TEST BANK for Auditing and Assurance Services, 18th edition by Arens Alvin, Elder Randal, Beasley Ma by StudyGuide

(Auditing and Assurance Services, 18e Alvin Arens, Randal Elder, Mark Beasley, Chris Hogan) (Test Bank all Chapters)

Chapter 1

The Demand for Audit and Other Assurance Services

1.1 Learning Objective 1-1 1) In the auditing process, A) the types and amounts of evidence remain constant from audit to audit. B) the criteria for evaluating information will not vary depending on the information being audited. C) the audit report communicates the auditor's findings to users. D) records are gathered by the auditor to determine whether the audited information is stated in accordance with SEC standards. Answer: C Terms: Audit process Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 2) Which of the following is considered audit evidence? A) Oral statements made by Written Auditor management Communications Observations Y N N B) Oral statements made by management N

Written Communications Y

Auditor Observations Y

Oral statements made by management Y

Written Communications Y

Auditor Observations Y

Oral statements made by management N

Written Communications N

Auditor Observations Y

3) Which of the following can be used as a criterion for evaluating information being audited? A) International Financial Reporting Standards (IFRS) B) Generally Accepted Accounting Principles (GAAP) C) Internal Revenue Code (IRC) D) all of the above Answer: D Terms: Criteria by which an auditor evaluates information Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 4) Auditors do not provide which of the following? A) assurance on financial statements B) assurance on the effectiveness of system of internal controls over financial reporting C) assurance on corporate sustainability reports D) absolute assurance on the financial statements including assuming responsibility for them Answer: D Terms: Nature of Objectives of Auditing Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 5) The accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and some established criteria is defined as A) accounting. B) financial reporting. C) tax reporting. D) auditing. Answer: D Terms: Definition of auditing Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 6) The criteria by which an auditor evaluates the information under audit may vary with the information being audited. Answer: TRUE Terms: Criteria by which an auditor evaluates information Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking

7) One criterion used by an external auditor to evaluate published financial statements is known as generally accepted auditing standards. Answer: FALSE Terms: Criteria used by external auditor to evaluate published financial statements Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 8) Auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports. Answer: TRUE Terms: Independence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 9) To perform an audit, there must be information in a verifiable form and some criteria by which the auditor can evaluate the information. Answer: TRUE Terms: Independence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 10) An auditor must be competent and have an independent mental attitude. Answer: TRUE Terms: Criteria used by external auditor to evaluate published financial statements Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 11) Auditors are not allowed to audit subjective information like the effectiveness of computer controls or the efficiency of manufacturing-related operations. Answer: FALSE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 12) In an audit of system of internal controls over financial reporting, the auditor may rely upon the Internal Control - Integrated Framework issued by COSO. Answer: TRUE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 3 Copyright © 2023 Pearson Education, Inc.

13) In circumstances where the auditor is being asked to audit subjective types of information, typically, the auditor and the entities being audited should agree in writing about the criteria being audited after the audit starts. Answer: FALSE Terms: Information and Established Criteria for the Performance of Audits Difficulty: Moderate Objective: LO 1-1 AACSB: Reflective thinking 14) Evidence is paramount to audit and attestation engagements. List the four basic types of audit evidence. Answer: The four types of audit and attestation evidence include 1. Electronic and documentary data about transactions 2. Written and electronic communications with outsiders 3. Observations by the auditor 4. Oral testimony of the auditee (client) Terms: Basic types of audit evidence Difficulty: Easy Objective: LO 1-1 AACSB: Reflective thinking 1.2 Learning Objective 1-2 1) Recording, classifying, and summarizing economic events in a logical manner for the purpose of providing financial information for decision making is commonly called A) finance. B) auditing. C) accounting. D) economics. Answer: C Terms: Recording, classifying, and summarizing economic events Difficulty: Easy Objective: LO 1-2 AACSB: Reflective thinking 2) An accountant A) must possess expertise in the accumulation of audit evidence. B) must decide the number and types of items to test. C) must have an understanding of the principles and rules that provide the basis for preparing the accounting information. D) must be a CPA. Answer: C Terms: Distinguishes auditors from accountants Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 4 Copyright © 2023 Pearson Education, Inc.

3) When auditing accounting data, auditors focus on A) determining whether recorded information properly reflects the economic events that occurred during the accounting period. B) determining if fraud has occurred. C) determining if taxable income has been calculated correctly. D) analyzing the financial information to be sure that it complies with government requirements. Answer: A Terms: Auditing financial accounting data primary concern Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 4) The trait that distinguishes auditors from accountants is the A) auditor's ability to interpret accounting principles generally accepted in the United States. B) auditor's education beyond the bachelor's degree. C) auditor's ability to interpret FASB Statements. D) auditor's expertise in the accumulation and the interpretation of audit evidence. Answer: D Terms: Distinguishes auditors from accountants Difficulty: Challenging Objective: LO 1-2 AACSB: Reflective thinking 5) Auditors focus on determining whether recorded information properly reflects the economic events that occurred during the accounting period. Answer: TRUE Terms: Roles of accountants and auditors Difficulty: Easy Objective: LO 1-2 AACSB: Reflective thinking 6) Both accountants and auditors must possess expertise in the accumulation and interpretation of audit evidence. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 7) Accountants are not directly responsible for developing a system that ensures the entity's economic events are properly recorded on a timely basis and at a reasonable cost. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

8) Financial statement users do not confuse auditing with accounting any longer. Answer: FALSE Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking 9) Discuss the differences and similarities between the roles of accountants and auditors. What additional expertise must an auditor possess beyond that of an accountant? Answer: The role of accountants is to record, classify, and summarize economic events in a logical manner for the purpose of providing financial information for decision making. To provide relevant information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the accounting information. In addition, accountants must develop a system to ensure that the entity's economic events are properly recorded on a timely basis and at a reasonable cost. The role of auditors is to determine whether the recorded information prepared by accountants properly reflects the economic events that occurred during the accounting period. Because U.S. or international accounting standards provide the criteria for evaluating whether financial information is properly recorded, auditors must thoroughly understand those accounting standards. In addition to understanding accounting, the auditor must possess expertise in the accumulation and interpretation of audit evidence. It is this expertise that distinguishes auditors from accountants. Determining the proper audit procedures, deciding the number and types of items to test, and evaluating the results are unique to the auditor. Terms: Roles of accountants and auditors Difficulty: Moderate Objective: LO 1-2 AACSB: Reflective thinking

1.3 Learning Objective 1-3 1) ________ risk reflects the possibility that the information upon which the business decision was made was inaccurate. A) Client acceptance B) Information C) Business D) Control Answer: B Terms: Risk that reflects the possibility that information upon which business risk decision was made Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 2) The possibility that a business may not be able to repay a bank loan because of an economic downturn is referred to as A) materiality risk. B) information risk. C) interest rate risk. D) business risk. Answer: D Terms: Business risk Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 3) A bank loan officer is trying to decide whether the bank should make a loan to a particular company. The interest rate the bank will charge the company is determined by many factors. Which of the following factors is influenced by the auditor's report? A) the risk-free interest rate risk B) information risk C) the business risk for/of the customer D) All of the above are influenced by the auditor's report. Answer: B Terms: Interest rate risk/factor influenced by auditor's report Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 4) Auditing can have a significant effect on both information risk and business risk. Answer: FALSE Terms: Business risk and information risk Difficulty: Moderate Objective: LO 1-3 AACSB: Reflective thinking 7 Copyright © 2023 Pearson Education, Inc.

1.4 Learning Objective 1-4 1) A correct relationship among the auditor, the client, and the external users is A) management of a public company hires the independent auditor. B) the audit committee of a private company hires the independent auditor. C) the client provides capital to the external users. D) the external users can rely upon the auditor's report to reduce information risk. Answer: D Terms: Relationships among auditor, client, and external users Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 2) The most common way for users to obtain reliable information is to A) have an internal audit. B) have an independent audit. C) verify all information individually. D) verify the information with management. Answer: B Terms: Obtain reliable information Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 3) External users of the financial statements A) value the auditor's report because of the auditor's independence from the client. B) look to the auditor's report as an indication of the statements' reliability. C) use the audited information on the assumption that it is reasonably complete, accurate, and unbiased. D) all of the above. Answer: D Terms: Relationships among auditor, client, and external users Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 4) Which of the following is not a cause of information risk? A) Society, today, is not as complex as it used to be. B) Remoteness of information. C) The volume and the complexity of data and exchange transactions. D) The biases and the motives of the information provider. Answer: A Terms: Causes of Information Risk Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

5) Large businesses, especially, have the ability to reduce information risk. Which of the following is not a way for a large business to reduce information risk? A) Paying higher interest rates on loans. B) The user verifies the information they need by any possible means. C) The user of information shares information risk with management. D) Having an independent audit performed of the financial statements. Answer: A Terms: Causes of Information Risk Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 6) As society becomes more complex, decision makers are more likely to receive reliable information. Answer: FALSE Terms: Reducing information risk Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking 7) Management is required by GAAP to reduce information risk, even if the costs outweigh the benefits. Answer: FALSE Terms: Reducing information risk Difficulty: Moderate Objective: LO 1-4 AACSB: Reflective thinking 8) Explain what is meant by information risk, and list the four causes of this risk. Answer: Information risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. Four causes of information risk are • remoteness of information, • biases and motives of the provider, • voluminous data, and • complex exchange transactions. Terms: Information risk definition and causes Difficulty: Easy Objective: LO 1-4 AACSB: Reflective thinking

1.5 Learning Objective 1-5 1) In the audit of historical financial statements, management asserts that the financial statements are fairly stated in accordance with what standards? A) regulatory accounting principles B) applicable international accounting standards C) applicable U.S. accounting standards D) Both B and C Answer: D Terms: Audit of historical financial statements Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 2) Any service that requires a CPA firm to issue a report about the reliability of an assertion that is made by another party is a(n) A) accounting and bookkeeping service. B) attestation service. C) assurance service. D) tax service. Answer: B Terms: Assurance services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 3) Three common types of attestation services are A) audits of historical financial statements, reviews of historical financial statements, and audits of system of internal control over financial reporting. B) audits of historical financial information, verifications of historical financial information, and attestations regarding system of internal controls. C) reviews of historical financial information, verifications of future financial information, and attestations regarding system of internal controls. D) audits of historical financial information, reviews of controls related to investments, and verifications of historical financial information. Answer: A Terms: Types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

4) Which of the following services provides the lowest level of assurance on a financial statement? A) review B) audit C) Neither service provides assurance on financial statements. D) Each service provides the same level of assurance on financial statements. Answer: A Terms: Service provides lowest level of assurance on a financial statement Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 5) Which of the following is an accurate statement regarding assurance services? A) Assurance services must be performed by a CPA. B) An attestation service is not a type of assurance service. C) Assurance services improve the quality of information for decision makers. D) Assurance services can only be performed on financial data. Answer: C Terms: Assurance services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 6) Audits A) are an assurance service, but not an attestation service. B) are designed to provide absolute assurance that the financial statements are free of material misstatement. C) are required for publicly traded companies in the United States. D) do not require the auditor to express their opinion in a written report. Answer: C Terms: Audit assurance Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 7) A high, but not absolute, level of assurance is called A) probable assurance. B) reasonable assurance. C) limited assurance. D) incomplete assurance. Answer: B Terms: Reasonable assurance Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

8) Which of the following is an accurate statement regarding the various types of other assurance services? A) Assurance services must be about the reliability of another party's assertion about compliance with specified criteria. B) Other assurance services must meet the definition of an attestation service. C) The primary purpose of a management consulting engagement is to improve the quality of information. D) The market for other forms of assurance services is open to non-CPA competitors. Answer: D Terms: Assurance services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 9) CPA firms are never allowed to provide bookkeeping services for clients. Answer: FALSE Terms: CPA services provided to clients Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 10) Section 404 of the Sarbanes-Oxley Act requires public companies to have an external auditor attest to their system of internal controls over financial reporting. Answer: TRUE Terms: Section 404 of the Sarbanes-Oxley Act Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 11) Most public companies' audited financial statements are available on the SEC's EDGAR database. Answer: TRUE Terms: Public companies' audited financial statements: SEC's EDGAR database Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 12) The primary purpose of a management consulting engagement is to generate a recommendation(s) to management. Answer: TRUE Terms: Nonassurance services provided by CPAs; management consulting Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

13) Audits and some types of attestation services are no longer limited by regulation to licensed CPAs. Answer: FALSE Terms: Who can provide audits and certain types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 14) Evaluating system of internal controls at third-party service providers, such as cloud computing suppliers, is not an attestation type of service which a CPA is allowed to perform today. Answer: FALSE Terms: Who can provide other types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 15) It is increasingly important for companies to ask their third-party service provider of services, including payroll and other types of transaction processing, for attestation reports covering a review of the effectiveness of system of internal controls in place at the third-party service provider. Answer: TRUE Terms: Who can provide other types of attestation services Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking 16) Two types of attestation services provided by CPA firms are audits and reviews. Discuss the similarities and differences between these two types of attestation services. Which type provides the least assurance? Answer: In both the review and audit of the historical financial statements, management asserts that the statements are fairly stated in accordance with accounting standards. The CPA provides a lower level of assurance for reviews of financial statements compared to the high level for audits, therefore less evidence is needed. A review is often adequate to meet financial statement users' needs. It can be provided by a CPA firm at a much lower fee than an audit because less evidence is needed. An audit is the most common assurance service provided by CPA firms. Publicly traded companies in the U.S. are required to have audits under the federal securities acts. Many nonpublic companies have a review to limit audit fees. Terms: Attestation services; Audits and reviews of historical financial statements Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking

17) What is an audit of system of internal control over financial reporting? Answer: For an audit of system of internal control over financial reporting, management asserts that system of internal controls have been developed and implemented following well established criteria. Section 404 of the Sarbanes-Oxley Act requires public companies to report management's assessment of the effectiveness of system of internal control. The Act also requires auditors for larger public companies to attest to the effectiveness of system of internal control over financial reporting. This evaluation, which is integrated with the audit of financial statements, increases user confidence about future financial reporting, because effective system of internal controls reduce the likelihood of future misstatements in the financial statements. Terms: Engagement to attest on system of internal control over financial reporting Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 18) What are the four categories of attestation services? Answer: The four categories of attestation services include • Audit of historical financial statements • Audit of system of internal control over financial reporting • Review of historical financial statements • Other attestation services that may be applied to a broad range of subject matters. Terms: Categories of attestation services Difficulty: Moderate Objective: LO 1-5 AACSB: Reflective thinking 19) CPA firms perform numerous services that generally fall outside the scope of assurance services. Give three examples of such services. Answer: Three specific examples of services performed by CPAs that generally fall outside the scope of assurance services are • accounting and bookkeeping services • tax services • management and consulting services. Terms: Nonassurance services provided by CPAs Difficulty: Easy Objective: LO 1-5 AACSB: Reflective thinking

1.6 Learning Objective 1-6 1) One objective of an operational audit is to A) determine whether the financial statements fairly present the entity's operations. B) determine if the auditee is in compliance with GAAP. C) make recommendations for improving performance. D) report on the entity's relative success in attaining profit maximization. Answer: C Terms: Objective of operational audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 2) An examination of part of an organization's procedures and methods for the purpose of evaluating efficiency and effectiveness is what type of audit? A) operational audit B) compliance audit C) financial statement audit D) production audit Answer: A Terms: Examination of part of an organization's procedures and method to evaluate efficiency and effectiveness Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 3) An audit to determine whether an entity is following specific procedures or rules set down by some higher authority is classified as a(n) A) audit of financial statements. B) compliance audit. C) operational audit. D) production audit. Answer: B Terms: Audit to determine whether entity followed specific procedures or rules Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

4) Which one of the following is more difficult to evaluate objectively? A) presentation of financial statements in accordance with generally accepted accounting principles B) compliance with government regulations C) efficiency and effectiveness of operations D) All three of the above are equally difficult. Answer: C Terms: Most difficult to evaluate objectively Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking 5) Which of the following audits can be regarded as generally being a compliance audit? A) IRS agents' examinations of taxpayer returns B) GAO auditor's evaluation of the computer operations of governmental units C) an internal auditor's review of a company's payroll authorization procedures D) a CPA firm's audit of a public company Answer: A Terms: Compliance audit Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking

6) Which of the following are required to have a written report regarding the assertion of another party? A) Financial Statement Operational Compliance Attestation Assurance Audit Audit Audit Engagement Engagement Y Y Y Y Y B) Financial Statement Audit Y

Operational Audit Y

Compliance Audit Y

Attestation Assurance Engagement Engagement Y N

C) Financial Statement Audit Y

Operational Audit Y

Compliance Audit Y

Attestation Assurance Engagement Engagement N N

Operational Audit

Compliance Audit

Attestation Assurance Engagement Engagement

D) Financial Statement Audit N

Answer: B Terms: Required to have a written report Difficulty: Challenging Objective: LO 1-6 AACSB: Reflective thinking 7) In a financial statement audit, the auditor A) gathers evidence to determine whether the statements contain material errors or other misstatements. B) must have a thorough understanding of the entity and its environment. C) determines whether the financial statements are stated in accordance with specified criteria. D) all of the above. Answer: D Terms: Audit of historical financial statements Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

8) Which of the following is not an example of a compliance audit? A) The accounting personnel at the Chinese subsidiary following the financial statement preparation procedures prescribed in writing by the corporate controller. B) Is the company paying the minimum wage rates required by state laws? C) Determining if a company is meeting the financial covenants of a loan agreement with its lenders. D) Is the computerized processing of payroll at the Indian subsidiary operating effectively and efficiently? Answer: D Terms: Examples of compliance audits Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 9) The primary purpose of a compliance audit is to determine whether the financial statements are prepared in compliance with generally accepted accounting principles. Answer: FALSE Terms: Compliance audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 10) Results of compliance audits are typically reported to the company's management rather than to a broad spectrum of outside users. Answer: TRUE Terms: Compliance audit Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 11) An integrated approach to auditing considers both the risk of misstatements and operating controls intended to prevent misstatements. Answer: TRUE Terms: Audit of historical financial statements; integrated approach Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking

12) Discuss the similarities and differences between financial statement audits, operational audits, and compliance audits. Give an example of each type. Answer: Financial statement audits, operational audits, and compliance audits are similar in that each type of audit involves accumulating and evaluating evidence about information to ascertain and report on the degree of correspondence between the information and established criteria and/or procedures, rules, or regulations. The differences between each type of audit are the information being examined and the criteria used to evaluate the information. A financial statement audit is conducted to determine whether financial statements are stated in accordance with specified criteria, normally the U.S. or international standards. Auditors not only focus on accounting transactions, but also focus on an integrated approach in which both the risk of misstatements and the operating controls are considered. The auditor must have a thorough understanding of the entity and its environment. An operational audit evaluates the efficiency and effectiveness of any part of an organization's operating procedures and methods. At completion of an operational audit, management normally expects recommendations for improving operations. In operational auditing, the reviews are not limited to accounting. It is more difficult to objectively evaluate whether the efficiency and effectiveness of operations meets established criteria than it is for compliance and financial statement audits. Also, establishing criteria for evaluating the information in an operational audit is extremely subjective. Thus, operational auditing is more like management consulting than what is usually considered auditing. A compliance audit is conducted to determine whether the auditee is following specific procedures, rules, or regulations set by some higher authority. Results of compliance audits are typically reported to management, like in the operational audits, rather than to outside users as is done with financial statement audits. An example of a financial statement audit would be the annual audit of IBM Corporation, in which the external auditors examine IBM's financial statements to determine the degree of correspondence between those financial statements and generally accepted accounting principles. An example of an operational audit would be an internal auditor's evaluation of whether the company's computerized payroll-processing system is operating efficiently and effectively. An example of a compliance audit would be an IRS auditor's examination of an entity's federal tax return to determine the degree of compliance with the Internal Revenue Code. Terms: Financial statement audits, operational audits and compliance audits Difficulty: Challenging Objective: LO 1-6 AACSB: Analytic thinking

13) To perform an audit, it is necessary for the information to be in a verifiable form and there must be some criteria by which the auditor can evaluate the information. Detail the information and criteria that would be used when (A)an independent CPA firm audits a company's historical financial statements. (B) an Internal Revenue Service auditor audits that same company's tax return. (C) an internal auditor performs an operational audit to evaluate whether the company's computerized payroll processing system is operating efficiently and effectively. Answer: (A) The information used by a CPA firm in a financial statement audit is the financial information in the company's financial statements. The most commonly used criteria are applicable U.S. or international accounting standards. (B) The information used by an IRS auditor is the financial information in the company's federal tax return. The criteria used are the internal revenue code and interpretations. (C) The information used by an internal auditor when performing an operational audit of the payroll system could include various items such as the number of errors made, costs incurred by the payroll department, and number of payroll records processed each month. The criteria would consist of company standards for departmental efficiency and effectiveness. Terms: Information and criteria used by CPA firm, Internal Revenue Service auditor, and internal auditor Difficulty: Moderate Objective: LO 1-6 AACSB: Reflective thinking 1.7 Learning Objective 1-7 1) Internal auditors A) must be independent of the entity that employs them. B) report to the accounting department. C) are employed by all types of organizations. D) must be CPAs. Answer: C Terms: Internal audit Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 2) Which type of auditor audits the financial information prepared by various federal government agencies before it is submitted to Congress? A) internal auditor B) revenue agent C) independent auditor D) GAO auditor Answer: D Terms: Types of auditors Difficulty: Easy Objective: LO 1-7 AACSB: Reflective thinking 20 Copyright © 2023 Pearson Education, Inc.

