from an increase in the fair value of available for sale securities in the income account for trading securities. c. A substantial fluctuation in the price of the investee's common stock on a national stock exchange. d. The investee's decision to reduce cash dividends declared per share of its common stock.

A. This is the correct answer. An error in recording amortization of the excess of the investor's cost over the investment's underlying book value could have been the cause of a lower than expected return on an equity method investment.

One of the typical characteristics of management fraud is a. Illegal acts committed by management to evade laws and regulations. b. Victimization of investors through the use of materially misleading financial statements. c. Falsification of documents in order to misappropriate funds from an employer. d. Conversion of stolen inventory to cash deposited in a falsified bank account.

B. Management fraud is victimization of investors through the use of materially misleading financial statements.

The risk of material misstatement is composed of which audit risk components? a. Inherent risk and detection risk. b. Inherent risk and control risk. c. Control risk and detection risk. d. Inherent risk, control risk, and detection risk.

B. The risk of material misstatement is composed of inherent risk and control risk.

Failure to meet company objectives is a result of a. Inherent risk. b. Information risk. c. Business risk. d. Audit risk.

C. This is the definition of business risk.

An audit committee is a. Composed of members of the audit team. b. A committee composed of persons not associating in any way with the client or the board of directors. c. Composed of members of a company's board of directors who are not involved in the day-to-day d. Composed of internal auditors.

C. An audit committee is composed of members of a company's board of directors who are not involved in the day-to-day operations of the company.

Which of the following matters relating to an entity's operations would an auditor most likely consider as an inherent risk factor in planning an audit? a. The entity's fiscal year ends on June 30. b. The entity's financial statements are generated at an outside service center. c. The entity enters into significant derivative transactions as hedges. d. The entity's financial data is available only in computer-readable form.

C. By their very nature, derivative transactions are designed to be used as hedges for exposure on existing contracts are quite complex. The accounting rules that provide the basis for GAAP in this area are also complex. As a result of this complexity, the inherent risk of material misstatement is higher.

The auditors assessed risk of material misstatement at 0.50 and said they wanted to achieve a 0.05 risk of failing to express a correct opinion on financial statements that were materially misstated. What detection risk do the auditors plan to use for planning the remainder of the audit work? a. 0.20. b. 0.75. c. 0.10. d. 0.00.

C. DR = AR/ (IR x CR) = 0.05/0.50 = 0.10.

Auditors perform analytical procedures in the planning stage of an audit for the purpose of a. Determining which of the financial statement assertions are the most important for the client's financial statements. b. Determining the nature, timing, and extent of further audit procedures for auditing the inventory. c. Identifying unusual conditions that deserve more auditing effort. d. Deciding the matters to cover in an engagement letter.

C. This is the "attention-directing" purpose.

Analytical procedures can be used in which of the following ways? a. As a means of overall review near the end of the audit. b. As "attention-directing" methods when planning an audit at the beginning. c. As substantive audit procedures to obtain evidence during an audit. d. All of the other answers are correct.

D. All of the other answer choices are correct (and, so, this is the best answer). Analytical procedures can be used when planning the audit, when performing substantive procedures during an audit, and as a method of overall review near the end of the audit.

The risk that the auditors' own testing procedures will lead to the decision that material misstatements do not exist in the financial statements when in fact such misstatements do exist is a. Inherent risk. b. Control risk. c. Audit risk. d. Detection risk.

D. This is the definition of detection risk.