Auditing Chapter 5 - Test Review Questions

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 B/S date.4)The terms and manner of settlement.

In their review of audit working papers, what do managers and partners look for?

In their review of audit working papers, managers and partners look for indications that the audit was performed in accordance with generally accepted auditing standards and firm quality control policies and procedures; and they judge whether the evidence accumulated during the audit supports the CPA firm's opinion on the client's financial statements.

What are the major functions of audit working papers?

The major functions include: 1. providing evidence to confirm the achievement of the audits over all objectives 2. Providing evidence to confirm that the audit was planned and performed according to GAAS 3. Providing evidence to support the financial audit opinion

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

What is the purpose of a "second partner review"? What should be the extent of the second partner's association with the engagement being reviewed?

The purpose of a second partner review is to provide assurance that all of the CPA firm's quality control policies have been met during the engagement and that the audit performed is in accordance with GAAP.

Distinguish among routine, nonroutine, and estimation transactions. Include an example of each.

- Routine transactions involve recurring financial activities recorded in the accounting records in the normal course of business. Examples include sales transactions, purchase transactions, cash disbursements, cash receipts, and payroll transactions. - Nonroutine transactions involve activities that occur only periodically. Examples include taking physical inventories, calculating depreciation, and consolidating financial results. - Estimation transactions are financial reporting activities that involve creating an accounting estimate. Examples include estimating the allowance for uncollectible accounts, estimating warranty reserves, and assessing assets for impairment

List the major types of audit working papers and give a brief explanation of each.

1)Audit administrative working papers- aid the auditors in planning and administration of the audit, and include such items as the audit programs, questionnaires and flowcharts, decision aids, time budgets, and engagement letters (2)Working trial balance- represents the backbone of the auditors' working papers, for it contains the balances of the ledger accounts, the adjustments, and reclassifications deemed necessary by the auditors, and the adjusted amounts that appear in the financial statements. It also contains references to all supporting schedules and analyses, thus serving to control the other types of working papers. (3)Lead schedules- working papers that serve to combine similar general ledger accounts, the total of which appears on the working trial balance. (4)Adjusting journal entries- material misstatements in the accounts disclosed by the auditors' investigation are corrected by means of adjusting journal entries. These appear on the auditors' working trial balance, and in addition, a list of such entries is turned over to the client at the conclusion of the audit with the request that they are approved and entered in the accounting records. (5)Reclassification entries- entries necessary to properly reflect financial results but not representing misstatements in the financial records of the client. (6)Supporting schedules- although the term schedule is at times applied to various types of working papers, the preferred usage is to designate a listing of the details or elements comprising the balance in an account at a specified date. Preparation of such a listing is often an essential step in determining the nature of an account. (7)Analyses- consist of working papers showing the changes which occurred in an account during a given period. By analyzing an account, the auditors determine its nature and contents. (8)Reconciliations- working papers that prove the relationship between two amounts obtained from different sources. (9)Computational working papers- used to verify such data as interest expense, income taxes, and earnings per share. (10)Corroborating documents- working papers that provide support for specific representations made in the financial statements, such as letters of representations from clients, lawyers' letters, audit confirmations, and copies of the contracts

In an audit of financial statements, the auditors gather various types of audit evidence. List seven major types of evidence and provide a procedural example of each

1. Accounting Information System (e.g. - journals & ledgers) 2. Documentary evidence (e.g. - invoices, purchase orders) 3. Third Party Representation (e.g. - confirmation of debt, cash & receivables 4. Physical Evidence (e.g. - plant & equipment, inventory) 5. Computations (e.g. - depreciation, foot sales journal) 6. Data Interrelationships (e.g. - analytical procedures) 7. Client Representations (e.g. - representation letters, replies to inquiries)

Distinguish between the component of audit risk that the auditors gather evidence to assess versus the component of audit risk that they collect evidence to restrict.

Because inherent risk and control risk are a result of characteristics of the client and its internal controls, auditors assess them. Because detection risk is a function of the effectiveness of the audit procedures used to gather evidence, it is restricted to the appropriate level based on the scope of procedures performed.

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

Inherent risk - the possibility of material misstatement of an assertion before considering the client's internal control. Control risk - the risk that a material misstatement could occur in a relevant assertion and not be prevented or detected on a timely basis by the client's internal control.

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

Inherent risk refers to the possibility of material misstatement of an assertion before considering the client's internal control. 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

Describe the relationship between detection risk and audit risk

Like audit risk, detection risk does not assess detection risk, rather it makes auditors seek to restrict it through the performance of substantive procedures