3) The primary role of the United States General Accounting Office is the enforcement of the Federal tax laws as defined by Congress and interpreted by the courts. Answer: FALSE Terms: Primary role of United States General Accounting Office Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 4) CPA firms are often called and thought of by outsiders as external auditors, independent auditors, or internal auditors. Answer: FALSE Terms: Primary role of CPA firms Difficulty: Easy Objective: LO 1-7 AACSB: Reflective thinking 5) Compliance is a secondary objective of audits performed by the GAO of the financial information prepared by the various Federal government agencies before that information is submitted to Congress. Answer: FALSE Terms: Primary role of the GAO Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 6) The GAO reports to the Public Company Accounting Oversight Board, which reports to the Securities and Exchange Commission. Answer: FALSE Terms: GAO reports to and is responsible only to Congress Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking

7) Match the engagement described to the (A) type of audit and (B) auditor that would most likely perform the engagement. Each engagement will have an answer from List-A and List-B. An answer can be used once, more than once, or not at all. List A - Type of Audit: a. Financial Statement b. Compliance c. Operational

List B - Type of Auditor: d. Internal e. External f. Government g. IRS

Engagement: 1. Evaluate a company's payroll processing for economy of scale. 2. Evaluate/determine if bank covenants are being met. 3. Evaluate financial statements that are to be submitted to a bank. 4. Evaluate the promptness of materials inspection in a manufacturer's receiving department. 5. Determine if Medicare reimbursements are in accordance with the Healthcare Financing Administration (HCFA). 6. Determine if the tax return of a multinational corporation is in accordance with the tax code. 7. Determine if a public school is properly applying their reimbursement for the payment-in-kind program. 8. Determine the effectiveness of a Department of Defense project. Answer: 1. c, d 2. b, d 3. a, e 4. c, d 5. b, f 6. b, g 7. b, e 8. c, f Terms: Financial statement audit; Compliance audit; Operational audit; Types of auditors Difficulty: Challenging Objective: LO 1-7 AACSB: Analytic thinking

8) Discuss the similarities and differences between the roles of independent auditors, GAO auditors, internal revenue agents, and internal auditors. Answer: The roles of all four types of auditors are similar in that they involve the accumulation and evaluation of evidence about information to ascertain and report on the degree of correspondence between the information and established criteria. The differences in their roles center around the information audited and the criteria used to evaluate that information. Independent auditors primarily audit companies' financial statements. GAO auditors' primary responsibility is to perform the audit function for Congress. IRS auditors are responsible for the enforcement of federal tax laws. Internal auditors primarily perform operational and compliance audits for their employing company. Terms: Roles of independent auditors, GAO auditors, internal revenue agents and internal auditors Difficulty: Moderate Objective: LO 1-7 AACSB: Reflective thinking 1.8 Learning Objective 1-8 1) The three requirements for becoming a CPA include all but which of the following? A) uniform CPA examination requirement B) education requirements C) character requirements D) experience requirement Answer: C Terms: Requirements for becoming a CPA Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking 2) The use of the Certified Public Accountant title is regulated by A) the federal government. B) state law through the licensing departments of each state. C) the American Institute of Certified Public Accountants through the licensing departments of the tax and auditing committees. D) the Securities and Exchange Commission. Answer: B Terms: Certified Public Accountant title Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking

3) The AICPA, working together with NASBA, recently completed a significant revision of the CPA examination effective January 2024, referred to as the CPA Evolution. The 'Core' content of this revised licensure process is focused on each of the following topics that should be familiar to newly licensed CPAs except A) information systems and controls. B) accounting. C) audit and attestation. D) tax. Answer: A Terms: Structure of the CPA Examination Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking 4) The "Disciplines" content of the revised licensure process focuses on one of three areas to be selected by the individual seeking licensure. Which of the following is not one of these areas? A) Audit and Attestation B) Business Analysis and Reporting C) Tax Compliance and Planning D) Information Systems and Controls Answer: A Terms: Structure of the CPA Examination Difficulty: Moderate Objective: LO 1-8 AACSB: Reflective thinking 5) List and discuss the three primary requirements to become a CPA. Answer: The three primary requirements for becoming a CPA are: • Educational requirement. Normally, an undergraduate degree or a graduate degree with a major in accounting, including a minimum number of accounting credits is required. Most states now require 150 semester hours (225 quarter hours) for licensure as a CPA. Some states require fewer credits before taking the examination, but require 150 semester credits before receiving the CPA certificate. • Uniform CPA examination requirement. This is presently a four-part, computer-based examination with components on auditing and attestation, financial accounting and reporting, regulation, and business environment and concepts. Exam covers content that a newly licensed CPA must possess. Some states also require a separate ethics requirement. Significant changes to the CPA exam incorporating a "core" plus "discipline" approach will be effective January 2024. • Experience requirement. The experience requirement varies from state to state with some states requiring no experience, while other states require up to two years of audit experience. Some states include experience working for governmental units or in industry, including internal auditing. Terms: Primary requirements to become CPA Difficulty: Easy Objective: LO 1-8 AACSB: Reflective thinking 24 Copyright © 2023 Pearson Education, Inc.

Auditing and Assurance Services, 18e (Arens) Chapter 2 The CPA Profession 2.1 Learning Objective 2-1 1) The legal right to perform audits is granted to a CPA firm by regulation of A) each state. B) the Financial Accounting Standards Board (FASB). C) the American Institute of Certified Public Accountants (AICPA). D) the Auditing Standards Board. Answer: A Terms: Legal rights to perform audits Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 2) Which of the following is not a characteristic of a small local CPA firm? A) Most small firms have fewer than 25 professionals. B) Small firms perform audits on small and not-for-profit businesses. C) Tax services are more important than auditing services to the small firm. D) Small firms are prohibited by the SEC from auditing publicly traded companies. Answer: D Terms: Characteristics of a small firm Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 3) Sarbanes-Oxley and the Securities and Exchange Commission restrict auditors from providing many consulting services to their publicly traded audit clients. Which of the following is true for auditors of publicly traded companies? I. They are restricted from providing consulting services to privately held companies. II. There is no restriction on providing consulting services to non-audit clients. A) I only B) II only C) I and II D) Neither I nor II Answer: B Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking

4) Which of the following does not describe a size category for a CPA firm? A) Big Four national firms B) Big Four international firms C) local firms D) national and regional firms Answer: A Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 5) ________ is one of the Big Four international CPA firms. A) Deloitte B) KPMG C) Ernst & Young D) All of the above are classified as Big Four international CPA firms. Answer: D Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 6) In which type of service does the CPA assemble the financial statements but provide no assurance to third parties? A) audit B) compilation C) review D) bookkeeping Answer: B Terms: Compilation Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 7) ________ is not one of the National/Regional CPA Firms. A) PwC B) BDO USA C) Grant Thornton D) RSM US Answer: A Terms: Three categories for describing size of audit firms Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking

8) Which of the following is not an accurate definition or description of a local CPA firm? A) Some local CPA firms have several offices. B) Local CPA firms do not compete for clients with the Big Four CPA firms. C) Some local CPA firms are affiliated with other CPA firms to share resources. D) Many local CPA firms provide primarily accounting and tax services to their clients only. Answer: B Terms: Three categories for describing size of audit firms Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 9) Advisory services are once again the largest source of revenue for the Big 4 accounting firms. Which of the following statements is not correct regarding this increase in advisory service revenues? A) The PCAOB has in the past expressed interest in the growing size of these advisory practices, and changed SOX since then to allow providing nonaudit services to publicly listed audit clients. B) Proponents state these increases create incentives for the firms to lose their focus on providing audit services. C) Opponents argue that these advisory services provide the exposure these firms need expertisewise to perform their audit engagements. D) The European Union has a rule limiting the amount of nonaudit fees that can be earned from publicly listed clients. Answer: A Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 10) Many small, local accounting firms perform audits as their primary service to their clients. Answer: FALSE Terms: Small accounting firms do not perform audits as their primary service to their clients Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 11) Sarbanes-Oxley and the Securities and Exchange Commission restrict auditors from providing many consulting services to their publicly traded audit clients. Answer: TRUE Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking

12) Small local CPA Firms are allowed under Sarbanes-Oxley and the Securities and Exchange Commission a special exemption to perform audits of publicly listed firms. Answer: FALSE Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Difficulty: Easy Objective: LO 2-1 AACSB: Reflective thinking 13) In addition to attestation and assurance services, CPA firms provide other services to their clients. List three of these services. Answer: Other services performed by a CPA firm include: • accounting and bookkeeping services • tax services • management consulting and risk advisory services • business valuation • forensic accounting • corporate responsibility • sustainability reporting • information technology advisory services Terms: Activities of CPA firms Difficulty: Moderate Objective: LO 2-1 AACSB: Reflective thinking 2.2 Learning Objective 2-2 1) Which of the following statements is true as it relates to limited liability partnerships? A) Only senior partners are liable for the partnership's debts. B) Partners have no liability in a limited liability partnership arrangement. C) Partners are personally liable for the acts of those under their supervision. D) All partners must be AICPA members. Answer: C Terms: Limited liability partnerships Difficulty: Challenging Objective: LO 2-2 AACSB: Reflective thinking 2) Which staff level in a CPA firm performs most of the detailed audit work? A) partner B) staff assistant C) senior auditor D) senior manager Answer: B Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 4 Copyright © 2023 Pearson Education, Inc.

3) Which staff level in a CPA firm manages the overall relationship with the client and manages the audit, in general? A) the audit partner B) the audit staff assistant C) the senior or in-charge auditor with 2-5 years' experience D) the manager and senior manager Answer: D Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 4) All of the Big Four accounting firms and many of the smaller CPA firms now operate as limited liability partnerships. Answer: TRUE Terms: Limited liability partnerships Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 5) Limited liability companies are structured and taxed like a general partnership, but their owners have limited personal liability similar to that of a general corporation. Answer: TRUE Terms: Limited liability companies Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking 6) In a CPA firm, the audit partner coordinates the performance of audit procedures. Answer: FALSE Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking 7) In a CPA firm, the audit senior or the in-charge auditor performs most of the detailed audit work. Answer: FALSE Terms: Staff levels in CPA firm Difficulty: Easy Objective: LO 2-2 AACSB: Reflective thinking

8) List and describe the three factors that influence the organizational structure of all CPA firms. What are the most common forms of CPA firm organization? Answer: The three factors that influence the organization of a CPA firm include: 1. The need for independence from clients. Independence permits auditors to remain unbiased in drawing conclusions about the financial statements. 2. The importance of a structure to encourage competence. Competency permits auditors to conduct audits and perform other services effectively and efficiently. 3. The increased litigation risk faced by auditors. Audit firms continue to experience increases in litigation-related costs. Some organizational structures afford a degree of protection to individual firm members. Common forms of audit firm organization include: • Proprietorship • General Partnership • General Corporation • Professional Corporation • Limited Liability Company • Limited Liability Partnership Terms: Factors that influence the organizational structure of CPA firms Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking 9) List and describe the six organizational structures available to CPA firms. Answer: CPA firms can take one of six organizational forms: • Proprietorship. This form is limited to firms with only one owner. • General partnership. This form is similar to a proprietorship, except that it applies to multiple owners. • General corporation. Shareholders in a general corporation are liable only to the extent of their investment in the corporation. Many states prohibit CPA firms from organizing as a general corporation. • Professional corporation. A professional corporation provides professional services and is owned by one or more shareholders. Personal liability protection for shareholders in professional corporations varies widely from state to state. • Limited liability company. This form combines the most favorable attributes of a general corporation and a general partnership. LLCs are typically structured and taxed like a general partnership, but its owners have limited personal liability similar to that of a general corporation. • Limited liability partnership. An LLP is owned by one or more partners. It is structured and taxed like a general partnership. However, the personal liability protection of an LLP is less than that of a general corporation or an LLC, but it is greater than a general partnership. Many accounting firms now operate as LLPs. Terms: Organizational structures available to CPA firms Difficulty: Moderate Objective: LO 2-2 AACSB: Reflective thinking

2.3 Learning Objective 2-3 1) The organization that is responsible for providing oversight for auditors of public companies is called the A) Auditing Standards Board. B) American Institute of Certified Public Accountants. C) Public Oversight Board. D) Public Company Accounting Oversight Board. Answer: D Terms: Organization responsible for providing oversight for auditors of public companies Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking 2) Members of the Public Company Accounting Oversight Board are appointed and overseen by the A) U.S. Congress. B) American Institute of Certified Public Accountants. C) Auditing Standards Board. D) Securities and Exchange Commission. Answer: D Terms: Members of Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking 3) The Public Company Accounting Oversight Board A) performs inspections of the quality controls of firms that audit public companies. B) establishes auditing standards that must be followed by CPAs on all audits. C) oversees auditors of private companies. D) performs all of the above functions. Answer: A Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking

4) Assume the Public Company Accounting Oversight Board (PCAOB) identifies a violation during its inspection of a registered accounting firm. The PCAOB can A) report the matter to enforce disciplinary the Securities and suspend the license to action against the Exchange practice of the CPA accounting firm Commission guilty of the violation Yes Yes Yes B) report the matter to enforce disciplinary the Securities and suspend the license to action against the Exchange practice of the CPA accounting firm Commission guilty of the violation Yes Yes No C) enforce disciplinary action against the accounting firm Yes

report the matter to the Securities and suspend the license to Exchange practice of the CPA Commission guilty of the violation No No

D) enforce disciplinary action against the accounting firm No

report the matter to the Securities and suspend the license to Exchange practice of the CPA Commission guilty of the violation No No

Answer: B Terms: Public Company Accounting Oversight Board inspection violations Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 5) Has audit quality improved since the passage of Sarbanes-Oxley Act (SOX)? A) The frequency of financial statement restatements has increased since SOX. B) PCAOB audit engagement findings continue to document audit deficiencies. C) Finally, the auditing professions agrees on the definition of audit quality. D) Guidance has been provided on "Audit Quality Indicators" since SOX. Answer: B Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

6) The Public Company Accounting Oversight Board (PCAOB) provides oversight to auditors of publicly traded and private companies. Answer: FALSE Terms: Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-3 AACSB: Reflective thinking 7) The PCAOB requires annual inspections of accounting firms that audit more than ten public companies. Answer: FALSE Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 8) The PCAOB requires annual inspections of other registered accounting firms that audit less than 100 publicly listed companies at least once every 3 years. Answer: TRUE Terms: Public Company Accounting Oversight Board Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking 9) The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). What are the PCAOB's primary functions? Answer: The PCAOB provides oversight for auditors of public companies; establishes auditing, attestation, and quality control standards for public company audits; and performs inspections of audit engagements as well as the quality controls at audit firms performing those audits. Terms: Sarbanes-Oxley Act; Public Company Accounting Oversight Board primary functions Difficulty: Moderate Objective: LO 2-3 AACSB: Reflective thinking

2.4 Learning Objective 2-4 1) The form that must be completed and filed with the Securities and Exchange Commission whenever a company experiences a significant event that is of interest to public investors is the A) Form S-1. B) Form 8-K. C) Form 10-K. D) Form 10-Q. Answer: B Terms: SEC Form 8-K, reporting significant events Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 2) The form that must be filed with the Securities and Exchange Commission whenever a company plans to issue new securities to the public is the A) Form S-1. B) Form 8-K. C) Form 10-K. D) Form 10-Q. Answer: A Terms: Form must be completed and filed with Securities and Exchange Commission when company plans to issue new securities Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 3) Which of the following is a correct statement regarding the SEC? A) The Securities Act of 1934 requires most companies planning to issue new securities to the public to submit a registration statement to the SEC for approval. B) All public companies must file monthly statements with the SEC. C) The Form 10-K must be filed within 30 days after the close of the fiscal year. D) The SEC has the power to establish rules for any CPA associated with audited financial statements submitted to the commission. Answer: D Terms: Securities and Exchange Commission Difficulty: Challenging Objective: LO 2-4 AACSB: Reflective thinking

4) With respect to the SEC, A) the attitude of the SEC is generally considered in any major change proposed by the FASB. B) the SEC is the sole agency responsible for setting generally accepted accounting principles. C) the SEC requirements of greatest interest to CPAs are set forth in their enforcement regulations. D) the SEC has the power to establish rules for all CPAs. Answer: A Terms: Securities and Exchange Commission influence on setting generally accepted accounting principles Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 5) Which of the following is not a publication issued by the Securities and Exchange Commission? A) Accounting and Auditing Enforcement Actions B) Staff Accounting Bulletins C) Regulation S-X D) State Board of Accountancy Enforcement Actions Answer: D Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 6) The difference between the Securities Act of 1933 and the Securities Act of 1934 is that only the 1934 Act requires audited financial statements. Answer: FALSE Terms: Securities Acts of 1933 and 1934 Difficulty: Easy Objective: LO 2-4 AACSB: Reflective thinking 7) Form 10-K must be filed with the SEC whenever a public company experiences a significant event. Answer: FALSE Terms: Form 10-K; SEC Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking

8) The overall purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions. Answer: TRUE Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 9) Form 10-Q must be filed monthly with the Securities and Exchange Commission by every publicly held company. Answer: FALSE Terms: Form 10-Q; SEC Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking 10) Discuss the purpose of the Securities and Exchange Commission and its influence on setting generally accepted accounting principles. Answer: The SEC, an agency of the federal government, assists in providing investors with reliable information upon which to make investment decisions. The SEC has considerable influence in setting generally accepted accounting principles (GAAP) and disclosure requirements for financial statements as a result of its authority for specifying reporting requirements considered necessary for fair disclosure to investors. The SEC has the power to establish rules for any CPA associated with audited financial statements submitted to the commission. The attitude of the SEC is generally considered in any major change proposed by the Financial Accounting Standards Board (FASB), the independent organization that establishes U.S. GAAP. Terms: Securities and Exchange Commission influence on setting generally accepted accounting principles Difficulty: Moderate Objective: LO 2-4 AACSB: Reflective thinking

2.5 Learning Objective 2-5 1) Statements on Standards for Accounting and Review Services (SSARS) are issued by the A) Accounting and Review Services Committee. B) Professional Ethics Executive Committee. C) Securities and Exchange Commission. D) Financial Accounting Standards Board. Answer: A Terms: Statements on Standards for Accounting and Review Services (SSARS) Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking 2) The American Institute of Certified Public Accountants (AICPA) A) is responsible for issuing licenses to new CPAs. B) restricts its membership to CPAs who are independent auditors. C) sets auditing standards for both public and private companies. D) sets rules of conduct that CPAs are required to meet. Answer: D Terms: AICPA has authority to establish standards and rules Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking 3) In 2017, the American Institute of CPAs joined with which of the following to form the Association of International Certified Public Accountants? A) the Chartered Institute of Management Accountants B) the Securities and Exchange Commission C) the Public Accounting Oversight Board D) the Japanese Institute of Certified Public Accountants Answer: A Terms: AICPA joins with the CIMA (Chartered Institute of Management Accountants) Difficulty: Moderate Objective: LO 2-5 AACSB: Reflective thinking 4) Membership in the AICPA is restricted to CPAs who are currently practicing as independent auditors. Answer: FALSE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking

5) Membership in the AICPA is mandatory for all licensed practicing CPAs. Answer: FALSE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 6) A CPA must meet continuing education requirements to maintain their license to practice. Answer: TRUE Terms: Membership in AICPA Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 7) The Auditing Standards Board (ASB) of the AICPA is responsible for issuing pronouncements on auditing matters in the U.S. for the audits of every type of entity. Answer: FALSE Terms: AICPA Standards and Rules Difficulty: Easy Objective: LO 2-5 AACSB: Reflective thinking 8) What are the major functions of the AICPA? Answer: Major functions of the AICPA include: • Setting standards and rules that all members and other practicing CPAs must follow. These standards consist of auditing standards for auditors of private companies, compilation and review standards, other attestation standards, and the Code of Professional Conduct. • Research and publication on many different subjects related to accounting, auditing, attestation and assurance services, management consulting services, and taxes. AICPA publications include the Journal of Accountancy, industry audit guides for several industries, periodic updates of the Codification of Statements on Auditing Standards, and the Code of Professional Conduct. • Promoting the accounting profession through organizing national advertising campaigns • Promoting new assurance services • Developing specialist certifications to help market and ensure the quality of services in specialized practice areas • Writing and grading the uniform CPA examination • Providing continuing education seminars and educational aids for its members in its CPExpress online learning library and its daily mail alerts about emerging professional issues Terms: Major functions of AICPA Difficulty: Challenging Objective: LO 2-5 AACSB: Reflective thinking

2.6 Learning Objective 2-6 1) Which of the following are audit standards used in professional practice by audit firms? A) International Standards AICPA Auditing PCAOB Auditing on Auditing Standards Standards Yes No No B) International Standards on Auditing Yes

AICPA Auditing Standards Yes

PCAOB Auditing Standards No

International Standards on Auditing Yes

AICPA Auditing Standards Yes

PCAOB Auditing Standards Yes

International Standards on Auditing No

AICPA Auditing Standards Yes

PCAOB Auditing Standards Yes

Answer: C Terms: Standards used in professional practice Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 2) Who is responsible for establishing auditing standards for privately held companies? A) Securities and Exchange Commission B) Public Company Accounting Oversight Board C) Auditing Standards Board D) National Association of Accounting Answer: C Terms: Establishing auditing standards for privately held companies Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking

3) Standards issued by the Public Company Accounting Oversight Board must be followed by CPAs who audit A) both private and public companies. B) public companies only. C) private companies, public companies, and nonprofit entities. D) private companies only. Answer: B Terms: Public Company Accounting Oversight Board Standards Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 4) The International Standards on Auditing (ISA) A) are issued by the AICPA. B) override a country's regulations governing the audit of a company. C) has many of the same standards as the Auditing Standards Board (ASB). D) must be followed by companies whose stock is traded in the U.S. Answer: C Terms: International Standards on Auditing; International Auditing and Assurance Standards Board Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 5) ________ are referred to as U.S. generally accepted auditing standards (GAAS). A) AICPA auditing standards B) SEC auditing standards C) PCAOB auditing standards D) Sarbanes-Oxley standards Answer: A Terms: Auditing standards of the United States Difficulty: Moderate Objective: LO 2-6 AACSB: Reflective thinking 6) Which of the following is a true statement regarding auditing standards? A) Prior to the passage of Sarbanes-Oxley, the FASB established auditing principles for U.S. public companies. B) PCAOB auditing standards are applicable to entities outside the U.S. C) There are no similarities between PCAOB standards and International Standards on Auditing. D) The Auditing Standards Board has revised most of its standards to converge with the international standards. Answer: D Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

7) Which of the following is true with regards to the various auditing standards? A) Statements on Auditing Standards (SASs) are issued by the PCAOB. B) The ASB uses the ISA as the base standard when developing a new Statement on Auditing Standard. C) The ASB redrafted existing AICPA auditing standards to align them with respective International Standards on Auditing (ISAs). D) Both B and C are correct. Answer: D Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Challenging Objective: LO 2-6 AACSB: Reflective thinking 8) Which of the following is not one of the main sets of auditing standards around the world today? A) AICPA Auditing Standards B) International Standards on Auditing C) PCAOB Auditing Standards D) Securities and Exchange Commission Auditing Standards Answer: D Terms: Auditing standards of the United States and International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 9) The PCAOB considers International Standards on Auditing (ISA) when developing its standards. Answer: TRUE Terms: Public Company Accounting Oversight Board Standards Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 10) International Standards on Auditing are issued by the International Auditing and Assurance Standards Board (IAASB). Answer: TRUE Terms: International Standards on Auditing; International Auditing and Assurance Standards Board Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking

11) The ASB has revised its audit standards to converge with international standards. Answer: TRUE Terms: Auditing standards of the United States and International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 12) International Standards on Auditing (ISAs) override a country's regulations governing the audit of financial or other information. Answer: FALSE Terms: International Standards on Auditing Difficulty: Easy Objective: LO 2-6 AACSB: Reflective thinking 2.7 Learning Objective 2-7 1) The "Principles Underlying an Audit in Accordance with Generally Accepted Auditing Principles" provide a framework to help auditors A) understand the ten GAAS standards. B) obtain complete assurance that the financial statements are free from any error. C) report on the financial statements. D) prevent fraud. Answer: C Terms: GAAS; New principles underlying GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 2) Which of the following is not one of the responsibilities of an auditor under the principles underlying an audit of financial statements? A) possess appropriate competence and capabilities B) comply with relevant ethical requirements C) plan work and supervise assistants D) maintain professional skepticism and exercise professional judgment Answer: C Terms: Principles underlying an audit performed in accordance with GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking

3) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, the auditor must fulfill several performance responsibilities, including A) verifying that all audit work is performed by a CPA with a minimum of three years' experience. B) obtaining sufficient, appropriate audit evidence. C) exercising professional judgment. D) providing an opinion on the financial statements. Answer: B Terms: GAAS- New principles underlying GAAS; Purpose of an audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 4) The Statements on Auditing Standards issued by the Auditing Standards Board A) are regarded as authoritative literature. B) mandate the amount of evidence that must be obtained. C) must be followed in all situations. D) are optional guidelines which an auditor may choose to follow or not follow when conducting an audit. Answer: A Terms: Generally Accepted Auditing Standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 5) An auditor need not abide by a particular auditing standard if the auditor believes that A) the issue in question is immaterial in amount. B) more expertise is needed to fulfill the requirement. C) the requirement of the standard has not been addressed by the PCAOB. D) fraud is involved. Answer: A Terms: Auditor need not abide by a particular auditing standard Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 6) When assessing the risk of material misstatements in the financial statements, A) inadequate system of internal control procedures will mitigate client business risk. B) GAAS specifies in detail how much and what types of evidence the auditor needs to obtain. C) company management is responsible for determining materiality levels. D) the auditor must understand the client's business and industry. Answer: D Terms: Generally Accepted Auditing Standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 19 Copyright © 2023 Pearson Education, Inc.

7) In order to properly plan and perform an audit, an important fact for both the auditor and the client to understand is that A) the system of internal control policies and procedures are developed by the auditors. B) the purpose of an audit is to prevent fraud. C) management is responsible for the preparation of the financial statements. D) management can restrict the auditor's access to important information relevant to the financial statements. Answer: C Terms: GAAS- New principles underlying GAAS; Purpose of an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 8) The principles underlying an audit A) contain the procedures that must be followed during an audit. B) carry the same authority as AICPA auditing standards. C) only apply to the audits of public companies. D) provide structure for the clarified Codification. Answer: D Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 9) The AICPA principles underlying an audit are organized around four principles. Which of the following is not one of those principles? A) fairness B) responsibilities C) reporting D) performance Answer: A Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

10) Which of the following statements about Generally Accepted Audit Standards are true? I. They serve as broad guidelines to auditors for conducting an audit engagement. II. They are sufficiently specific to provide a meaningful guide to practitioners. III. They represent a framework upon which the AICPA can provide interpretations. A) I and II B) I and III C) II and III D) I, II and III Answer: B Terms: Generally Accepted Auditing Standards Difficulty: Challenging Objective: LO 2-7 AACSB: Reflective thinking 11) The AICPA principles and the auditing standards should be viewed by practitioners as A) ideals to work towards, but which are not achievable. B) maximum standards that denote excellent work. C) minimum standards of performance that must be achieved on each audit engagement. D) benchmarks to be used on all audits, reviews, and compilations. Answer: C Terms: Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) Difficulty: Challenging Objective: LO 2-7 AACSB: Reflective thinking 12) Which of the following is an accurate statement regarding principles and auditing standards? A) The principles underlying an audit give specific guidance to an auditor when a problem arises in an audit. B) The principles underlying an audit state that the only objective of an audit is to provide financial statement users with an opinion. C) All auditing standards issued by the PCAOB are given two classification numbers. D) The Statement on Auditing Standard (SAS) number identifies the order in which it was issued in relation to other SASs. Answer: D Terms: Principles underlying an audit versus auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

13) ________ is an attitude that includes a questioning mind, being alert to conditions that might indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence. A) Reasonableness B) Diligence C) Professional skepticism D) Competence Answer: C Terms: Professional skepticism Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 14) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, the auditor fulfills several performance responsibilities, including A) complying with the AICPA Code of Professional Conduct. B) issuing a written report on the financial statements. C) determining and applying materiality levels. D) having the appropriate competence to perform the audit. Answer: C Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 15) Which of the following is not true regarding the purpose of an audit performed on a set of financial statements in accordance with generally accepted auditing standards? A) to provide users of the financial statements with an opinion on the financial statements B) to provide users of the financial statements with absolute assurance that the financial statements contain no errors in them C) to provide financial statement users with an opinion on whether the financial statements are presented fairly or not D) to provide financial statement users with an opinion in accordance with the applicable financial reporting framework Answer: B Terms: Purpose of a GAAS audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking

16) In situations in which the CPA or the CPA's assistants are not qualified to perform the audit work, which of the following is not an option the CPA or the CPA firm has? A) The CPA and the CPA's assistants have a professional obligation to acquire the required knowledge and skills. B) The CPA and the CPA's assistants should simply rely more upon the client's representations when performing the audit. C) The CPA should suggest someone else or another CPA firm which is qualified to perform the work. D) The CPA should decline the audit engagement. Answer: B Terms: Auditor's Responsibilities: Competence and Capabilities Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 17) Professional skepticism must be maintained only if the auditor suspects fraud. Answer: FALSE Terms: Generally Accepted Auditing Standards; Responsibilities Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 18) Statements on Auditing Standards (SASs) are issued by the Public Company Accounting Oversight Board. Answer: FALSE Terms: Statements on Auditing Standards (SAS); Public Company Accounting Oversight Board Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 19) The AU-C number identifies the order in which it was issued in relation to all other codified auditing standards. Answer: FALSE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 20) Similar to the Financial Accounting Standards Board (FASB) Codification, the AICPA has codified the Statement of Auditing Standards. Answer: TRUE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 23 Copyright © 2023 Pearson Education, Inc.

21) The PCAOB website includes a reference tool that identifies the analogous AICPA and IAASB auditing standards for each PCAOB standard. Answer: TRUE Terms: Classification of auditing standards Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 22) An auditor should accept the fact that management of an audit client may restrict access to persons within the entity from whom the auditor may need to obtain audit evidence due to client confidentiality. Answer: FALSE Terms: Purpose of an Audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 23) List the four principles underlying an audit. Answer: • Purpose of an audit • Responsibilities of the auditor • Performance-auditor actions when performing the audit • Reporting Terms: GAAS; New principles underlying GAAS Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 24) Principles related to the auditor's responsibilities in the audit stress three important personal qualities that the auditor should possess. List and discuss these three qualities. Answer: 1. Appropriate competence and capabilities. The auditor is required to have formal education in auditing and accounting, adequate practical experience for the work being performed, and continuing professional education. 2. Comply with relevant ethical requirements. The AICPA Code of Professional Conduct outlines the ethical requirements for CPAs who practice in accounting firms or work in organizations as part of management. The Code and auditing standards stress the need for independence in audit engagements. 3. Maintain professional skepticism and exercise professional judgment. Professional skepticism is an attitude that includes a questioning mind, being alert to conditions that might indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence. In making judgments about the presence of a material misstatement, auditors are responsible for applying relevant training, knowledge, and experience in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. Terms: Principles underlying an audit Difficulty: Moderate Objective: LO 2-7 AACSB: Reflective thinking 24 Copyright © 2023 Pearson Education, Inc.

25) Performance is one of the principles underlying an audit. List three performance responsibilities. Answer: Performance responsibilities include: • obtain reasonable assurance about whether financial statements are free of material misstatement • plan work and supervise assistants • determine and apply materiality level(s) • identify and assess risks of material misstatements based on understanding of the entity and its environment, including system of internal controls • obtain sufficient appropriate audit evidence Terms: Principles underlying an audit Difficulty: Easy Objective: LO 2-7 AACSB: Reflective thinking 2.8 Learning Objective 2-8 1) Quality control for a CPA firm A) includes the organizational structure of the firm and the procedures it establishes. B) is tailored to each specific audit engagement. C) is a guarantee that auditing standards are followed. D) is required only for firms auditing SEC companies. Answer: A Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 2) The method used by a CPA firm to ensure that the firm meets its professional responsibilities to clients and others is A) continuing professional education. B) compliance with generally accepted reporting standards. C) quality control. D) peer review. Answer: C Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

3) Within the context of quality control, the primary purpose of continuing professional education and training activities is to enable a CPA firm to provide its personnel with A) technical training that assures proficiency as a valuation expert. B) professional education that is required in order to perform with due professional care. C) knowledge required to fulfill assigned responsibilities. D) knowledge required to perform a peer review. Answer: C Terms: Quality control; Continuing professional education and training activities Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 4) The purpose of establishing quality control policies and procedures to accept or continue a client relationship is to A) provide reasonable assurance that personnel are adequately trained to fulfill their responsibilities. B) monitor the risk factors concerning misstatements that arise from the misappropriation of assets. C) document objective criteria for the CPA firm's peer review. D) minimize the likelihood of associating with a client whose management may lack integrity. Answer: D Terms: Purpose of quality control policies and procedures to accept or continue client relationship Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 5) Which of the following is an element of the CPA's quality control system that should be considered in establishing its quality control policies and procedures? A) considering audit risk and materiality B) using statistical sampling techniques C) assigning appropriately experienced personnel to engagements D) complying with laws and regulations Answer: C Terms: Quality control policies and procedures Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

6) Which of the following is not an essential component of quality control? A) policies and procedures to ensure that firm personnel are actively engaged in marketing strategies B) policies and procedures to ensure that the work performed by firm personnel meet applicable professional standards C) policies to ensure that personnel maintain their independence in fact and in appearance D) policies that ensure that monitoring activities are effectively applied Answer: A Terms: Component of quality control Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 7) Which one of the following is not true regarding the American Institute of Certified Public Accountants peer review requirement? A) A CPA firm must develop and adhere to quality control standards. B) Peer reviews are mandatory. C) A CPA firm will lose AICPA eligibility if a peer review is not performed. D) Firms required to be registered with and inspected by the PCAOB are exempt. Answer: D Terms: AICPA peer review Difficulty: Challenging Objective: LO 2-8 AACSB: Reflective thinking 8) How often is the AICPA Peer Review Program performed of an AICPA member CPA firm administered by a State CPA Society under the overall direction of the AICPA Peer Review Board? A) every year B) every 2 years C) every 3 years D) every 5 years Answer: C Terms: AICPA CPA Firm Member Peer Review Requirement Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

9) Which of the following is not a purpose of the Center for Audit Quality which is affiliated with the AICPA? A) to serve the capital markets B) to serve public company auditors C) to serve investors D) to serve the International Accounting Standards Board (IASB) Answer: D Terms: Audit Practice and Quality Centers Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 10) Quality controls are established for the entire CPA firm whereas auditing standards are applicable to the individual engagement. Answer: TRUE Terms: Quality controls and auditing standards Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 11) In order to be eligible for membership in the AICPA, public accounting firms must be enrolled in an AICPA-approved practice monitoring program. Members of the firm can still be eligible for AICPA membership even if their firms are not enrolled in an AICPA-approved practice monitoring program. Answer: FALSE Terms: Peer review requirements Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking 12) Discuss the relationship between quality control and generally accepted auditing standards. Answer: For a CPA firm, quality control comprises the methods used to ensure that the firm meets its professional responsibilities to clients and others. Quality control is closely related to but distinct from auditing standards. The standards recognize that a quality control system can provide only reasonable assurance, not a guarantee that auditing standards are followed. A CPA firm must make sure that auditing standards are followed on every audit. Quality controls are the procedures used by the entire CPA firm to ensure that the principles in auditing standards are followed on every audit. Quality controls are established for the entire CPA firm, whereas auditing standards are applicable to individual engagements. Terms: Relationship between quality control and generally accepted auditing standards Difficulty: Easy Objective: LO 2-8 AACSB: Reflective thinking

13) List and describe the six elements of quality control. Who establishes the standards for quality control? Answer: • Leadership responsibilities for quality within the firm – The firm should promote a culture that quality is essential in performing engagements and should establish policies and procedures that support that culture. • Relevant ethical requirements – All personnel on engagements should maintain independence in mind and in appearance, perform all professional responsibilities with integrity and maintain objectivity in performing their professional responsibilities. • Acceptance and continuation of client relationships and engagements – Policies and procedures should be established for deciding whether to accept or continue a client relationship or specific engagement. These policies and procedures should minimize the risk of associating with a client whose management lacks integrity. The firm should also only undertake engagements that can be completed with professional competence. • Human resources – Policies and procedures should be established to provide the firm with reasonable assurance that all new personnel are qualified to perform their work competently, work is assigned to personnel who have adequate technical training and proficiency, all personnel should participate in continuing professional education and professional development activities that enable them to fulfill their assigned responsibilities, and personnel selected for advancement should have the qualifications necessary for the fulfillment of their assigned responsibilities. • Engagement performance – Policies and procedures should exist to ensure that the work performed by engagement personnel meets applicable professional standards, legal and regulatory requirements, and the firm's standards of quality. • Monitoring – Policies and procedures should exist to ensure that the other quality control elements are being effectively applied. Quality control standards are established by the Auditing Standards Board for auditors of private companies and by the Public Company Accounting Oversight Board for auditors of public companies. Terms: Elements of quality controls Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

14) Listed below are policies or procedures that the Crystal Cove audit firm has in place. For each identified policy or procedure, state if it is an auditing standard or a quality control standard. Audit firm Policy or Procedure Standards Category 1. Determination on whether to accept or a. auditing standard reject a new client. b. quality control standard 2. A client evaluation form. 3. All personnel participate in continuing professional education. 4. Conducting the audit with professional skepticism. 5. Answering an independence questionnaire. 6. Determine and apply materiality levels. 7. Audit staff workpapers are reviewed by audit seniors, then managers. 8. Plan work and supervise assistants. Answer: 1. b 2. b 3. b 4. a 5. b 6. a 7. b 8. a Terms: Auditing standards and quality control standards Difficulty: Moderate Objective: LO 2-8 AACSB: Reflective thinking

15) The following are definitions of terms that are listed on the right. Match the definition with its associated term. Each term can be used once, more than once or not at all. Definition Audit Term 1. an organizational structure where professional a. AICPA services are provided by one or more shareholders b. PCAOB 2. the grantor of the right to practice public c. Securities Exchange Commission accounting d. Form 10-K 3. a report filed to indicate a significant event e. IAASB 4. sets professional standards and rules for f. Form S-1 members g. due professional care 5. oversees accounting firms who audit public h. limited liability partnership companies i. professional corporation 6. an organizational structure where the owners are j. limited liability company taxed like a partnership and have limited personal k. peer review liability l. 1933 Securities Act 7. a report that is filed when a company wishes to m. 1934 Securities Act issue new securities n. Form 8-K 8. the methods used to ensure the firm meets its o. state regulation professional responsibilities to clients and others p. Code of Professional Conduct 9. assists in providing investors with reliable q. quality control standards information r. auditing standards 10. requires annual inspections of accounting firms auditing more than 100 public companies 11. practice monitoring by a CPA firm for another CPA firm 12. fulfilling duties diligently and carefully 13. requires a registration statement Answer: 1. i, 2. o, 3. n, 4. a, 5. b, 6. j, 7. f, 8. q, 9. c, 10. b, 11. k, 12. g, 13. l Terms: AICPA; PCAOB; Securities Exchange Commission; Form S-1; Form 8-K; Due professional care; Professional Corporation; Limited Liability Company; Peer review; 1933 Securities Act; State Regulation; Quality Control Standards Difficulty: Moderate Objective: LO 2-1, LO 2-3, LO 2-4, LO 2-5, and LO 2-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 3 Audit Reports 3.1 Learning Objective 3-1 1) Which of the following is a correct statement regarding the standard unmodified opinion audit report? A) The format of the audit report for public and nonpublic entities are identical. B) The auditor's responsibility paragraph includes a statement that the auditors are responsible for selecting the appropriate accounting principles. C) The audit report includes the name of the lead partner on the audit. D) The auditor's responsibilities paragraph includes a statement that the auditor considers system of internal controls when designing the audit procedures performed. Answer: D Terms: Parts of standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 2) Auditing standards require that the audit report must be titled and that the title must A) include the word "independent." B) indicate if the auditor is a CPA. C) indicate if the auditor is a proprietorship, partnership, or corporation. D) indicate the type of audit opinion issued. Answer: A Terms: Auditing standards require audit report title Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

3) To emphasize the fact that the auditor is independent, a typical addressee of the audit report could be A) Company Controller Shareholders Board of Directors No Yes Yes B) Company Controller No

Shareholders No

Board of Directors Yes

C) Company Controller Yes

Shareholders Yes

Board of Directors No

D) Company Controller Yes

Shareholders No

Board of Directors No

Answer: A Terms: Audit report addressee Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 4) The auditor's responsibilities section of the standard unmodified opinion audit report states that the audit is designed to A) discover all errors and/or irregularities. B) discover material errors and/or irregularities. C) conform to generally accepted accounting principles. D) obtain reasonable assurance whether the statements are free of material misstatement. Answer: D Terms: Auditor's responsibilities paragraph of the standard unqualified audit report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

5) The audit report date on a standard unmodified opinion audit report indicates A) the last day of the fiscal period. B) the date on which the financial statements were filed with the Securities and Exchange Commission. C) the last date on which users may institute a lawsuit against either the client or the auditor. D) the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements. Answer: D Terms: Audit report date on standard unqualified report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 6) The standard audit report for nonpublic entities refers to GAAS and GAAP in which sections? A) GAAS GAAP Auditor's Responsibilities Auditor's Responsibilities paragraph paragraph B) GAAS Auditor's Responsibilities paragraph

GAAP Auditor's Opinion paragraph

C) GAAS Management's Responsibilities and Auditor's Opinion paragraphs

GAAP Management's Responsibilities and Auditor's Opinion paragraphs

D) GAAS GAAP Auditor's responsibilities Management's and Basis for Opinion Responsibilities and paragraphs Auditor's Opinion paragraphs Answer: D Terms: Standard unqualified audit report for nonpublic entities; GAAS and GAAP Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking

7) Which of the following is not explicitly stated in the standard unmodified opinion audit report? A) The financial statements are the responsibility of management. B) The audit was conducted in accordance with generally accepted accounting principles. C) The auditors believe that the audit evidence provides a reasonable basis for their opinion. D) An audit includes assessing the accounting estimates used. Answer: B Terms: Standard unmodified opinion audit report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 8) The standard unmodified opinion audit report for a nonpublic entity must A) have a report title that includes the word "CPA." B) be addressed to the company's stockholders and creditors. C) be dated. D) include an explanatory paragraph. Answer: C Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 9) The management's responsibilities section of the standard unmodified opinion audit report for a nonpublic company states that the financial statements are A) the responsibility of the auditor. B) the responsibility of management. C) the joint responsibility of management and the auditor. D) none of the above. Answer: B Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

10) The first paragraph of the standard unmodified opinion audit report for a nonpublic company effective for audits of financial statements for fiscal years ending on or after December 15, 2023 performs which of the following functions? I. Presents the auditors' opinion, first. II. Provides additional information related to the responsibilities of management for preparing the financial statements. III. Provides additional information regarding the responsibilities of the auditor in conducting the audit. A) I only B) I and II C) II and III D) I and III Answer: D Terms: First paragraph of unmodified opinion audit report for a U.S. nonpublic company Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 11) Which of the following statements are true for the standard unmodified opinion audit report of a nonpublic entity for fiscal years ending on or after June 15, 2019? I. The management's responsibilities paragraph states that management is responsible for the preparation and the fair presentation of the financial statements. II. The opinion paragraph is stated as a statement of absolute fact and a guarantee by the auditor. A) I only B) II only C) I and II D) Neither I nor II Answer: A Terms: Standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 12) The auditor's responsibilities section of the standard unmodified opinion audit report states that the auditor is A) responsible for the financial statements and the opinion on them. B) responsible for the financial statements. C) exercising professional judgment throughout the audit. D) expressing an opinion on the effectiveness of system of internal controls. Answer: C Terms: Standard unqualified audit report for a nonpublic entity Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

13) If the balance sheet of a private company is dated December 31, 2022, the audit report is dated February 8, 2023, and both are released on February 15, 2023, this indicates that the auditor has searched for subsequent events that occurred up to A) December 31, 2022. B) January 1, 2023. C) February 8, 2023. D) February 15, 2023. Answer: C Terms: Audit report subsequent event dating Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 14) The appropriate audit report date for a standard unmodified opinion audit report for a nonpublic entity should be A) the date the financial statements are given to the Board of Directors. B) the date of the financial statements. C) the date the auditor completed the auditing procedures in the field. D) 60 days after the date of the financial statements as required by the SEC. Answer: C Terms: Standard unqualified audit report for a nonpublic entity Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 15) Most auditors believe that financial statements are "presented fairly" when the statements are in accordance with GAAP, and that it is also necessary to A) determine that they are not in violation of FASB statements. B) examine the substance of transactions and balances for possible misinformation. C) review the statements using the accounting principles promulgated by the SEC. D) assure investors that net income reported this year will be exceeded in the future. Answer: B Terms: Financial statements are presented fairly in accordance with GAAP Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking 16) An audit provides a guarantee that a material misstatement will not exist in the financial statements. Answer: FALSE Terms: Audit and reasonable assurance Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking

17) AICPA auditing standards provide uniform wording for the auditor's report to enable users of the financial statements to understand the audit report. Answer: TRUE Terms: Uniform wording for auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 18) Users of the financial statements rely on the auditor's report because of the absolute assurance the report provides. Answer: FALSE Terms: Users of financial statements rely on auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 19) The auditor's opinion paragraph of the auditor's report states that the auditor is responsible for the preparation, presentation and opinion on the financial statements. Answer: FALSE Terms: Auditor's opinion paragraph of auditor's report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 20) The audit report date is the date the auditor completed audit procedures in the field. Answer: TRUE Terms: Audit report date Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 21) The basis of opinion section of the audit report issued for financial statements of a nonpublic company should refer to auditing standards generally accepted in the United States of America. Answer: TRUE Terms: Audit reports issued for financial statements of private company; Basis for opinion paragraph; Generally accepted auditing standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

22) In the auditor's responsibilities paragraph of the audit report issued for financial statements of a nonpublic company, the auditor expresses an opinion about the system of internal controls of the company. Answer: FALSE Terms: Audit reports issued for financial statements of private company; Auditor's responsibilities paragraph; Generally accepted auditing standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 23) The audit report is normally addressed to the company's president or chief executive officer. Answer: FALSE Terms: Audit report normally addressed Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 24) The phrase "accounting principles generally accepted in the United States of America" can be found in the auditor's opinion paragraph of a standard unmodified opinion report. Answer: TRUE Terms: Generally accepted accounting principles; Opinion paragraph of the standard unqualified report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 25) The date of the auditor's report is indicative of the last day of the auditor's responsibility for the review of significant events occurring after the balance sheet date. Answer: TRUE Terms: Date of auditor's report indicates auditor's responsibility Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 26) The phrase "auditing standards generally accepted in the United States of America" can be found in the auditor's opinion paragraph of a standard unmodified opinion report for a nonpublic company. Answer: FALSE Terms: Auditing standards generally accepted in the United States; Opinion and basis of opinion paragraphs in standard unqualified report for public company Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking

27) The phrase "Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material error" is included in the auditor's opinion section of an audit report. Answer: FALSE Terms: Standard unqualified audit report for a nonpublic entity; eight parts of the report Difficulty: Moderate Objective: LO 3-1 AACSB: Reflective thinking 28) The European Union has not yet implemented requirements for mandatory audit rendering and auditor rotation despite many years of debate on this subject. Answer: FALSE Terms: Mandatory auditor rotation and audit rendering Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 29) The Auditing Standards Board (ASB) sets auditing standards in the U.S. for nonpublic entities. Answer: TRUE Terms: Setting of Auditing Standards Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 30) The PCAOB and the AICPA recently adopted new auditor reporting standards which are designed to make the standard audit report less informative for users. Answer: FALSE Terms: Standard Audit Report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking 31) PCAOB auditing standards require communication of "critical audit matters in the standard unmodified audit report." The AICPA reporting standards also require communication of "key audit matters." Answer: FALSE Terms: Standard Audit Report Difficulty: Easy Objective: LO 3-1 AACSB: Reflective thinking

32) Describe the standard unmodified opinion audit report to be issued for an audit of a private company for fiscal years ending on or after June 15, 2019. Begin by specifying the eight parts of the report, and then discuss the contents of each part. Answer: The parts of the standard unmodified opinion audit report are as follows: • Report title. The title must include the word "independent." Examples of appropriate titles are "independent accountant's opinion," or "report of independent auditor." • Audit Report address. The report is usually addressed to the company's stockholders or the company's board of directors or the company. It should not be addressed to company management. • Auditor's Opinion section. The opinion section, which states the auditor's conclusions based upon the results of the audit, is presented first due to its importance and must include the heading "Opinion." This paragraph states that an audit was performed to distinguish the report from a compilation or review report. It also lists the financial statements that were audited, including the notes to the financial statements as well as the balance sheet dates and the accounting periods for the income statement and statement of cash flows. The wording of the financial statements in the report should be identical to the titles used by management on the financial statements. • Basis for Opinion section. The basis for opinion paragraph states the audit was conducted in accordance with auditing standards generally accepted in the United States of America and references additional responsibilities as detailed in the auditor's responsibilities section of the report. The auditor also provides an affirmative statement that they are independent of the company and that they have fulfilled their professional ethical obligations. The final sentence indicates the auditor believes that sufficient appropriate evidence has been obtained to support the auditor's opinion. • Management's Responsibility section. The report must include the heading: Responsibilities of Management and Those Charged with Governance for the Financial Statements, and a paragraph that describes management's responsibility for the financial statements. This responsibility includes selecting the appropriate accounting principles and maintaining system of internal control over financial reporting sufficient for preparation of financial statements that are free of material misstatements due to fraud or error. This section references management's responsibility under accounting standards to assess the ability of the company to continue as a going concern and also references the responsibility of those charged with governance (e.g., the board of directors) to oversee the financial reporting process. • Auditor's Responsibilities section. This section must include the heading "Auditor's Responsibilities for the Audit of the Financial Statements" followed by three paragraphs that describe the auditor's responsibility. The first paragraph notes that the audit is designed to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to fraud or error. The inclusion of the word material conveys that auditors are only responsible to search for significant misstatements, not minor misstatements that do not affect users' decisions. The use of the term reasonable assurance is intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the financial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee.

The second paragraph describes the scope of the audit and the evidence accumulated about the amounts and disclosures in the financial statements. This paragraph starts with the statement that the auditor exercised professional judgment and maintain professional skepticism throughout the audit in accordance with GAAS. This paragraph indicates that the procedures depend on the auditor's professional judgment and includes an assessment of the risk of material misstatements in the financial statements. It also indicates that the auditor considers internal control relevant to the preparation and fair presentation of the financial statements in designing the audit procedures performed, but this assessment of internal control is not for the purpose of and is not sufficient to express an opinion on the effectiveness of the entity's internal control. The last two bullet points of this paragraph indicate that the audit includes evaluating the appropriateness of accounting policies selected, the reasonableness of accounting estimates, the overall financial statement presentation, and the ability of the company to continue as a going concern. Finally, the third paragraph indicates the auditor communicates to those charged with governance the planned scope and timing of the audit as well as any significant findings, including significant deficiencies and material weaknesses in internal control. • Signature and Address of Audit Firm. The signature identifies the CPA firm or practitioner who performed the audit. Typically, the firm's name is used because the entire CPA firm has the legal and professional responsibility to ensure that the quality of the audit meets professional standards. The city and state of the audit firm should also be indicated. • Audit Report Date. The appropriate date for the report is the one on which the auditor completed the auditing procedures needed to obtain sufficient appropriate audit evidence. This date is important to users because it indicates the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements. Terms: Standard unqualified audit report for a nonpublic entity effective for fiscal years ending on or after June 15, 2019; eight distinct parts of the report. Terms: Standard unqualified audit report for a nonpublic entity effective for fiscal years ending on or after June 15, 2019; eight distinct parts of the report Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking

33) EPM, Inc., is a publicly listed manufacturing company with a calendar year-end. Their financial statements include a balance sheet, a statement of income, statement of cash flows, and statement of stockholders' equity. For the most recent audit, Harrington and Perry, LLP, from Denver, Colorado, audited the 2023 and 2022 financial statements. The auditors completed all significant fieldwork on March 5, 2023 and issued the audit report on March 16, 2023. Required: Consider all the facts given and write the PCAOBs new standard unmodified opinion audit report. Answer: Audit Report To the shareholders and the board of directors of EPM, Inc. Address Opinion on the Opinion on the Financial Statements Financial Statements We have audited the accompanying balance sheets of EPM, Inc. (the "Company") as of December 31, 2023 and 2022, the related statements of income, cash flows, and stockholders' equity, for each of the three years in the period ended December 31, 2023, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the EPM, Inc. at December 31, 2023 and 2022, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2023, in conformity with generally accepted accounting principles. Basis for Opinion

Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. We conducted our audits in accordance with auditing standards generally accepted in the United States of America (GAAS). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial 12 Copyright © 2023 Pearson Education, Inc.

statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters

Critical Audit Matters [if applicable] The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. [Include critical audit matters]

Signature and Address of Audit Firm

Harrington and Perry, LLP Denver, Colorado We have served as the Company's auditor since [year]. March 5, 2023

Terms: Example of PCAOB's New Standard Unqualified Audit Report - Report of Independent Registered Public Accounting Firm Difficulty: Challenging Objective: LO 3-1 AACSB: Reflective thinking

3.2 Learning Objective 3-2 1) What category of audit report will be issued if the auditor concludes that the financial statements are not fairly presented? A) disclaimer B) qualified C) standard unmodified opinion D) adverse Answer: D Terms: Audit reports in various situations Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking 2) The standard unmodified audit report A) is sometimes called a clean opinion. B) can be issued only with an explanatory paragraph. C) can be issued if only a balance sheet and income statement are included in the financial statements. D) is sometimes called a disclaimer report. Answer: A Terms: Conditions for standard unmodified audit report Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking 3) An audit of historical financial statements most commonly includes the A) balance sheet, statement of retained earnings, and the statement of cash flows. B) income statement, the statement of cash flows, and the statement of net working capital. C) statement of cash flows, balance sheet, and the statement of retained earnings. D) balance sheet, income statement, statement of cash flows, and the statement of changes in stockholders' equity. Answer: D Terms: Audit of historical financial statements Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking

4) When analyzing the various types of audit reports, A) the unmodified opinion with an emphasis-of-matter paragraph is the most common type of report. B) companies will generally make the appropriate changes to their accounting records to avoid a qualification by the auditor. C) management is more concerned about a qualified report than a disclaimer report. D) an adverse report is issued when the auditor is unable to form an opinion on the financial statements. Answer: B Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking 5) Financial statement users are normally much more concerned about a disclaimer than an unmodified opinion audit report that contains an additional emphasis-of-matter paragraph. Answer: TRUE Terms: Audit reports in various situations Difficulty: Easy Objective: LO 3-2 AACSB: Reflective thinking 6) An auditor will issue a disclaimer when he or she concludes that the financial statements are not fairly presented. Answer: FALSE Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking

7) There are four conditions that must be met before an auditor can issue a standard unmodified opinion audit report for the audit of a private company. Please discuss each of these four conditions. Answer: The four conditions that justify issuing a standard unmodified report are: • All statements—balance sheet, income statement, statement of changes in stockholder's equity, and statement of cash flows—are included in the financial statements. • Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagement in a manner that enables him or her to conclude that the audit was performed in accordance with auditing standards. • The financial statements are presented fairly in all material respects in accordance with U.S. generally accepted accounting principles or other appropriate accounting framework. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. • There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of the report. Terms: Conditions for standard unqualified report for audit of private company Difficulty: Moderate Objective: LO 3-2 AACSB: Reflective thinking

3.3 Learning Objective 3-3 1) Whenever an auditor issues an audit report for a public company, the auditor can choose to issue a report in which of the following forms? I. A combined report on financial statements and system of internal control over financial reporting II. Separate reports on financial statements and system of internal control over financial reporting A) I only B) II only C) either I or II D) neither I nor II Answer: C Terms: Combined report on financial statements and system of internal control over financial reporting Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 2) The unqualified opinion audit report for public entities includes which of the following sections and/or paragraphs? A) report title, address, and opinion B) basis for opinion and discussion of critical audit areas C) auditor information and date D) All of the above are included. Answer: D Terms: Standard unqualified audit report for public entities Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 3) Auditing standards for public companies are established by the A) SEC. B) FASB. C) PCAOB. D) IRS. Answer: C Terms: Audit standards for public companies; PCAOB Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking

4) Under PCAOB standards, A) the standard unmodified opinion audit report is referred to as an unqualified opinion audit report. B) the scope paragraph states that the financial statements are the responsibility of management. C) system of internal controls of a public company must be audited every five years. D) the scope paragraph is the same as the scope paragraph for private companies. Answer: A Terms: Public Company Accounting Oversight Board Standards Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 5) The separate report on system of internal control over financial reporting A) cannot contain a cross-reference to the auditor's report on the financial statements. B) includes a paragraph that addresses the inherent limitations of system of internal controls. C) is addressed to the PCAOB. D) includes a scope paragraph which refers to the framework used to evaluate system of internal controls. Answer: B Terms: Separate report on system of internal control Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 6) Section 404(b) of the Sarbanes-Oxley Act requires that the auditor of a public company attest to management's report on the efficiency of system of internal controls over financial reporting. Answer: FALSE Terms: Section 404(b) of Sarbanes-Oxley Act; Internal controls over financial reporting Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 7) Auditors of public company financial statements must issue separate reports on system of internal control over financial reporting. Answer: FALSE Terms: Separate report on system of internal control Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 8) PCAOB standards use the term "unqualified opinion" to refer to the standard unmodified opinion audit report. Answer: TRUE Terms: Public Company Accounting Oversight Board Standards Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

9) If the auditor also issues a separate report on system of internal control over financial reporting for a public company, the additional paragraph following the opinion paragraph is included to reference the audit report on system of internal control. Answer: TRUE Terms: Separate report on system of internal control Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 10) The basis for opinion paragraph of the audit report for a public company is worded exactly the same as the basis for opinion section for a U.S. nonpublic company. Answer: FALSE Terms: Basis of opinion paragraph for public companies Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 11) Similar to AICPA standards, the new PCAOB standard requires the auditor to disclose critical audit matters in the auditor's report. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 12) The critical audit matters section of the auditor's report notes that this communication of critical audit matters alters the auditor's opinion on the financial statements. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 13) PCAOB audit report requirements require the auditor to include the auditor's signature, tenure, city and state where the audit firm is located, as well as the audit report date. Answer: TRUE Terms: Disclosure of year in which auditor began serving the entity Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking

14) The PCAOB expects that in most audits, the auditor will determine that at least one matter involved especially challenging, subjective, or complex auditor judgment. Answer: TRUE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 15) If the auditor concludes there are no critical audit matters, the auditor is not required to disclose this fact in the audit report. Answer: FALSE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 16) The critical audit matters section of the audit report is required for audits of fiscal years ending on or after June 30, 2019 for large companies, and fiscal years ending on or after December 31, 2020 for all other audits to which these requirements apply. Answer: TRUE Terms: Critical audit matters requirement Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking 17) PCAOB auditing standards require the disclosure of the audit engagement partner's name and other accounting firms participating in the audit engagement in the audit report. Answer: FALSE Terms: Disclosure of engagement partner and other audit participants Difficulty: Easy Objective: LO 3-3 AACSB: Reflective thinking

18) With regards to critical audit matters as defined by the PCAOB, the auditor would likely consider what type(s) of issues that involved "especially challenging, subjective, or complex auditor judgment" matters? Name at least three specific matters. Answer: • the auditor's assessment of the risks of material misstatement, including significant risks • the degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty • the nature and timing of significant unusual transactions and the extent of audit effort and judgment related to those transactions • the degree of auditor subjectivity in applying audit procedures to address the matter or in evaluation the results of those procedures • the nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter and the nature of audit evidence obtained regarding the matter. Terms: Critical audit matters Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking 19) The PCAOB performs a study of the contents of initial audit reports filed after the critical audit matters were first required to be disclosed in the audit reports for larger public companies. Name some of the more frequent topical areas which were reported as critical audit matters in this initial study. Answer: goodwill; intangible assets; revenue recognition; and income tax related matters. Terms: Critical audit matters Difficulty: Moderate Objective: LO 3-3 AACSB: Reflective thinking

3.4 Learning Objective 3-4 1) Examples of unmodified opinions which contain modified wording (without adding an emphasis-of-matter paragraph) include A) reports involving other auditors. B) the lack of consistent application of generally accepted accounting principles. C) substantial doubt about the audited company (or the entity) continuing as a going concern. D) lack of consistent application of GAAP. Answer: A Terms: Modified unqualified opinion without adding an emphasis of matter paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 2) A CPA may wish to emphasize specific matters regarding the financial statements even though an unqualified opinion will be issued. Normally, such explanatory information is A) included in the scope paragraph. B) included in the opinion paragraph. C) included in a separate paragraph in the report. D) included in the introductory paragraph. Answer: C Terms: Unmodified opinion with emphasis on specific matters regarding the financial statements Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 3) All of the following are causes for the addition of an emphasis of a matter paragraph under both AICPA and PCAOB standards except for A) emphasis of a matter. B) reports involving other auditors. C) lack of consistent application of generally accepted accounting principles. D) auditor agrees with a departure from promulgated accounting principles. Answer: B Terms: Unqualified opinion with addition of emphasis of matter paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking

4) The term "explanatory paragraph" was replaced in the AICPA auditing standards with A) going concern paragraph. B) emphasis-of-matter paragraph. C) departure from principles paragraph. D) consistency paragraph. Answer: B Terms: Unqualified opinion with modified wording Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 5) Which of the following are changes that affect the comparability of financial statements but not the consistency and therefore, do not have to be included in the auditor's report? A) error corrections not involving principles B) changes in accounting estimates C) variations in the format and presentation of financial information D) all of the above Answer: D Terms: Changes that affect the comparability of financial statements Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 6) Which of the following is least likely to cause uncertainty about the ability of an entity to continue as a going concern? A) The entity is suing a competitor for a minor patent infringement. B) The entity has lost a major customer. C) The entity has significant recurring operating losses. D) The entity has working capital deficiencies. Answer: A Terms: Going concern Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

7) When there is uncertainty about a company's ability to continue as a going concern, the auditor's concern is the possibility that the client may not be able to continue its operations or meet its obligations for a "reasonable period of time." For this purpose, a reasonable period of time is considered not to exceed A) six months from the date of the financial statements. B) one year from the date of the financial statements. C) six months from the date of the audit report. D) one year from the date of the audit report. Answer: B Terms: Going concern; time period Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 8) When the auditor concludes that there is substantial doubt about the entity's ability to continue as a going concern, the appropriate audit report could be I. an unmodified opinion audit report with an explanatory paragraph. II. a disclaimer of opinion. A) I only B) II only C) I or II D) Neither I nor II Answer: C Terms: Auditor concludes substantial doubt about entity's ability to continue as going concern Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 9) When a company's financial statements contain a departure from GAAP with which the auditor concurs, the departure should be explained in A) the scope paragraph. B) an introductory paragraph. C) the opinion paragraph. D) an explanatory paragraph. Answer: D Terms: Justified Departure Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

10) William Gregory, CPA, is the principal auditor for an international corporation. Another CPA has examined and reported on the financial statements of a significant subsidiary of the corporation. Gregory is satisfied with the independence and professional reputation of the other auditor, as well as the quality of the other auditor's examination. With respect to his report on the consolidated financial statements, taken as a whole, Gregory A) must not refer to the examination of the other auditor. B) must refer to the examination of the other auditor. C) may refer to the examination of the other auditor. D) must refer to the examination of the other auditors along with the percentage of consolidated assets and revenue that they audited. Answer: C Terms: Reports involving other auditors Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 11) A company has changed its method of inventory valuation from an unacceptable one to one in conformity with generally accepted accounting principles. The auditor's report on the financial statements of the year of the change should include A) no reference to consistency. B) a reference to a prior period adjustment in the opinion paragraph. C) an explanatory paragraph that justifies the change and explains the impact of the change on reported net income. D) an explanatory paragraph explaining the change. Answer: D Terms: Consistency modifications Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 12) Which of the following modifications of the auditor's report does not include an explanatory paragraph? A) A qualified report is due to a GAAP departure. B) The report includes an emphasis of a matter. C) There is a very material scope limitation. D) A principal auditor accepts the work of another auditor. Answer: D Terms: Shared opinions Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

13) No reference is made in the auditor's report to other auditors who perform a portion of the audit when I. the other auditor audited an immaterial portion of the audit. II. the other auditor is well known or closely supervised by the principal auditor. III. the principal auditor has thoroughly reviewed the work of the other auditor. A) I and II B) I and III C) II and III D) I, II and III Answer: D Terms: Shared opinions Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 14) When an auditor is trying to determine how changes can affect consistency and/or comparability, he or she should keep in mind that A) changes that affect comparability but not consistency require an explanatory paragraph. B) items that materially affect the comparability of financial statements requires a disclaimer of opinion. C) changes that affect consistency require an explanatory paragraph if they are material. D) changes that involve either comparability or consistency only need to be mentioned in the footnotes. Answer: C Terms: Standard audit report; explanatory paragraph; consistency and comparability Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 15) All of the following would require an emphasis of matter paragraph except for A) the existence of material related party transactions. B) the lack of auditor independence. C) important events occurring subsequent to the balance sheet date. D) material uncertainties disclosed in the footnotes. Answer: B Terms: Unmodified opinion with emphasis on specific matters regarding the financial statements Difficulty: Easy Objective: LO 3-4 AACSB: Analytic thinking

16) Under AICPA auditing standards, the primary auditor issuing the opinion on the financial statements is called the A) component auditor. B) principal auditor. C) group engagement partner. D) majority auditor. Answer: C Terms: Reports involving other auditors Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 17) Which of the following is false concerning the principal CPA firm's alternatives when issuing a report when another CPA firm performs part of the audit? A) Issue a joint report signed by both CPA firms. B) Make no reference to the other CPA firm in the audit report, and issue the standard unqualified opinion. C) Make reference to the other auditor in the report by using modified wording (a shared opinion or report). D) A qualified opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor. Answer: A Terms: Shared opinions Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking 18) Which of the following requires recognition in the auditor's opinion as to consistency? A) the correction of an error in the prior year's financial statements resulting from a mathematical mistake in capitalizing interest B) a change in the estimate of provisions for warranty costs C) the change from the cost method to the equity method of accounting for investments in common stock D) a change in depreciation method which has no effect on current year's financial statements but is certain to affect future years Answer: C Terms: Consistency Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking

19) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Correction of an error by changing from Change from LIFO to FIFO an accounting principle that is not generally acceptable to one that is generally acceptable Yes Yes B) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable No C) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Yes D) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable No

Change from LIFO to FIFO

Yes

Answer: A Terms: Changes that require explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

20) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Change in the estimated life Variation in the format of the of an asset financial statements Yes Yes B) Change in the estimated life Variation in the format of the of an asset financial statements No No C) Change in the estimated life Variation in the format of the of an asset financial statements Yes No D) Change in the estimated life Variation in the format of the of an asset financial statements No Yes Answer: B Terms: Changes that require explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

21) Indicate which change(s) would require an explanatory paragraph in the audit report. A) The CPA concludes there is Change from FIFO to LIFO substantial doubt about the entity's ability to continue as a going concern. Yes Yes B) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. No

Change from FIFO to LIFO

C) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. Yes

Change from FIFO to LIFO

D) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern. No

Change from FIFO to LIFO

Yes

Answer: A Terms: Changes that would require an explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

22) Indicate which change(s) would require an explanatory paragraph in the audit report. A) Changes in reporting entities, such as the inclusion of an Make reference to the work additional company in the of another auditor to indicate combined financial shared responsibility in an statements unqualified opinion. Yes Yes B) Changes in reporting entities, such as the inclusion of an Make reference to the work additional company in the of another auditor to indicate combined financial shared responsibility in an statements unqualified opinion. No No C) Changes in reporting entities, such as the inclusion of an Make reference to the work additional company in the of another auditor to indicate combined financial shared responsibility in an statements unqualified opinion. Yes No D) Changes in reporting entities, such as the inclusion of an Make reference to the work additional company in the of another auditor to indicate combined financial shared responsibility in an statements unqualified opinion. No Yes Answer: C Terms: Changes that would require an explanatory paragraph in audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

23) When there is a lack of consistent application in accounting principles, A) the nature and impact of the change should be adequately disclosed. B) the auditor should discuss the nature of the change and point the reader to the footnote that discusses the change. C) the materiality of the change is evaluated based on the current year effect of the change. D) all of the above. Answer: D Terms: Lack of consistent application of GAAP; auditing standards Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 24) Under PCOAB auditing standards, the primary auditor issuing the opinion on the financial statements is called the A) component auditor. B) principal auditor. C) group engagement partner. D) majority auditor. Answer: B Terms: Reports involving other auditors Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 25) If the group engagement partner is not willing to assume any responsibility for the work of the other auditor, A) a qualified or disclaimer of opinion is required, depending upon materiality. B) an adverse opinion is required. C) a qualified or adverse opinion is required, depending upon materiality. D) a going concern opinion is required. Answer: A Terms: Reports involving other auditors Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 26) An unmodified opinion audit report with an emphasis-of-matter paragraph is issued when the auditor believes the financials are fairly stated but also believes additional information should be provided. Answer: TRUE Terms: Modified unqualified audit report Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking

27) Changes in accounting estimates requires the auditor to issue a modified audit report with a consistency paragraph inserted after the opinion paragraph. Answer: FALSE Terms: Changes of accounting estimates; Modified unqualified audit report Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 28) The only unmodified opinion audit report that does not include an explanatory paragraph is when other auditors are involved. In this case, only the introductory paragraph is modified. Answer: FALSE Terms: Modified unqualified opinion Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 29) Items that materially affect the comparability of the financial statements generally require disclosure in the footnotes. Answer: TRUE Terms: Items that materially affect comparability of financial statements Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 30) Changes in an estimate, such as a change in the estimated useful life of an asset for depreciation purposes, affect consistency but not comparability, and therefore require an explanatory paragraph in the audit report. Answer: FALSE Terms: Comparability and consistency Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 31) Changes in reporting entities, such as the inclusion of an additional company in combined financial statements, affect comparability but not consistency, and therefore do not require an explanatory paragraph in the audit report. Answer: FALSE Terms: Comparability and consistency Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking

32) When an auditor relies upon a different CPA firm to perform part of the audit and chooses to issue a shared opinion, only the auditor's responsibility paragraph should be modified. Answer: FALSE Terms: Auditor reliance on different CPA firm to perform part of audit; Shared opinion Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking 33) When other auditors are involved in the audit and they qualify their portion of the audit, the principal auditor must decide if the amount in question is material to the financial statements as a whole. Answer: TRUE Terms: Shared responsibility Difficulty: Challenging Objective: LO 3-4 AACSB: Reflective thinking 34) The unmodified opinion audit report with emphasis-of-matter paragraph does not meet the criteria of a complete audit with satisfactory results. Answer: FALSE Terms: Unmodified opinion audit report with emphasis-of-matter-explanatory paragraph Difficulty: Easy Objective: LO 3-4 AACSB: Reflective thinking 35) When there is a lack of consistent application of GAAP due to a new accounting pronouncement, no explanatory paragraph is required. Answer: FALSE Terms: Lack of consistent application of GAAP; auditing standards Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

36) Discuss each of the five circumstances when an auditor would issue an unmodified opinion audit report with an emphasis-of-matter paragraph or nonstandard report wording. Answer: An unmodified opinion audit report with an emphasis-of-matter paragraph or nonstandard report wordings appropriate in the following circumstances: • Lack of consistent application of GAAP. When the client has not followed generally accepted accounting principles consistently in the current period in relation to the preceding period, an unmodified opinion audit report with an explanatory paragraph following the opinion paragraph is appropriate. • Substantial doubt about continuing as a going concern. When an auditor concludes there is substantial doubt about the client's ability to continue as a going concern, an unmodified opinion audit report with an explanatory paragraph following the opinion paragraph is appropriate. The auditor also has the option of issuing a disclaimer of opinion. • A departure from GAAP with which the auditor concurs. If adherence to GAAP would result in misleading financial statements, an unmodified opinion audit report with an explanatory paragraph is appropriate. • Emphasis of a matter. If the auditor wants to emphasize specific matters in the audit report, an explanatory paragraph discussing those matters may be added to an unmodified report. • Reports involving other auditors. When an auditor relies upon a different CPA firm to perform part of the audit, the auditor can indicate that responsibility for the audit is shared with another CPA firm by modifying the wording of an unmodified report. Terms: Circumstances where an auditor will issue modified unqualified report with explanatory paragraph or modified wording Difficulty: Moderate Objective: LO 3-4 AACSB: Reflective thinking

3.5 Learning Objective 3-5 1) As a result of management's refusal to permit the auditor to physically examine inventory, the auditor must depart from the unmodified opinion audit report because A) the financial statements have not been prepared in accordance with GAAP. B) the scope of the audit has been restricted by circumstances beyond either the client's or auditor's control. C) the financial statements have not been audited in accordance with GAAS. D) the scope of the audit has been restricted. Answer: D Terms: Auditor must depart from unmodified opinion audit report; Management refusal to permit the auditor to physically examine inventory Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking 2) An adverse opinion is issued when the auditor believes A) some parts of the financial statements are materially misstated or misleading. B) the financial statements would be found to be materially misstated if an investigation were performed. C) the auditor is not independent. D) the overall financial statements are so materially misstated that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP. Answer: D Terms: Adverse opinion Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking

3) An auditor can express a qualified opinion due to a A) Departure from Lack of Sufficient GAAP Lack of Consistency Evidence Yes No No B) Departure from GAAP No

Lack of Consistency Yes

Lack of Sufficient Evidence No

Departure from GAAP Yes

Lack of Consistency No

Lack of Sufficient Evidence Yes

Lack of Consistency Yes

Lack of Sufficient Evidence Yes

D) Departure from GAAP Yes

Answer: C Terms: Qualified opinion Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking

4) An auditor determines the financial statements include at least a material departure from GAAP. Which type of opinion may be issued? A) Disclaimer Qualified Adverse Yes No No B) Disclaimer No

Qualified Yes

Adverse No

Disclaimer Yes

Qualified No

Adverse Yes

Disclaimer No

Qualified Yes

Adverse Yes

Answer: D Terms: Opinion, GAAP departure Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 5) A qualified opinion can be issued for which of the following? I. When a limitation on the scope of the audit has occurred II. When the auditor lacks independence III. When generally accepted accounting principles have not been used A) I and II B) I and III C) II and III D) I, II and III Answer: B Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

6) In which situation would the auditor be choosing between "except for" qualified opinion and an adverse opinion? A) Lack of auditor independence B) A client-imposed scope limitation C) A circumstance-imposed scope limitation D) Lack of full disclosure within the footnotes Answer: D Terms: Qualified opinion and adverse opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 7) When the auditor determines that the financial statements are fairly stated, but there is a nonindependent relationship between the auditor and the client, the auditor should issue A) an adverse opinion. B) a disclaimer of opinion. C) either a qualified opinion or an adverse opinion. D) either a qualified opinion or an unqualified opinion with modified wording. Answer: B Terms: Audit report when auditor not independent Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 8) If the auditor lacks independence, a disclaimer of opinion must be issued A) if the client requests it. B) only if it is highly material. C) only if it is material but not pervasive. D) in all cases. Answer: D Terms: Disclaimer when auditor lacks independence Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 9) If the phrase "except for" is present in the opinion paragraph of the audit report, the auditor has issued a(n) A) adverse opinion. B) disclaimer of opinion. C) unqualified opinion. D) qualified opinion. Answer: D Terms: Departure from unqualified audit report Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 39 Copyright © 2023 Pearson Education, Inc.

10) When analyzing the various types of opinions that the auditor can issue, A) an adverse opinion must contain the phrase "except for" in the opinion paragraph. B) an adverse opinion can only be issued when there is a lack of knowledge by the auditor. C) a disclaimer of opinion can be issued for material or immaterial misstatements. D) a qualified opinion report can be used only when the auditor concludes that the overall financial statements are fairly stated. Answer: D Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 11) Items that materially affect the comparability of financial statements generally require disclosure in the footnotes. If the client refuses to properly disclose the item, the auditor will most likely issue A) a disclaimer. B) an unqualified opinion. C) a qualified opinion. D) an adverse opinion. Answer: C Terms: Disclosure and comparability Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 12) Which of the following scenarios does not result in a qualified opinion? A) A scope limitation prevents the auditor from completing an important audit procedure. B) Circumstances exist that prevent the auditor from conducting a complete audit. C) The auditor lacks independence with respect to the audited entity. D) An accounting principle at variance with GAAP is used. Answer: C Terms: Qualified opinion Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

13) Whenever the client imposes restrictions on the scope of the audit, the auditor should be concerned that management may be trying to prevent discovery of misstatements. In such cases, the auditor will likely issue a A) disclaimer of opinion in all cases. B) qualification of both scope and opinion in all cases. C) disclaimer of opinion whenever materiality is in question. D) qualification of both scope and opinion whenever materiality is in question. Answer: C Terms: Client imposed restrictions on scope of audit Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 14) In which of the following circumstances would an auditor most likely express an adverse opinion? A) The CEO refuses to let the auditor have access to the board of director meeting minutes. B) The financial statements are not in conformity with the FASB statement on loss contingencies. C) Information comes to the auditor's attention that raises substantial doubt about the ability for the client to continue as a going concern. D) Tests of controls show that the system of internal control structure is so poor that the auditor has to assess control risk at the maximum. Answer: B Terms: Adverse opinion circumstances Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 15) Which of the following statements is true? I. The auditor is required to issue a disclaimer of opinion in the event of a material uncertainty. II. The auditor is required to issue a disclaimer of opinion in the event of a going concern problem. A) I only B) II only C) I and II D) Neither I nor II Answer: D Terms: Disclaimer of opinion Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking

16) The most common case in which conditions beyond the client's and auditor's control cause a scope restriction in an engagement is when the A) auditor is not appointed until after the client's year-end. B) client won't allow the auditor to confirm receivables for fear of offending its customers. C) auditor doesn't have enough staff to satisfactorily audit all of the client's foreign subsidiaries. D) client is going through Chapter 11 bankruptcy. Answer: A Terms: Scope restriction beyond client and auditor control Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 17) When the client fails to make adequate disclosure in the body of the statements or in the related footnotes, it is the responsibility of the auditor to A) inform the reader that disclosure is not adequate, and to issue an adverse opinion. B) inform the reader that disclosure is not adequate, and to issue a qualified opinion. C) present the information in the audit report and issue an unqualified or qualified opinion. D) present the information in the audit report and to issue a qualified or an adverse opinion. Answer: D Terms: Inadequate disclosure Difficulty: Challenging Objective: LO 3-5 AACSB: Reflective thinking 18) A qualified opinion audit report is issued when all auditing conditions have been met, no significant misstatements have been discovered, and it is the auditor's opinion that the financial statements are fairly stated in accordance with GAAP. Answer: FALSE Terms: Qualified opinion audit report Difficulty: Easy Objective: LO 3-5 AACSB: Reflective thinking 19) Auditors should issue a disclaimer of opinion when there is a highly material client-imposed scope restriction. Answer: TRUE Terms: Disclaimer of opinion; Client-imposed scope restriction Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

20) Whenever an auditor issues a qualified report, he or she must use the term "except for " in the opinion paragraph. Answer: TRUE Terms: Qualified report; Except for in opinion paragraph Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 21) A qualified report can take the form of a qualification of both the scope and the opinion or of the opinion alone. Answer: TRUE Terms: Qualified report; Scope limitation Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 22) When an auditor discovers a highly material GAAP violation in the financial statements and the client refuses to correct it, the auditor should issue a disclaimer of opinion. Answer: FALSE Terms: Disclaimer of opinion; Highly material GAAP violation in the financial statements and client refuses to correct it Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 23) Client imposed restrictions on the audit always require a disclaimer of opinion. Answer: FALSE Terms: Disclaimer of opinion; Client-imposed restrictions on audit Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 24) An auditor should issue a qualified opinion with an explanatory paragraph whenever there is a material uncertainty affecting the financial statements. Answer: FALSE Terms: Qualified opinion with explanatory paragraph Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking

25) There are three conditions necessitating a departure from an unqualified audit report. Name, discuss and state the appropriate audit report for each of these three conditions. Answer: The three conditions requiring a departure from an unqualified report are: • Scope Restrictions. A scope restriction can be imposed by the client or due to circumstances beyond the auditor's or client's control. In either case the scope restriction prevents the auditor from accumulating sufficient evidence to reach a conclusion regarding whether financial statements are stated in accordance with GAAP. The type of opinion, depending upon materiality, would be either a qualified or a disclaimer of opinion report. • GAAP Departures. In this situation the financial statements are not prepared in accordance with GAAP. Accordingly, the auditor would issue a qualified opinion if the GAAP violation were moderately material, or an adverse opinion if the GAAP violation were highly material. • Auditor lacks independence. Independence is ordinarily determined by the AICPA Code of Professional Conduct. When the auditor is not independent, the only report the auditor can issue is a disclaimer of opinion. Terms: Conditions necessitating a departure from an unqualified audit report Difficulty: Moderate Objective: LO 3-5 AACSB: Reflective thinking 3.6 Learning Objective 3-6 1) A misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of A) the PCAOB. B) a reasonable user of the financial statements. C) an accountant. D) the SEC. Answer: B Terms: Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 2) Misstatements must be compared with some measurement base before a decision can be made about materiality. A commonly accepted measurement base includes A) net income. B) total assets. C) working capital. D) all of the above. Answer: D Terms: Misstatements and materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

3) When comparing misstatements with a measurement base, the auditor must consider the pervasiveness of the misstatement. Of the following examples, the most pervasive misstatement is a(n) A) understatement of inventory. B) understatement of retained earnings caused by a miscalculation of dividends payable. C) misclassification of notes payable as a long-term liability when it should be current. D) misclassification of salary expense as a selling expense. Answer: A Terms: Pervasive misstatements Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 4) The dollar amount of some misstatements cannot be accurately measured. For example, if the client were unwilling to disclose an existing lawsuit, the auditor must estimate the likely effect on A) net income. B) users of the financial statements. C) the auditor's exposure to lawsuits. D) management's future decisions. Answer: B Terms: Misstatements accurately measured Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 5) If most or all users' decisions that are based on the financial statements are likely to be significantly affected, the materiality level is A) unrestricted. B) material. C) pervasive. D) risky. Answer: C Terms: Materiality qualifications Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

6) When a client fails to follow GAAP, the audit report can be unmodified, qualified, or adverse depending on the materiality. What factors affect materiality that an auditor should consider? A) the dollar amount in comparison to a base B) if the misstatement can be measured C) the nature of the item D) All the above are factors an auditor should consider regarding materiality. Answer: D Terms: Client fails to follow GAAP; Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 7) Which of the following is a correct statement regarding materiality? A) There are well-defined guidelines that enable auditors to determine if something is material. B) Misstatements must be compared with some benchmark before a decision can be made about the materiality level of the failure of a company to follow GAAP. C) Pervasiveness is not considered when comparing potential misstatements with a base or benchmark. D) To evaluate overall materiality, the auditor does not combine all unadjusted misstatements. Answer: B Terms: Materiality Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 8) Management has recorded prepaid insurance as an asset in the previous year. This year, to reduce record-keeping costs, it expenses insurance. If the amount is immaterial to the financial statements, A) a disclaimer opinion is issued. B) a qualified opinion is issued. C) a standard unmodified opinion audit report is issued. D) no audit report can be issued. Answer: C Terms: Standard unmodified opinion audit report Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

9) The highest level of materiality exists when A) users are likely to make incorrect decisions if they rely on the overall financial statements. B) there has been a departure from GAAP. C) amounts are material but do not overshadow the financial statements as a whole. D) a scope limitation has been imposed. Answer: A Terms: Materiality levels Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 10) Materiality is essential when an auditor considers his/her determination of the appropriate report for a given set of circumstances. Answer: TRUE Terms: Materiality; Appropriate report Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking 11) A pervasive exception is one that affects different parts of the financial statements. Answer: TRUE Terms: Pervasive exception Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking 12) An item with a "psychological" effect (e.g., where the item maintains an increasing earnings trend) is a qualitative factor that may affect the auditor's decision regarding materiality. Answer: TRUE Terms: Psychological effect; Materiality Difficulty: Challenging Objective: LO 3-6 AACSB: Reflective thinking 13) As misstatements become more pervasive, the likelihood of issuing a disclaimer rather than a qualified opinion increases. Answer: FALSE Terms: Materiality level and type of opinion Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking

14) It is typically more difficult to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. Answer: TRUE Terms: Materiality level and type of opinion Difficulty: Moderate Objective: LO 3-6 AACSB: Reflective thinking 15) Discuss how materiality affects audit reporting decisions. Answer: When determining the appropriate audit report to issue, the auditor considers three levels of materiality for a given condition. These three levels are (1) immaterial, (2) material without overshadowing the financial statements as a whole, and (3) so material and so pervasive that overall fairness of the statements is in question. For conditions involving a GAAP violation, the materiality level of the violation influences whether an unmodified, qualified, or adverse opinion is issued. For conditions involving a scope restriction, the materiality of the restriction influences whether a standard unmodified opinion report, a report with a qualified scope and opinion, or a disclaimer report is issued. Terms: Materiality effect on audit reporting decisions Difficulty: Easy Objective: LO 3-6 AACSB: Reflective thinking

3.7 Learning Objective 3-7 1) A restriction on the scope of the auditor's examination requires A) a qualifying paragraph to be included in the introduction. B) an opinion paragraph preceding the qualifying paragraph. C) a disclaimer opinion. D) a basis for a qualified opinion paragraph. Answer: B Terms: Scope limitation and type of audit report Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 2) An auditor who issues a qualified opinion because sufficient appropriate evidence was not obtained should describe the limitations in an explanatory paragraph. The auditor should also modify the A) Scope paragraph Opinion paragraph Notes to the financial statements Yes No Yes B) Scope paragraph No C) Scope paragraph No D) Scope paragraph Yes

Opinion paragraph Notes to the financial statements Yes Yes

Opinion paragraph Notes to the financial statements Yes No

Answer: D Terms: Qualified opinion insufficient evidence Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking

3) When an auditor issues a qualified report due to a scope limitation an explanatory paragraph is normally added. Which, if any, of the following paragraphs are also modified? A) Introductory Scope Opinion Yes Yes Yes B) Introductory Yes

Scope Yes

Opinion No

Introductory No

Scope Yes

Opinion No

Introductory No

Scope Yes

Opinion Yes

Answer: D Terms: Qualified report due to scope restriction; Paragraphs modified Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 4) When a qualified or adverse opinion is issued, the qualifying paragraph is inserted A) between the introductory and scope paragraphs. B) after the opinion section and before the management responsibility section. C) after the opinion paragraph, as a fourth paragraph. D) immediately after the address, as the first paragraph. Answer: B Terms: Qualified or adverse opinion paragraph placement Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 5) When the client fails to include information that is necessary for the fair presentation of financial statements in the body of the statements or in the footnotes, A) it is the auditor's responsibility to present the information in the audit report. B) the auditor should issue a qualified or an adverse opinion. C) the qualification is put in an added paragraph preceding the opinion. D) all of the above. Answer: D Terms: Type of audit opinion when statements are not in conformity with GAAP Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 50 Copyright © 2023 Pearson Education, Inc.

6) If the financial statements include an income statement and a balance sheet but exclude the statement of cash flows, the auditors A) can issue an unqualified report. B) should issue a qualified opinion due to the departure from GAAP. C) should issue a qualified opinion because the missing statement of cash flows constitutes a scope limitation. D) should include the statement of cash flows, modify the report, and issue an unqualified opinion. Answer: B Terms: Report when financial statements exclude statement of cash flows Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 7) Which of the following is incorrect concerning scope limitations? A) If client imposed, the auditor should be concerned about the client trying to prevent discovery of a material misstatement. B) An unqualified opinion can result if auditors can perform alternative procedures and are satisfied that the information is fairly stated. C) The most common circumstance-imposed scope restriction is due to the client changing their auditors. D) The most common circumstance-imposed scope limitation is when the auditor is appointed after the balance sheet date. Answer: C Terms: Scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 8) When dealing with materiality and scope limitation conditions, A) a disclaimer of opinion must be issued. B) it is easier to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. C) scope limitations imposed by the client are always considered material. D) an unqualified opinion may still be issued depending on the materiality of the scope limitation. Answer: D Terms: Scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

9) When a pervasive scope limitation exists, A) a disclaimer of opinion rather than a qualified opinion is generally required. B) the auditor's responsibility paragraph is modified to indicate that the auditor was not able to obtain sufficient appropriate evidence to express an audit opinion. C) sections of the auditor's responsibility paragraph are eliminated to avoid stating anything that might lead readers to believe that other parts of the financial statements might be fairly stated. D) all of the above. Answer: D Terms: Pervasive scope limitation Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 10) When there is a scope restriction, what type of audit report can be issued? A) unmodified opinion B) qualification of scope and opinion C) disclaimer of opinion D) any of the above Answer: D Terms: Audit reports in various situations Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 11) Subsequent to the close of Spacely Sprockets fiscal year ending October 31, 2023, a major debtor has declared bankruptcy due to a series of events. The receivable is significantly material in relation to the financial statements, and recovery is doubtful. The debtor had confirmed the full amount due to Spacely Sprocket at the balance sheet date. Because the account was confirmed at the balance sheet date, Spacely refuses to disclose any information in relation to this subsequent event. The CPA believes that all other accounts were stated fairly at the balance sheet date. In addition, Spacely changed their method of inventory valuation from FIFO to LIFO. This change was disclosed in Note X to the financial statements. Accordingly, what type of opinion should be expressed? A) unqualified with an explanatory paragraph B) qualified due to a GAAP departure C) qualified due to a scope limitation D) a combination of B and C Answer: B Terms: Audit report when client has subsequent event and change in inventory valuation Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking

12) For the report containing a disclaimer for lack of independence, the disclaimer is in the A) second or scope paragraph. B) third or opinion paragraph. C) first and only paragraph. D) fourth or explanatory paragraph. Answer: C Terms: Disclaimer in which report paragraph Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 13) When an adverse opinion is issued, a scope paragraph would be A) qualified. B) unchanged. C) deleted. D) expanded to identify the additional procedures which the auditor performed. Answer: B Terms: Adverse opinion and scope paragraph Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 14) After the balance sheet date but prior to issuance of the auditor's report the auditor learns that the client's facility in a foreign country has been expropriated. Management refuses to disclose this information in a financial statement footnote or present pro-forma data as to the effect of the event. The auditor should A) add a footnote to the financial statements. B) disclaim an opinion due to the client-imposed scope limitation. C) provide the information in the report and modify the opinion. D) issue an unqualified opinion but provide the information in the auditor report. Answer: C Terms: Material subsequent event management refusal to disclose Difficulty: Challenging Objective: LO 3-7 AACSB: Reflective thinking 15) Financial statement users are typically more concerned with an unmodified report with explanatory paragraphs than they are with a disclaimer of opinion. Answer: FALSE Terms: Financial statement users; Unqualified report with explanatory paragraphs; Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

16) A lack of independence will override any other scope limitations and requires a disclaimer of opinion. Answer: TRUE Terms: Lack of independence; Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 17) When a qualified opinion is issued, an explanatory paragraph is added immediately after the opinion paragraph to explain the nature of the qualification that affects the opinion. Answer: FALSE Terms: Qualified opinion explanatory paragraph and opinion paragraph Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 18) In the case of a disclaimer due to lack of independence, the entire scope paragraph is excluded from the report. Answer: TRUE Terms: Disclaimer of opinion Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking

19) The following is a portion of an adverse audit report issued for a public company. (Note: A separate report was issued on the effectiveness of system of internal control over financial reporting.) Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Wallace Corporation We have audited the accompanying balance sheet of Wallace Corporation as of December 31, 2023, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. The company has excluded from property and debt in the accompanying balance sheet certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $14,500,000, long-term debt by $13,200,000, and retained earnings by $1,300,000 as of December 31, 2023, and net income and earnings per share would be increased by $1,300,000 and $2.25, respectively, for the year then ended. Required: Complete the above adverse audit report by preparing the opinion paragraph. Do not date or sign the report. Answer: In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the financial statements referred to above do not present fairly the financial position of Wallace Corporation as of December 31, 2023, or the results of its operations and its cash flows for the year then ended. Terms: Adverse audit report Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

20) The following is the introductory paragraph, and the Basis for Qualified Opinion paragraph for Fast Times Corporation, a nonpublic company. Independent Auditor's Report To the shareholders and the board of directors of Fast Times Corporation We have audited the accompanying balance sheet of Fast Times Corporation as of September 30, 2023, and the related statements of income, retained earnings, and cash flows for the year then ended, and the related notes to the financial statements. Basis for Qualified Opinion We were unable to obtain audited financial statements supporting the company's investment in a foreign affiliate stated at $1,040,000, or its equity in earnings of that affiliate of $501,000, which is included in net income, as described in Note 14 to the financial statements. Because of the nature of the company's records, we were unable to satisfy ourselves as to the carrying value of the investment or the equity in its earnings by means of other auditing procedures. Required: Prepare the opinion paragraph for the above audit report. Do not date or sign the report. Answer: In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Fast Times Corporation as of September 30, 2023, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Terms: Qualified scope and opinion report Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking 21) Your CPA firm has completed the fieldwork for the 2023 audit of Sharp Corporation, a private company with an October year-end. You were preparing to draft a standard, unqualified audit report when you discovered that the audit manager on the Sharp engagement owns 10 shares of Sharp's common stock. Prepare the appropriate report. Answer: We are not independent with respect to Sharp Corporation, and the accompanying balance sheet as of October 31, 2023, and the related statements of income, retained earnings, and cash flows for the year then ended were not audited by us. Accordingly, we do not express an opinion on them. Note: There is no report title when the auditor issues a disclaimer due to a lack of independence. Terms: Audit report with lack of independence Difficulty: Moderate Objective: LO 3-7 AACSB: Reflective thinking 56 Copyright © 2023 Pearson Education, Inc.

22) Assume you are the partner in charge of the 2023 audit of Becker Corporation, a private company. The audit report has not yet been prepared. In each independent situation following (18), indicate the appropriate action (a-g) to be taken. The possible actions are as follows: a. Issue an unmodified opinion audit report. b. Qualify both the scope and opinion paragraphs. c. Qualify the opinion paragraph. d. Issue an unmodified opinion with an explanatory paragraph. e. Issue an unmodified opinion with revised wording (no explanatory paragraph). f. Issue an adverse opinion. g. Disclaim an opinion. The situations are as follows: ________ 1. Becker Corporation carries its property, plant, and equipment accounts at current market values. Current market values exceed historical cost by a highly material amount, and the effects are pervasive throughout the financial statements. ________ 2. Management of Becker Corporation refuses to allow you to observe, or make, any counts of inventory. The recorded book value of inventory is highly material. ________ 3. You were unable to confirm accounts receivable with Becker's customers. However, because of detailed sales and cash receipts records, you were able to perform reliable alternative audit procedures. ________ 4. One week before the end of fieldwork, you discover that the audit manager on the Becker engagement owns a material amount of Becker's common stock. ________ 5. You relied upon another CPA firm to perform part of the audit. Although you were the principal auditor, the other firm audited a material portion of the financial statements. You wish to refer to (but not name) the other firm in your report. ________ 6. You have substantial doubt about Becker's ability to continue as a going concern. ________ 7. Becker Corporation changed its method of computing depreciation in 2023. You concur with the change and the change is properly disclosed in the financial statement footnotes. ________ 8. Ten days after the balance sheet date, one of Becker's buildings was destroyed by a fire. Becker refuses to disclose this information in a footnote to the financial statements, but you believe disclosure is required to conform with GAAP. The amount of the uninsured loss was material, but not highly material. Answer: 1. f, 2. g, 3. a, 4. g, 5. e, 6. d or g, 7. d, 8. c Terms: Audit reports in various situations Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

23) Smith and Jones, CPAs, audited the consolidated financial statements of Concord Inc. and all but one of its subsidiaries for the year ended September 30, 2023 and are expressing an unqualified opinion on the financials presented as a whole. Smith, the engagement partner, instructed Mary, an assistant on the engagement, to draft the auditor's report on November 4, 2023, the date of fieldwork completion. In drafting the report, Mary considered the following: • In preparing its financial statements, Concord changed its method of accounting for research and development costs and properly expensed these amounts. Management described the change in principle in Note 10 to the consolidated financial statements. • Ball & Brown, CPAs, audited the financial statements of Biotherm, Inc., a consolidated subsidiary of Concord for the year ended September 30, 2023. The subsidiary's financial statements reflect total assets of 22% and total revenues of 20% of the consolidated totals. Ball & Brown expressed an unqualified opinion and furnished to Smith & Jones a copy of their auditor report. Smith & Jones have decided not to assume responsibility for the work of Ball & Brown insofar as it relates to the expression of an opinion on the consolidated financial statements taken as a whole because of the materiality of Biotherm's financial statements to the consolidated whole. Ball & Brown's report will not be presented together with that of Smith & Jones. • Concord is the subject of a grand jury investigation into possible violations of federal antitrust laws and possible related crimes. Related civil class actions are pending. Concord's management has adequately disclosed in Note 12 to their consolidated financial statements. Because of the early stage of the investigation, the ultimate outcome of these matters cannot be determined at this time. Therefore, no provision for any liability that may result has been recorded. • Concord experienced a net loss in 2023 and is currently in default under substantially all of its debt agreements. Management's plans in regard to these matters are adequately disclosed in Note 14 to Concord's consolidated financial statements. The financials do not include any adjustments that might result from the outcome of this uncertainty. These matters raise substantial doubt about Concord's ability to continue as a going concern. Ball reviewed Mary's draft and indicated in his review notes that there were many deficiencies in Mary's Draft. The audit report that Mary drafted follows. Independent Auditor's Report We have audited the consolidated financial statements of Concord, Inc., and subsidiaries as of September 30, 2023, and the related consolidated statements of income, changes in stockholder's equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Biotherm, Inc., a wholly-owned subsidiary, which statements reflect total assets and revenues constituting 22% and 20% respectively at September 30, 2019 of the consolidated totals. Those statements were audited by Ball & Brown, CPAs, whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included for Biotherm, Inc. is based solely on their report.

We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used, as well as assessing control risk. We believe our audits provide a reasonable basis for our opinion. In our opinion, based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Concord Inc., as of September 30, 2023 in conformity with generally accepted accounting principles, except for the uncertainty, which is discussed in Note 12 to the consolidated financials. The accompanying consolidated financial statements have been prepared assuming that the Company will continue in existence for a reasonable period of time. As discussed in Note 14 to the consolidated financial statements, the Company suffered a net loss and is currently in default under substantially all of its debt agreements. Management's plans in regard to these matters are also described in Note 14. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Smith & Jones, CPAs November 4, 2023 Required: The following items present some of the deficiencies in the drafted audit report noted by Smith. For each deficiency, indicate whether: S. Smith's review note is correct M. Mary's draft is correct B. Both Smith's review note and Mary's draft are incorrect Smith's Review Notes 1. An explanatory paragraph is required between the scope and opinion paragraphs for the change in accounting principles referring the reader to Note 10. 2. The names of the other auditors do not need to be explicitly stated in the introductory paragraph. Only that "other auditors" performed the audit and provided their report. 3. The opinion paragraph should extend the auditor's opinion beyond financial position to include the results of Concord's operations and flows. 4. The reference to the uncertainty in the opinion paragraph is incomplete. It should describe the nature of the uncertainty as pertaining to the grand jury investigation into possible violations of federal antitrust laws. 59 Copyright © 2023 Pearson Education, Inc.

5. The explanatory paragraph following the opinion paragraph does not include the terms "substantial doubt" and "going concern". These terms are required to be used in this paragraph. 6. The explanatory paragraph following the opinion paragraph includes an inappropriate statement that "the consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty." This statement is misleading and should be omitted. Answer: 1. B 2. S 3. S 4. B 5. S 6. M Terms: Deficiencies in audit reports Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

24) In auditing the long-term investments account, Arens, CPA, is unable to obtain audited financial statements for an investee located in a foreign country. Levine concludes sufficient appropriate audit evidence regarding this investment cannot be obtained. For each of the following situations below, identify the appropriate opinion type and report modification by selecting a choice from the appropriate tables below.

Situation 1. Assume the potential effect on the financial statements is immaterial. 2. Assume the potential effect on the financial statements is moderate. 3. Assume the potential effect on the financial statements is high.

U Q A D

Opinion Type Unmodified Qualified Adverse Disclaimer

Opinion Type

Intro

Scope Opinion Exp1

Standard Paragraph Choice Explanatory Paragraph O Omit 0 None required N No change + Insert before opinion M Modify - Insert after opinion

Answer: Situation 1. Assume the potential effect on the financial statements is immaterial. 2. Assume the potential effect on the financial statements is moderate. 3. Assume the potential effect on the financial statements is high.

Opinion Type

Intro

Scope Opinion Exp1

Terms: Circumstances and required audit reports Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking

25) Audit situations 1 through 10 present various independent factual situations an auditor might encounter in conducting an audit. List A represents the types of opinions the auditor ordinarily would issue, and List B represents the report modifications (if any) that would be necessary. For each situation, select one response from List A and one from List B. Select, as the best answer for each item, the action the auditor normally would take. Items from either list may be selected once, more than once, or not at all. Assume the following: • The auditor is independent • The auditor previously expressed an unmodified opinion on the prior-year financial statements unless otherwise noted • Only single-year (not comparative) statements are presented for the current year (unless otherwise stated) • The conditions for an unmodified opinion exist unless contradicted in the factual scenario • The conditions stated in the factual scenario are material • No report modifications are to be made except in response to the factual scenario Factual Scenario 1. The financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with GAAP. 2. In auditing the Long-Term Investments account, an auditor is unable to obtain audited financial statements for an investee located in a foreign country. The auditor concludes that sufficient competent evidential matter regarding this investment cannot be obtained but it is not pervasive to the financials as a whole. 3. Due to recurring operating losses and working capital deficiencies the auditor has substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time. However, the financial statement disclosures are adequate. 4. The principal auditor decides to refer to the work of another auditor, who audited a wholly owned subsidiary of the entity and issued an unqualified opinion. 5. An entity issues financial statements that present financial position and results of operations but omits the related statement of cash flows. Management discloses in the notes to the financial statements that it does not believe the statement of cash flows to be useful. 6. An entity changes its depreciation method for production equipment from straight-line to units of production based on hours of utilization. The auditor concurs with the change, although it has a material effect on the comparability of the entity's financial statements. 7. An entity is a defendant in a lawsuit alleging infringement of certain patent rights. However, management cannot reasonably estimate the ultimate outcome of the litigation. The auditor believes that there is a reasonable possibility of a significant material loss, but the lawsuit is adequately disclosed in the notes to the financial statements. 8. An entity discloses certain lease obligations in the notes to the financial statements. The auditor believes that the failure to capitalize these leases is a departure from GAAP. 9. The entity wishes to show comparative financial statements and include the prior year. However, the prior year financial statements contained a qualification due to an inappropriate method of GAAP. Accordingly, management corrected the prior year GAAP deficiency and included the updated numbers in the comparative financials for the current year. 10. The entity wishes to show comparative financial statements and include the prior year. However, the prior year financial statements were audited by another auditor who refuses to reissue his opinion. 62 Copyright © 2023 Pearson Education, Inc.

List A Opinion Choices

A Qualified

B Unmodified

C Adverse

D Disclaimer

E Either Qualified or Adverse

F Either Disclaimer or Adverse

G Either Qualified or Disclaimer

List B Report Modification Choices H Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph w/o modifying the three standard paragraphs. I Describe the circumstances in the opinion paragraph w/o adding an emphasis-of-matter paragraph. J Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph and modify the opinion paragraph. K Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the opinion paragraph. L Describe the circumstances in an emphasis-of-matter paragraph preceding the opinion paragraph and modify the scope & opinion paragraph. M Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph and modify the scope & opinion paragraph. N Describe the circumstances in the scope paragraph w/o adding an emphasisof-matter paragraph. O Describe the circumstances in an emphasis-of-matter paragraph following the opinion paragraph w/o modifying the three standard paragraphs. P Describe the circumstances in the introductory paragraph w/o adding an emphasis-of-matter paragraph. Q Describe the circumstances in the introductory paragraph w/o adding an emphasis-of-matter paragraph, and modify the scope & opinion paragraphs. R Issue the standard auditor's report w/o modification. S None of the above.

Answer: 1. B, R 2. A, L 3. B, I 4. B, Q 5. A, J 6. B, I 7. B, R 8. E, J 9. B, H 10. B, R Terms: Audit situations and required reports with modifications Difficulty: Challenging Objective: LO 3-7 AACSB: Analytic thinking 3.8 Learning Objective 3-8 1) When accounting principles are not consistently applied, and the materiality level is immaterial, the auditor will issue a(n) A) standard unmodified opinion. B) unmodified opinion with an explanatory paragraph. C) adverse opinion. D) disclaimer opinion. Answer: A Terms: Audit report and different levels of materiality Difficulty: Moderate Objective: LO 3-8 AACSB: Analytic thinking 2) The first step to be followed when deciding the appropriate audit report in a given set of circumstances is to A) decide the appropriate type of report for the condition. B) write the report. C) determine whether any conditions exist requiring a departure from a standard unmodified opinion audit report. D) decide the materiality for each condition. Answer: C Terms: Auditor's decision process for audit reports Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

3) In most audits, the auditor issues a(n) A) modified opinion audit report. B) standard unmodified opinion audit report. C) scope limited audit report. D) adverse audit report. Answer: B Terms: Standard unmodified opinion audit report Difficulty: Challenging Objective: LO 3-8 AACSB: Reflective thinking 4) More than one modification should be included in the audit report when A) the auditor is not independent and the auditor knows that the company has not followed generally accepted accounting principles. B) there is substantial doubt about the going concern of the company and information about the causes of the uncertainties is not adequately disclosed in the footnotes. C) there is a scope limitation and there is substantial doubt about the company's ability to continue as a going concern. D) all of the above. Answer: D Terms: Standard report; More than one condition requiring a departure or modification Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 5) When there is a justified departure from GAAP which is considered material, the auditor should issue a(n) A) standard unmodified opinion. B) disclaimer of opinion. C) unmodified opinion with an explanatory paragraph. D) adverse opinion. Answer: C Terms: Audit report and different levels of materiality Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

6) If there is a deviation in the statements' preparation in accordance with GAAP and another accounting principle was applied on a basis that was not consistent with that of the preceding year, A) the auditor must choose which modification to include in the audit report. B) only the most material modification can be disclosed. C) more than one modification should be included in the report. D) none of the above. Answer: C Terms: Standard report; More than one condition requiring a departure or modification Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 7) After the auditor determines whether any conditions exist which require a departure from a standard unmodified opinion audit report, the next step in the decision process is to A) write the report. B) decide the materiality for each condition. C) decide the appropriate type of report for the condition. D) discuss the report with management. Answer: B Terms: Auditor's decision process for audit reports Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking 8) For departures from GAAP or scope restrictions, the auditor must decide if the potential effect on the financial statements is A) immaterial. B) material. C) highly material. D) any of the above. Answer: D Terms: Auditor's best defense when existing material misstatements in the financial statements Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking

9) If the scope restriction imposed by the client is so material that the overall fairness of the financial statements is in question, the auditor should issue a(n) A) standard unmodified opinion. B) disclaimer of opinion. C) adverse opinion. D) unmodified opinion with revised wording in the scope paragraph. Answer: B Terms: Disclaimer of opinion; Client-imposed scope restriction Difficulty: Moderate Objective: LO 3-8 AACSB: Reflective thinking 10) The final step in the auditor's decision process for audit reports is to write the audit report. Answer: TRUE Terms: Auditor's decision process for audit reports Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking 11) Auditors usually make the materiality judgment by referring to a standard checklist. Answer: FALSE Terms: Materiality levels Difficulty: Easy Objective: LO 3-8 AACSB: Reflective thinking

3.9 Learning Objective 3-9 1) Which of the following is not true regarding International Financial Reporting Standards (IFRS)? A) IFRS is increasing accepted worldwide to prepare financial statements. B) Foreign companies listed on U.S. exchanges are not allowed to report under IFRS. C) It is uncertain today if or when the SEC will allow U.S. companies to report under IFRS. D) It is uncertain today if or when the SEC will allow U.S. companies to provide IFRS financial statement as supplementary information. Answer: B Terms: International accounting and auditing standards Difficulty: Moderate Objective: LO 3-9 AACSB: Reflective thinking 2) Auditing standards in the United States allow an auditor to perform an audit of a nonpublic U.S. entity in accordance with both generally accepted auditing standards in the U.S. and the ISAs. Answer: TRUE Terms: Auditing standards of the United States and International Standards of Auditing Difficulty: Moderate Objective: LO 3-9 AACSB: Reflective thinking 3) An auditor may be engaged to report on financial statements prepared in accordance with IFRS. In these situations, the auditor is required to refer to U.S. accounting standards rather than IFRS standards in the opinion paragraph. Answer: FALSE Terms: International accounting and auditing standards Difficulty: Moderate Objective: LO 3-9 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 4 Professional Ethics 4.1 Learning Objective 4-1 1) Ethics are A) needed in the professions, but is not needed for society in general. B) a set of moral principles or values. C) not formed by life experiences. D) always incorporated in laws. Answer: B Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 2) ________ means that a person acts according to conscience, regardless of the situation. A) Caring B) Fairness C) Integrity D) Respect Answer: C Terms: Ethical principles and integrity Difficulty: Moderate Objective: LO 4-1 AACSB: Ethical understanding and reasoning 3) Which of the following is a prescribed set of moral principles or values? A) codes of business ethics for professional groups B) laws and regulations C) codes of conduct within an organization D) all of the above Answer: D Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 4) One of the main reasons people act unethically is that they choose to act selfishly. Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning

5) Most people define unethical behavior as conduct that differs from what they believe is appropriate given the circumstances. Answer: TRUE Terms: Unethical behavior Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 6) PCAOB inspections, especially information related to future inspections which will be made by the PCAOB staff and personnel of public company audits, is publicly available information. Answer: FALSE Terms: Ethical Principles and Confidential Information Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 7) Ethical values such as caring have been incorporated into the laws, as caring now been defined enough to be legally enforceable. Answer: FALSE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning 4.2 Learning Objective 4-2 1) A six-step approach is often used to resolve an ethical dilemma. The first step in this process is to A) identify the alternative actions available. B) identify the ethical issues from the facts. C) determine who will be affected by the outcome of the dilemma. D) obtain the relevant facts. Answer: D Terms: Ethical dilemma Difficulty: Moderate Objective: LO 4-2 AACSB: Ethical understanding and reasoning 2) Ethical frameworks help identify the ethical issues and will always lead to the appropriate course of action. Answer: FALSE Terms: Ethical Frameworks Difficulty: Moderate Objective: LO 4-2 AACSB: Ethical understanding and reasoning

3) A rationalization method that can easily result in unethical behavior is the argument that "everybody does it." Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 4) If an action is considered legal, it must also be considered ethical. Answer: FALSE Terms: Ethical dilemma Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 5) The likelihood of discovery and the consequences of unethical conduct can easily result in unethical conduct. Answer: TRUE Terms: Ethical Principles Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning 6) Auditors and accountants do not face many ethical dilemmas during their respective business careers. Answer: FALSE Terms: Ethical dilemma Difficulty: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning

7) Describe an ethical dilemma that an auditor or an accountant might face in his or her business career, then illustrate how the auditor or accountant might use the six-step approach presented in the text to resolve that dilemma. Be specific. Answer: An ethical dilemma is a situation a person faces in which a decision must be made about an appropriate behavior. Although students' answers will vary depending on the dilemma, their answer should list the following six steps, along with a discussion of how each step relates to their particular dilemma: 1. Obtain the relevant facts. Students should list the key facts from their dilemma. 2. Identify the ethical issues from the facts. Students should identify the key ethical issue(s) in their dilemma. 3. Determine who is affected by the outcome of the dilemma and how each person or group is affected. Students should identify who is involved and how each person is affected by the dilemma. 4. Identify the alternatives available to the person who must resolve the dilemma. Students should list the alternatives available to the auditor or accountant. 5. Identify the likely consequence of each alternative. Students should identify both the shortterm and long-term effects of each alternative. 6. Decide the appropriate action. Terms: Ethical dilemma Difficulty: Challenging Objective: LO 4-2 AACSB: Ethical understanding and reasoning

4.3 Learning Objective 4-3 1) The underlying reason for a code of professional conduct for any profession is A) the need for public confidence in the quality of service of the profession. B) it provides a safeguard to keep unscrupulous people out. C) it is required by federal legislation. D) it allows licensing agencies to have a yardstick to measure deficient behavior. Answer: A Terms: Reason for code of professional conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 2) Which of the following statements is true when the CPA has been engaged to perform an audit of financial statements? A) The CPA firm is engaged and paid by the client; therefore, the firm has primary responsibility to be an advocate for the client. B) The CPA firm is engaged and paid by the client, but the primary beneficiaries of the audit are those who rely on the financial statements. C) Should a situation arise where there is no convincing authoritative standard available, and there is a choice of actions which could impact a client's financial statements, the CPA is free to endorse the choice which is in the investors' interests. D) The CPA firm has primary responsibility to the FASB. Answer: B Terms: CPA engaged to perform audit of financial statements Difficulty: Moderate Objective: LO 4-3 AACSB: Ethical understanding and reasoning 3) The ________ is a standard of conduct for all members of the AICPA. A) IESBA Code of Conduct B) SEC Code of Conduct C) PCAOB Code of Professional Conduct D) AICPA Code of Professional Conduct Answer: D Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 4) Professionals are expected to conduct themselves at a higher level than most other members of society. Answer: TRUE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 5 Copyright © 2023 Pearson Education, Inc.

5) CPA firms have a similar relationship with the users of financial statements which they audit compared to the relationship other professionals have with their customers. Answer: FALSE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 6) Users of financial statements believe that CPA firms reduce the information risk associated with financial statements. Answer: TRUE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 7) Users of financial statements have the time and the ability to evaluate the audit performance of a CPA firm. Answer: FALSE Terms: Professionals and ethical conduct Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning 8) Explain why there is a special need for ethical conduct in the auditing profession. Answer: The reason for an expectation of a high level of professional conduct by any profession is the need for public confidence in the quality of service by the profession, regardless of the individual providing it. It is not practical for most customers to evaluate the quality of the performance of professional services because of their complexity. Therefore, since the users (e.g., the general public) of services provided by an auditor generally cannot evaluate the quality of the auditor's performance, it is critical to the auditing profession that the public have a high degree of confidence in the quality of the services provided by the auditor. Public confidence in the quality of professional services is enhanced when the profession encourages high standards of performance and ethical conduct by all its members. If users of auditing services were to lack confidence in the quality of those services, then the value of CPA firms' audits would be diminished, as would the demand for audits. It is essential that the users regard CPA firms as competent and unbiased. Terms: Need for ethical conduct in auditing profession Difficulty: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning

4.4 Learning Objective 4-4 1) Which of the following is (are) true concerning the Ethical Principles of the Code of Professional Conduct? I. They identify ideal conduct. II. They are general ideals and are not enforceable. A) I only B) II only C) I and II D) Neither I nor II Answer: C Terms: Ethical principles of the Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 2) Which of the following is not one of the major parts of the AICPA's Code of Professional Conduct? A) principles B) rules C) interpretations D) definitions Answer: D Terms: AICPA Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning

3) One of the AICPA's Ethical Principles deals with the public interest. It states that members should accept the obligation to act in a way that will A) Honor the public trust Serve the client's interest Yes Yes B) Honor the public trust No

Serve the client's interest No

Honor the public trust Yes

Serve the client's interest No

Honor the public trust No

Serve the client's interest Yes

Answer: C Terms: Ethical Principles; Public interest; Obligations Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 4) A CPA performs bookkeeping services for a client and then performs an audit of those financial statements. This is an example of a ________ threat. A) familiarity B) self-interest C) self-review D) management participation Answer: C Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 5) Since the rules cannot address all circumstances, the Code includes a conceptual framework approach for members to use to evaluate threats to compliance. Using this framework, A) the first step is to discuss the threat with the client's management team. B) all threats must be completely eliminated. C) safeguards can be used to eliminate any threat. D) more than one safeguard may be necessary. Answer: D Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 8 Copyright © 2023 Pearson Education, Inc.

6) Which part of the AICPA's Code of Professional Conduct is enforceable? A) ethical rulings B) rules of conduct C) principles D) interpretations Answer: B Terms: AICPA Code of Professional Conduct; Enforceable Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 7) Interpretations of the rules of conduct A) are enforceable. B) are finalized after being approved by the FASB. C) are issued as exposure drafts to the profession and others for comments. D) do not apply to members in business. Answer: C Terms: Interpretations of AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 8) The AICPA's Code of Professional Conduct requires independence for all A) attestation engagements. B) services performed by accountants in public practice. C) accounting and auditing services performed. D) professional work performed by CPAs. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 9) When a member observes the profession's technical and ethical standards and strives to continually improve her competence and quality of services, she is exercising A) due care. B) integrity. C) independence. D) objectivity. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

10) Four of the six Ethical Principles in the AICPA's Code of Professional Conduct are equally applicable to all members of the AICPA. Which of the following principles applies only to members in public practice? A) Scope and Nature of Services B) Integrity C) Due Care D) The Public Interest Answer: A Terms: Ethical Principles apply only to members in public practice Difficulty: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning 11) The Code of Professional Conduct is established by the membership of the AICPA, and the Interpretations of the Rules of Conduct are prepared by the A) Financial Accounting Standards Board. B) Securities and Exchange Commission. C) CPA licensing agencies within each state. D) Professional Ethics Executive Committee of the AICPA. Answer: D Terms: Code of Professional Conduct; Interpretations of Rules of Conduct Difficulty: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning 12) Due to a shortage of personnel, the client asks a member firm to assist with the authorization of accounting transactions. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) self-review D) undue influence Answer: A Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

13) It becomes obvious that a member of a CPA firm has developed a close relationship with an attest client. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) familiarity C) self-review D) undue influence Answer: B Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 14) An officer participates in litigation against the CPA firm. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) adverse interest B) self-interest C) self-review D) undue influence Answer: A Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 15) A member actively endorses an attest client's products or services. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) advocacy D) undue influence Answer: C Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

16) An attest client threatens the member with not awarding future additional engagements to the firm if the firm does not agree with the client on a particular accounting matter. This is an example of which type of threat to compliance with which of the rules under the AICPA's Code of Professional Conduct? A) management participation B) self-interest C) self-review D) undue influence Answer: D Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 17) An advantage of specific rules in the Code of Professional Conduct is the enforceability of minimum behavior and performance standards. Answer: TRUE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 18) It is a violation of the rules of conduct if someone does something on behalf of a member that is a violation if the member does it. Answer: TRUE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 19) An advantage of the principles of professional conduct in the Code of Professional Conduct is that they are more easily enforced than are the specific rules of conduct. Answer: FALSE Terms: Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 20) Safeguards can always reduce the threat to an acceptable level. Answer: FALSE Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

21) Interpretations of rules of conduct in the Code of Professional Conduct are not officially enforceable and practitioners need not justify departure from them. Answer: FALSE Terms: AICPA Code of Professional Conduct; Interpretation of rules Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 22) Adverse interest is the threat that a member will not act with objectivity because their interests are opposed to the client's interests. Answer: TRUE Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 23) In the AICPA's Code of Professional Conduct, the second principle of professional conduct, entitled "The Public Interest," applies only to members of the AICPA in public practice and not to members who work as accountants in business, government, or education. Answer: FALSE Terms: AICPA Code of Professional Conduct; Public Interest principle Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 24) In the AICPA's Code of Professional Conduct, the sixth principle of professional conduct, entitled "Scope and Nature of Services," applies to members of the AICPA who work in public practice, business, government, or education. Answer: FALSE Terms: AICPA Code of Professional Conduct; Scope and nature of services principle Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 25) The Conceptual Framework for AICPA Independence Standards can be used when making decisions on ethical matters not explicitly addressed in the Code. Answer: TRUE Terms: AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning

26) Each state also has rules of conduct that are required for licensing by the state. Answer: TRUE Terms: AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 27) Threats to compliance with the AICPA's Code of Professional Conduct fall into seven broad categories. List and explain three of these categories. Answer: Threats to compliance include: • Adverse interest. The threat that a member will not act with objectivity because the member's interests are opposed to the client's interests. • Advocacy. The threat that a member will promote a client's interest or position to the point that their objectivity or independence is compromised. • Familiarity. The threat that, due to a long or close relationship with a client, a member will become too sympathetic to the client's interest or too accepting of the client's work or product. • Management participation. The threat that a member will take on the role of client management or otherwise assume management responsibilities. • Self-interest. The threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, a client or persons associated with the client. • Self-review. The threat that a member will not appropriately evaluate the results of a previous judgment or service performed or supervised by the member or an individual in the member's firm and that the member will rely on that service in forming a judgment as part of another service. • Undue influence. The threat that a member will subordinate their judgment to an individual associated with a client or any relevant third party due to that individual's reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member. NOTE: The student only had to list and explain three of the above threats. Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 28) The AICPA Code of Conduct includes a conceptual framework approach for the member to evaluate threats to compliance with the Code. List the three steps necessary to evaluate the threats. Answer: The three steps to evaluate the threats to compliance with the Code are: 1. Identify the threats. 2. Evaluate the significance of the threat. 3. Identify and apply safeguards. Terms: Threats to compliance with rules under the AICPA Code of Professional Conduct Difficulty: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning 14 Copyright © 2023 Pearson Education, Inc.

29) What are the six Ethical Principles stated in the Code of Professional Conduct? Briefly discuss each principle. Are these principles enforceable? Answer: The six Ethical Principles of the Code of Professional Conduct are: 1. Responsibilities. Members should exercise sensitive professional and moral judgments. 2. The Public Interest. Members should demonstrate commitment to professionalism by serving the public interest and honoring the public trust. 3. Integrity. Members should perform all professional responsibilities with the highest sense of integrity. 4. Objectivity and Independence. Members should maintain objectivity and remain free of conflicts of interest. A member in public practice should be independent in both fact and appearance when providing auditing and other attestation services. 5. Due Care. Members should observe the profession's technical and ethical standards, strive continually to improve competence and quality of services, and discharge professional responsibilities to the best of their ability. 6. Scope and Nature of Services. A member in public practice should observe the principles of the Code of Professional Conduct in determining the scope and nature of services to be provided. The Ethical Principles are not enforceable. Terms: Ethical Principles Difficulty: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning 4.5 Learning Objective 4-5 1) For which of the following professional services must CPAs be independent? A) management advisory services B) audits of financial statements C) preparation of tax returns D) all of the above Answer: B Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 2) "Independence" in auditing means A) maintaining an indirect financial interest. B) not being financially dependent on a client. C) taking an unbiased viewpoint. D) being an advocate for a client. Answer: C Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

3) When CPAs are able to maintain their actual independence, it is referred to as independence in A) conduct. B) appearance. C) fact. D) total. Answer: C Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 4) The Sarbanes-Oxley Act ________ a CPA firm from doing both bookkeeping and auditing services for the same public company client. A) encourages B) prohibits C) allows D) allows on a case-by-case basis Answer: B Terms: Sarbanes-Oxley; non-audit services Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

5) Interpretations of the independence rule of the AICPA Code prohibit covered members from owning any stock or other direct investment in audit clients. Covered members would include which of the following? A) All partners in the Individuals on the attest The firm and its employee engagement office even if engagement benefit plans they have no engagement responsibility Yes Yes Yes B) All partners in the engagement office even if they have no engagement responsibility Yes

Individuals on the attest engagement

The firm and its employee benefit plans

Individuals on the attest engagement

The firm and its employee benefit plans

Yes

Individuals on the attest engagement

The firm and its employee benefit plans

C) All partners in the engagement office even if they have no engagement responsibility No D) All partners in the engagement office even if they have no engagement responsibility No

Answer: A Terms: Independence Rule; Direct investment; Covered members Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

6) The financial interests of a CPA's family members can affect the CPA's independence. Which of the following parties would not be included as a "direct financial interest" of the CPA? A) spouse B) dependent child C) relative supported by the CPA D) sibling living in the same city as the CPA Answer: D Terms: Independence; Direct financial interest Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 7) Interpretations of the rules regarding independence allow an auditor to serve as A) a director or officer of an audit client. B) an underwriter for the sale of a client's securities. C) a trustee of a client's pension fund. D) an honorary director for a not-for-profit charitable or religious organization. Answer: D Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 8) Independence is required of a CPA when performing A) management advisory services. B) all attestation services. C) all attestation and tax services. D) all professional services. Answer: B Terms: Independence Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 9) CPAs may provide bookkeeping services to their private company audit clients, but there are a number of conditions that must be met if the auditor is to maintain independence. Which of the following conditions is not necessary? A) The CPA must not assume a management role or function. B) The client must hire an external CPA to approve all of the journal entries prepared by the auditor. C) The auditor must comply with GAAS when auditing work prepared by his/her firm. D) The client must accept responsibility for the financial statements. Answer: B Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 18 Copyright © 2023 Pearson Education, Inc.

10) An example of an "indirect financial interest in a client" would be A) ownership of less than 10% of the client's stock by the covered members spouse. B) an ownership of less than 10% of the client's stock by a staff member who is not involved in the audit. C) the covered member's ownership of a mutual fund that has an investment in the client. D) All of the above are examples of an indirect financial interest in a client. Answer: C Terms: Indirect financial interest in a client Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 11) When determining whether independence is impaired because of an ownership interest in a client company, materiality will affect ownership A) in all circumstances. B) only for direct ownership. C) only for indirect ownership. D) under no circumstances. Answer: C Terms: Independence; Materiality Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 12) A direct financial interest violates independence in which of the following circumstances? A) when close relatives such as nondependent children, brothers, and sisters have a significant financial interest in the client B) when close relatives such as nondependent children, brothers, and sisters have any financial interest in the client C) when the CPA owns shares in a mutual fund that has an ownership interest in the client D) when close relatives such as a brother, sister, or in-laws are employed by the client in their engineering department Answer: A Terms: Direct financial interest, independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

13) A CPA sole practitioner purchased stock in a client corporation and placed it in a trust as an educational fund for the CPA's minor child. The trust securities were not material to the CPA but were material to the child's personal net worth. Would the independence of the CPA be considered to be impaired with respect to the client? A) Yes, because the stock is a direct financial interest. B) Yes, because the stock is an indirect financial interest that is material to the CPA's child. C) No, because the CPA does not have a direct financial interest in the client. D) No, because the CPA does not have a material indirect financial interest in the client. Answer: A Terms: Financial interest and independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 14) Julie and Lisa are sisters. Julie is a CPA auditing the company where Lisa works. Julie's independence is impaired if A) Lisa is the controller. B) Lisa owns 2% of the company. C) Lisa is the marketing manager. D) All of the above. Answer: A Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 15) Oehlers, CPA, is a staff auditor participating in the engagement of Capital Trust, Inc. Which of the following circumstances impairs Oehlers' independence? A) Oehlers' sister is an internal auditor employed by Capital Trust. B) Oehlers' friend, an employee of another local accounting firm, prepares the tax return of Capital Trust's CEO. C) Oehlers' and Capital Trust's 401K plans own stock with the same corporation. D) During the period of professional engagement, Capital Trust and Oehlers discussed business over lunch at a first-class restaurant. Answer: A Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

16) An auditor's independence is considered impaired if the auditor has A) an immaterial, indirect financial interest in a client. B) an outstanding $8,000 balance on a credit card issued by a client. C) an automobile loan from a client bank, collateralized by the automobile. D) a joint, closely held business investment with the client that is material to the auditor's net worth. Answer: D Terms: Financial interest and independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 17) According to the profession's ethical standards, an auditor would be considered independent in which of the following instances? A) The auditor's checking account, which is fully insured by a federal agency, is held at a client financial institution. B) The auditor is also an attorney who advises the client as its general counsel. C) An employee of the auditor serves as treasurer of a charitable organization that is a client. D) The client owes the auditor fees for two consecutive annual audits. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 18) Which of the following loans would be prohibited between a CPA firm or its members and an audit client? A) automobile loans B) loans fully collateralized by cash deposits at the same financial institution C) new home mortgage loans D) unpaid credit card balances not exceeding $10,000 in total Answer: C Terms: Independence; Loan exceptions Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

19) Under the AICPA independence rules, the auditor A) is prohibited from performing a company's audit and installing and designing the client's new information system. B) does not need to document the understanding and willingness of the client to perform all management functions associated with the nonaudit service. C) is prohibited from doing any bookkeeping services for the client if performing the audit. D) must follow the more restrictive SEC independence rules when dealing with a public company. Answer: D Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 20) The Code of Conduct rule on independence indicates that materiality must be considered when A) Evaluating direct investments made by the Evaluating indirect CPA ownership investments Yes Yes B) Evaluating direct investments made by the CPA No

Evaluating indirect ownership investments No

C) Evaluating direct investments made by the CPA Yes

Evaluating indirect ownership investments No

D) Evaluating direct investments made by the CPA No

Evaluating indirect ownership investments Yes

Answer: D Terms: Independence; Direct and indirect ownership investments Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

21) Which of the following instances would impair a CPA's independence when they have been retained as the auditor? I. A charitable organization where the CPA serves as treasurer II. A municipality where the CPA owns $250,000 of the $25 million outstanding bonds of the municipality III. A company that the CPA's investment club owns a 10% investment interest A) I and II B) I and III C) II and III D) I, II, and III Answer: D Terms: Impair independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 22) Under the AICPA independence rules, independence can be considered impaired when A) billed fees remain unpaid for professional services for more than ninety days. B) a client in bankruptcy has unpaid fees for more than one year. C) there is litigation by the client related to the auditor's tax or other nonaudit services for an immaterial amount. D) there is a lawsuit by the client claiming deficiencies in the previous year's audit. Answer: D Terms: Independence; Ramifications on auditor and CPA firm Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 23) Which of the following is least likely to impair a CPA firm's independence with respect to an audit client in the Oklahoma City office of a national CPA firm? A) A partner in the Oklahoma City office owns an immaterial amount of stock in the client. B) A partner in the Jersey City office owns 25% of the client's stock. C) A partner in the Oklahoma City office, who does not work on the audit engagement, previously served as controller for the audit client. D) A partner in the Chicago office previously served as vice president of finance for the audit client. Answer: D Terms: Independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

24) A CPA's financial interests in nonclients may have an effect on independence if the nonclients are investors in or investees of the client. Which situation would not impair a CPA's independence? A) The client has an immaterial investment in a nonclient investee in which the CPA has an immaterial investment. B) The CPA has a material indirect financial interest in a nonclient in which the client has a material investment. C) The client investor has a nonmaterial investment in the nonclient investee in which the CPA has a material investment. D) The CPA has a joint closely held investment with the client in a nonclient that is material to the client as well as the CPA. Answer: A Terms: Impair CPA independence Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 25) The CPA firm will lose its independence if A) a staff auditor providing audit services to the client acquires stock in that client. B) a staff tax preparer who provides 15 hours of non-audit services to the client acquires stock in that client. C) an audit manager in an office different than the office providing audit services has a direct, immaterial financial interest in the audit client. D) a covered member has an indirect, immaterial financial interest in an audit client. Answer: A Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 26) Interpretations to the Rules of Conduct permit a CPA firm to do both bookkeeping and auditing for the same private company client if three criteria are met. Which of the following is not one of those criteria? A) The client must accept full responsibility for the financial statements. B) The client is required to file an annual report, including audited financial statements, with the Securities and Exchange Commission. C) The CPA must not assume the role of employee or of manager. D) The CPA must follow applicable auditing standards. Answer: B Terms: SEC and allowed services Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

27) Which of the following circumstances impairs an auditor's independence? I. Litigation by a client against an audit firm claiming a deficiency in the previous audit II. Litigation by a client against an audit firm for a material amount related to tax services III. Litigation by an audit firm against a client claiming management fraud or deceit A) I and II B) I and III C) II and III D) I, II, and III Answer: B Terms: Impair auditor independence Difficulty: Challenging Objective: LO 4-5 AACSB: Reflective thinking 28) A CPA firm should decline an offer to perform consulting services engagement if A) the proposed engagement is not accounting related. B) recommendations made by the CPA firm are to be subject to review by the client. C) acceptance would require the CPA firm to make management decisions for an audit client. D) any of the above is true. Answer: C Terms: CPA firm should decline to perform consulting services Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 29) Interpretations of the AICPA's Code of Professional Conduct are dominated by the concept of A) independence. B) compliance with standards. C) accounting. D) acts discreditable to the profession. Answer: A Terms: Interpretations of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 30) Both SEC rules and the Sarbanes-Oxley Act prohibit auditors from providing bookkeeping services to their public company audit clients. Answer: TRUE Terms: SEC and allowed services Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning

31) Under the interpretations to the AICPA Code, independence is considered to be impaired if fees remain unpaid for professional services provided more than six months before the date of the current year's report. Answer: FALSE Terms: Independence and unpaid fees Difficulty: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning 32) Auditors are allowed to have an indirect financial interest in an audit client, such as ownership of stock in a client's company by the auditor's brother, as long as the amount of the financial interest is immaterial to the brother. Answer: TRUE Terms: Indirect financial interest; Immaterial Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 33) CPA firms are required to be independent when performing any professional service. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 34) The prohibition on direct financial interests applies to covered members in a position to influence an engagement. Answer: TRUE Terms: Independence and financial interests Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 35) All litigation by a client related to tax or other nonaudit services will impair independence. Answer: FALSE Terms: Litigation and auditor independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 36) Some CPA firms do not permit any ownership by staff of a client's stock regardless of which office serves that particular client. Answer: TRUE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 26 Copyright © 2023 Pearson Education, Inc.

37) A staff member in a national CPA firm is not allowed to own stock in a client corporation even if the staff member is not involved in the client corporation's audit engagement under the AICPA's independence rule. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 38) A partner of a CPA firm performing the audit of the Red Cross may be an honorary director of the Red Cross and also vote and participate in management functions at the Red Cross. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning 39) Audit firms frequently merge with other audit firms or form professional associations to enhance their capabilities to provide professional services. In these situations, it is not required for the network firm to be independent of audit and review clients of the other network firms for a period of 5 years. Answer: FALSE Terms: Independence Difficulty: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning

40) Each of the following situations involves a possible violation of the rule on independence. For each situation, (1) decide whether the Code of Professional Conduct has been violated, and (2) briefly explain how the situation violates (or does not violate) the Code of Professional Conduct. a. Harry Brown is a partner in the Topeka office of Hedley & Co., CPAs. Harry's brother is employed in an audit-sensitive position by Jensen Appliances, a publicly held company in Kansas. Jensen Appliances is one of Hedley & Co.'s audit clients. Neither Harry nor personnel from the Topeka office is involved in the audit of Jensen. Violation? Yes No Explanation: b. John Woods is an audit manager with Calden & Co., CPAs, a one-office CPA firm. John owns 100 shares of common stock in one of the firm's audit clients, but he does not provide any audit or non-audit services to the company. Violation? Yes No Explanation: c. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Fine & Herman also performs the annual audit of Henderson Corporation. Violation? Yes No Explanation: d. Bob Shelton, CPA, is the auditor of Cafe Ecko. A couple of weeks ago, Cafe Ecko's management commenced litigation against Bob, alleging he was negligent in last year's audit. Violation? Yes No Explanation: e. Hamilton Appliance has not paid Karen Linwood, CPA, her audit fee for the past two years. Karen is starting work on the current year's audit of Hamilton. Violation? Yes No Explanation:

Answer: a. No violation. Although partners in a CPA firm are not allowed to have close relatives employed in a position of significant influence by a client, it is acceptable to have a close relative employed in an audit sensitive position (with no significant influence), as long as the partner does not participate in the engagement and is not in an office that participates on the engagement. b. No violation. John is not a covered member with respect to the audit client as he has no responsibility for the engagement and is not in a position to influence the engagement. c. No violation. The AICPA does not prohibit CPA firms from providing bookkeeping, tax, and audit services to the same nonpublic client. d. Violation. When there is a lawsuit or intent to start a lawsuit between a CPA and an audit client's management related to audit services, independence is impaired. e. Violation. Independence is impaired if fees remain unpaid for services provided more than one year prior to the date of the report. Terms: Violation of rule on independence; AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning 41) Don Crosby, a partner in a national CPA firm, has just learned that his self-sufficient daughter has accepted a position as the CFO of Sunglasses, Inc., a current client within the office with which he is employed. Explain the independence ramifications on 1) Don's independence, 2) his office, and 3) the firm's independence. Answer: 1. Don's non-dependent daughter is considered a close relative. Because she has a key position for the client, Don's independence is impaired. 2. Because Don is considered a covered member, any office in which he is employed cannot be independent. 3. The firm will not be considered independent. However, the firm can maintain its independence if either: a. they move Don to an office that does not participate on the engagement or b. the audit engagement is assigned to an office in which Don is not employed. Terms: Independence; Ramifications on auditor and CPA firm Difficulty: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning

4.6 Learning Objective 4-6 1) Under the Sarbanes-Oxley Act, the audit committee of a public company A) must meet on a monthly basis. B) must be comprised entirely of financial experts. C) is responsible for the oversight of the work of the independent auditor. D) should have at least one independent member. Answer: C Terms: Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 2) The Sarbanes-Oxley Act requires which employees of an accounting firm to rotate off the engagement every five years? A) In-Charge Auditor Lead audit partner Yes Yes B) In-Charge Auditor No

Lead audit partner No

In-Charge Auditor Yes

Lead audit partner No

In-Charge Auditor No

Lead audit partner Yes

Answer: D Terms: Sarbanes-Oxley Act; Partner rotation Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 3) Which of the following statements is true with respect to audit committees? A) Audit committee members should consist of members of the company's management. B) All members of the audit committee must be financial experts. C) The audit committee of a public company is responsible for hiring the auditor. D) Audit committees must have a minimum of ten members. Answer: C Terms: Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 30 Copyright © 2023 Pearson Education, Inc.

4) The provisions of the Sarbanes-Oxley Act are most likely to allow which of the following non-audit services for audit clients? A) appraisal or valuation services (e.g., pension, post-employment benefit liabilities) B) financial information systems design and implementation C) internal audit outsourcing D) tax consulting Answer: D Terms: Sarbanes-Oxley Act; Allowed nonaudit services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 5) Which of the following services are allowed by the SEC whenever a CPA also audits the company? A) internal audit outsourcing B) legal services unrelated to the audit C) appraisal or valuation services D) services related to assessing the effectiveness of system of internal control over financial reporting Answer: D Terms: SEC and allowed services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 6) Which of the following services is not prohibited by the SEC whenever a CPA also audits the company? A) actuarial services B) assisting the company in preparing certain SEC registration statements (e.g., 10-Q, 10-K) C) investment banker services D) bookkeeping services Answer: B Terms: SEC and allowed services Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning

7) The members of a client's "audit committee" should be A) members of management. B) directors who are not a part of company management. C) non-directors and non-managers. D) directors and managers. Answer: B Terms: Members of audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 8) The Sarbanes-Oxley Act requires a cooling off period of ________ before a member of an audit team can work for a client in a key management position. A) one year B) eighteen months C) three years D) five years Answer: A Terms: Sarbanes-Oxley Act; Cooling off period Difficulty: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning 9) Which of the following is an accurate statement? A) Auditing standards detail the requirements that a CPA firm must follow when it is requested to provide an opinion on the application of accounting principles for a client of another CPA firm. B) SEC rules prohibit ownership in audit clients by those persons who can influence the audit. C) PCAOB rules require a CPA firm, before its selection as the company's auditor, to document all relationships between the firm and the company. D) All of the above are accurate statements. Answer: D Terms: Auditor independence Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning

10) Companies are required to disclose in their proxy statement or annual filings with the SEC the total amount of audit and non-audit fees paid to the audit firm for the two most recent years. Which of the following is not one of the categories of fees that must be disclosed? A) tax fees B) consulting fees C) audit-related fees D) all other fees Answer: B Terms: Annual SEC filings; Audit and non-audit fees Difficulty: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning 11) Which of the following is not an example of an audit-related fee required to be included in the audit-related fees category related to fees disclosed in the annual proxy statement? A) comfort letters B) reviews of SEC filings C) reviews of SEC inquiry letters D) tax avoidance planning services Answer: D Terms: Proxy audit and nonaudit fee disclosure requirements Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 12) The European Commission has a rule that generally requires, with some exceptions, audit firm rotation after how many years? A) 5 B) 10 C) 12 D) 15 Answer: B Terms: Mandatory European Commission audit firm rotation rule Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning

13) Which of the following is true regarding European Commission rules related to audit firm rotation? A) audit firm rotation is required after 10 years B) audit firm rotation can be extended to 20 years if the audit is put out to bid C) audit firm rotation can be extended to 24 years when more than one firm performs the audit D) All of the statements are true. Answer: D Terms: Mandatory European Commission audit firm rotation rule Difficulty: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning 14) A public company may obtain internal audit services from their financial statement auditor if it is approved by the company's audit committee. Answer: FALSE Terms: Public company; Non-audit services purchased Difficulty: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning 15) For a public company, the Sarbanes-Oxley Act requires audit committee approval of all nonaudit services prior to their performance by the company's external auditor. Answer: TRUE Terms: Sarbanes-Oxley Act; Audit committee Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 16) Under certain circumstances, a CPA firm can offer legal and expert services unrelated to the audit to publicly held audit clients. Answer: FALSE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 17) SEC and PCAOB rules allow CPAs to provide tax services for audit clients, including tax services for company executives which oversee financial reporting. Answer: FALSE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking

18) Nonaudit services provided that are not prohibited by the Sarbanes-Oxley Act and SEC rules must be preapproved by the company's audit committee. Answer: TRUE Terms: Sarbanes-Oxley Act; Prohibited Nonaudit Services Difficulty: Moderate Objective: LO 4-6 AACSB: Reflective thinking 4.7 Learning Objective 4-7 1) The CPA must not subordinate his or her professional judgment to that of others in any A) engagement. B) audit engagement. C) engagement excluding tax services. D) engagement where the opinion of a specialist is used. Answer: A Terms: CPA subordinate professional judgment Difficulty: Easy Objective: LO 4-7 AACSB: Ethical understanding and reasoning 2) Under the rules and interpretations of the AICPA Code, A) a CPA can be a client advocate during an audit, but not while performing tax or management services. B) staff auditors should always defer to the judgment of their immediate supervisor. C) a conflict of interest is a relationship that might interfere with objectivity or integrity. D) even if a conflict of interest is disclosed to the member's client or employer, it is still considered a violation of the rules of conduct. Answer: C Terms: Integrity, objectivity, and conflicts of interest Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

3) Several months after an unqualified audit report was issued, the auditor discovers the financial statements were materially misstated. The client's CEO agrees that there are misstatements, but refuses to correct them. The CEO claims that "confidentiality" prevents the CPA from informing anyone. Which of the following statements is correct? A) The CEO is correct and the auditor must maintain confidentiality. B) The CEO is incorrect, but since the audit report has been issued, it is too late to correct the report. C) The CEO is correct, but to be ethically correct, the auditor should violate the confidentiality rule and disclose the error. D) The CEO is incorrect, and the auditor has an obligation to issue a revised audit report, even if the CEO will not correct the financial statements. Answer: D Terms: Confidentiality on audit Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 4) A CPA firm may charge a contingent fee for A) an audit. B) consulting services for a client for which they do not perform any attestation services. C) the preparation of an original tax return for a client for which they do not perform any attestation services. D) the preparation of an amended tax return. Answer: B Terms: Contingent fees Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

5) A member in public practice shall neither receive from, nor pay to, a client a commission when the member or member's firm also performs certain services for that client. Commissions are allowed if the CPA performs A) A compilation that will be An audit of prospective used by a third party financial information Yes Yes B) A compilation that will be used by a third party No

An audit of prospective financial information No

C) A compilation that will be used by a third party Yes

An audit of prospective financial information No

D) A compilation that will be used by a third party No

An audit of prospective financial information Yes

Answer: B Terms: Commissions Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 6) The AICPA's Code of Professional Conduct states that a CPA should maintain integrity and objectivity. The term "objectivity" in the Code refers to a CPA's ability to A) choose independently between alternate accounting principles and auditing standards. B) distinguish between accounting practices that are acceptable and those that are not. C) be unyielding in all matters dealing with auditing procedures. D) maintain an impartial attitude on matters that come under the CPA's review. Answer: D Terms: AICPA Code of Professional Conduct; Objectivity Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

7) Which of the following is required for a firm to designate itself "Member of the American Institute of Certified Public Accountants" on its letterhead? A) At least one of the owners must be a member of the AICPA. B) All CPA owners must be members of the AICPA. C) The CPA owners whose names appear in the firm name must be members of the AICPA. D) A majority of the owners must be members of the AICPA. Answer: B Terms: Members of the AICPA requirements Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 8) CPAs are prohibited from which of the following forms of advertising? A) self-laudatory advertising B) celebrity endorsement advertising C) use of trade names, such as "Awesome Auditors" D) use of phrases, such as "Guaranteed largest tax refunds in town!" Answer: D Terms: Prohibited forms of advertising Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning 9) Which of the following would be considered a violation of the AICPA's Code of Professional Conduct? A) The CPA makes the audit files available to the client's bank without the permission of the client. B) The CPA firm charges a contingent fee for nonattestation services to a client for whom he or she does not perform any attestation services. C) The CPA firm takes a prospective client to lunch to discuss auditing services. D) A CPA firm uses the name San Diego Tax Specialists. Answer: A Terms: Code of ethics Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

10) The AICPA's Code of Professional Conduct requires CPAs to maintain the confidentiality of client information. This rule would be violated if a CPA disclosed information without a client's consent as a result of a A) subpoena or summons. B) peer review. C) complaint filed with the trial board of the Institute. D) request by a client's largest stockholder. Answer: D Terms: Confidentiality Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 11) Which one of the following statements is false? A) Confidentiality is broken when an auditor is presented with a subpoena concerning an audit client. B) Information that a CPA obtains from a client is generally not privileged. C) When a CPA firm conducts an AICPA-authorized peer review of the quality controls of another CPA firm, permission of the client is not needed to examine audit documentation. D) A CPA firm which observes substandard audit documentation of another firm during a peer review can initiate a complaint to the AICPA. Answer: A Terms: Confidentiality Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 12) A CPA firm A) can sell securities to a client for whom they perform an attestation service. B) can receive a commission for a client that they are engaged to perform an attestation service for. C) cannot receive a referral fee for recommending the services of another CPA. D) can receive a commission from a nonattestation client as long as the situation is disclosed. Answer: D Terms: Commissions and Referral Fees Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

13) Which of the following represents all of the ways a CPA firm can be organized? A) proprietorships and partnerships B) proprietorships, partnerships, and professional corporations C) proprietorships, general partnerships, general corporations, professional corporations, limited liability companies, and limited liability partnerships if permitted by state law D) single proprietorships, partnerships, professional corporations if permitted by state law, or regular corporations Answer: C Terms: AICPA Code of Professional Conduct; CPA firm form of organization Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 14) In which of the following circumstances would a CPA be ethically bound to refrain from disclosing any confidential client information? A) The CPA is issued a summons enforceable by a court order which orders the CPA to present confidential information. B) A major stockholder of a client company seeks accounting information from the CPA after management declined to disclose the requested information. C) The confidential client information is made available as part of a quality review of the CPA's practice by a peer review team authorized by the AICPA. D) An inquiry by a disciplinary body of a state CPA society requests confidential client information. Answer: B Terms: Confidential client information Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 15) Which of the following fee arrangements is not a violation of the AICPA's Code of Professional Conduct? A) basing fees as an expert witness on the amount awarded to the plaintiff, even though the CPA performs a compilation for client use B) basing consulting fees on a percentage of a bond issue, even though the CPA performs a review of the client's financial statements C) basing fees for a tax service on the amount of the refund that the client will receive D) basing consulting fees on a percentage of a bond issue, even though the CPA performs an audit of the client's financial statements Answer: A Terms: Fee arrangements not a violation of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning

16) Which of the following is not defined as an act discreditable in either the Rules or the Interpretations of the AICPA's Code of Professional Conduct? A) The CPA firm's partner in charge failed to file his tax return for the past year. B) The CPA firm discriminates in its hiring practices based on the age of the applicant. C) The CPA retains the client's books and records to enforce past-due payment of the CPA's bill, even after the client has demanded they be returned. D) The CPA firm's partner-in-charge was a passenger in a car driven by his wife. On the way home from the firm's Christmas party, she was charged with "driving while intoxicated." Answer: D Terms: Act discreditable Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning 17) Freedom from ________ means the absence of relationships that might interfere with objectivity or integrity. A) independence B) acts discreditable C) impartiality D) conflicts of interest Answer: D Terms: Conflicts of interest Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 18) Membership in the AICPA can be terminated without a hearing for A) a crime punishable by imprisonment for more than one year. B) the filing of a fraudulent income tax return on a client's behalf. C) the willful failure of a CPA to file their own personal tax return. D) all of the above. Answer: D Terms: Membership in AICPA terminated for discreditable acts Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 19) Which of the following activities is allowed for a CPA firm's attestation clients? A) contingent fees fixed by a court B) commissions for referring a review client to an insurance agency for insurance coverage C) preparation of tax returns for which fees are based upon client refunds D) Each of the above is allowed. Answer: A Terms: Activities allowed for CPA firm's attestation clients Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 41 Copyright © 2023 Pearson Education, Inc.

20) Imprisonment for a period of six months or longer will result in automatic expulsion from the AICPA. Answer: FALSE Terms: Imprisonment; Expulsion Difficulty: Easy Objective: LO 4-7 AACSB: Ethical understanding and reasoning 21) Under the Form of Organization and Name rule, a CPA firm is prohibited from practicing as a limited liability partnership. Answer: FALSE Terms: Form of Organization and Name rule Difficulty: Easy Objective: LO 4-7 AACSB: Reflective thinking 22) A CPA firm may use any name as long as it is not misleading. Answer: TRUE Terms: Form of Organization and Name rule Difficulty: Easy Objective: LO 4-7 AACSB: Reflective thinking; Analytic thinking 23) A CPA firm may practice public accounting only in a form of organization permitted by federal law or regulation. Answer: FALSE Terms: Form of Organization Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 24) Under the Confidential Client Information rule, permission is not required from the client to use the audit documentation relating to that client during an AICPA authorized peer review program with another CPA firm. Answer: TRUE Terms: Confidential Client Information Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 25) Information obtained by a CPA from a client is legally privileged in federal court. Answer: FALSE Terms: Legally privileged information Difficulty: Moderate Objective: LO 4-7 AACSB: Reflective thinking 42 Copyright © 2023 Pearson Education, Inc.

26) Members of the AICPA in public practice are prohibited from performing comparative advertising. Answer: FALSE Terms: Advertising and Other Forms of Solicitation Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 27) Under the Form of Organization and Name rule, a CPA firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless a majority of its owners are members of the Institute. Answer: FALSE Terms: Form of Organization and Name rule Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 28) Under the AICPA's Code of Professional Conduct, CPAs are prohibited from offering audit clients a discount for referring a prospective client even if they are disclosed. Answer: FALSE Terms: AICPA Code of Professional Conduct; Offer audit clients a discount Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 29) All owners of a CPA firm must be CPAs who are qualified to practice. Answer: FALSE Terms: CPA qualified to practice Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 30) Audit assistants should be allowed to document situations during the audit where they disagreed with a conclusion made by their superior(s) involving a significant audit matter. Answer: TRUE Terms: Integrity and Objectivity Rules Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 31) It is allowable for an auditor who is also an attorney to represent a client in legal matters. Answer: FALSE Terms: Integrity and Objectivity Rules Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 43 Copyright © 2023 Pearson Education, Inc.

32) The AICPA recently issued a new interpretation of the Code of Professional Conduct which addresses a number of suggested safeguards in situations where a member faces pressure from a colleague or a superior to report misleading financial results. Answer: TRUE Terms: Integrity and Objective Rules — Resisting Pressure Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning 33) Discuss the Confidential Client Information Rule, including the four exceptions to the rule. Answer: The Confidential Client Information Rule prohibits a member from disclosing any confidential client information without the specific consent from the client. However, there are four conditions when client permission is not required: • Obligations related to technical standards; the rule makes it clear that the auditor's responsibility to discharge professional standards is greater than that for confidentiality. • In response to a valid subpoena or summons and compliance with laws and regulations. • A peer review authorized by the AICPA, state CPA Society, or State Board of Accountancy. • The CPA is initiating or responding to an inquiry from a recognized investigative body or the professional ethics division. Terms: Confidential Client Information and exceptions Difficulty: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning

34) The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation, (1) determine the applicable rule from the Code, (2) decide whether or not the Code has been violated, and (3) briefly explain how the situation violates (or does not violate) the Code. a. In 2014, Freeman and Johnson, both CPAs, decided to form a CPA practice. In 2016, Freeman and Johnson approached Bill Delaney, a physician and medical expert, and asked him to assist them with their growing medical consulting practice. Delaney agreed, but only after he was given an ownership interest in the firm. Delaney does not intend to quit his private medical practice. Rule: ________ Explanation:

Violation? Yes No

b. Brian DePalie has a successful dentistry practice in Charleston. Brian has recommended one of his patients to Katie Walton, CPA. To show gratitude for the referral, Katie has agreed to pay Brian a token gift of $50. Katie discloses the payment arrangement to her new clients. Rule: ________ Explanation:

Violation? Yes No

c. The accounting firm of Bayer & Peng, CPAs, is negotiating a fee with a new audit client. They agree the client will pay $50,000 if Bayer & Peng issues a clean, unmodified opinion, $40,000 if a qualified opinion is issued, and only $20,000 if an adverse opinion is issued. Rule: ________ Explanation:

Violation? Yes No

d. Don Smith, CPA, is a member of the engagement team that performs the audit of Shaw Corporation. Don's five-year-old daughter, Precious, received ten shares of Shaw Corporation's common stock for her fifth birthday. The stock was a gift from Precious's grandmother. Rule: ________ Explanation:

Violation? Yes No

e. Jennifer Harris, CPA, is a partner in the CPA firm that audits Alltech, Inc., a closely held corporation. Jennifer's sister-in-law is the chief financial officer at Alltech, Inc. Rule: ________ Explanation:

Violation? Yes No

Answer: a. Violation of the rule on Form of Organization and Name. Non-CPA ownership of firms is allowable; however, non-CPA owners must actively provide services to the firm's clients as their principal occupation. b. No violation of the Commissions and Referral Fees rule. A CPA may pay a referral fee to a non-CPA as long as the payment is disclosed to the client. c. Violation of the Contingent Fees rule. Charging a contingent fee for attestation services is prohibited. d. Violation of the Independence rule. Don is a covered member for purposes of the independence rule. Because his daughter is a dependent, her ownership interest in Shaw is treated as a direct financial interest of her father. e. No violation of the Independence rule. According to the Code, a close relative is defined as a parent, sibling, or nondependent child. Thus, a sister-in-law is not considered to be a close relative. Terms: Violations of Rules of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5, LO 4-6, and LO 4-7 AACSB: Ethical understanding and reasoning 35) The following situations involve a possible violation of the AICPA's Code of Professional Conduct. For each situation, (1) determine the applicable rule from the Code, (2) decide whether or not the Code has been violated, and (3) briefly explain how the situation violates (or does not violate) the Code. a. Howard Cunningham & Co., CPAs, designates its firm as "Members of the American Institute of Certified Public Accountants." All of the partners of the firm are CPAs. However, one of the partners has recently chosen to allow her membership to lapse because of personal reasons. Rule: ________ Explanation:

Violation? Yes No

b. Brad Long, CPA, was traveling from Orlando to Miami, Florida when he was pulled over by a police officer on suspicion of driving under the influence. He was convicted in court of driving while under the influence of alcohol. Because of past convictions, Brad was sentenced to 5 years in prison. Rule: ________ Explanation:

Violation? Yes No

c. Kelley Brent, CPA, is a partner in a one-office CPA firm that audits Dane, Inc., a closely held corporation. Kelley's sister was recently appointed as the chief financial officer for Dane, Inc. Rule: ________ Explanation:

Violation? Yes No

d. Sarah Martin, CPA, is a senior auditor in the San Francisco office of Cooper & Howell, CPAs. Sarah's father is employed as the controller of Line Electronics, a public company in Detroit, Michigan. Line Electronics is one of the firm's audit clients. Neither Sarah nor the San Francisco office is involved in the audit of Line Electronics. Rule: ________ Explanation:

Violation? Yes No

e. On August 20, 20x9, Min Lee, CPA and partner, was offered and accepted the engagement to audit the annual financial statements of Jernigan Corporation for the year ended December 31, 20x7. Preliminary work began on the audit on September 15, 20x7 and the engagement ended on March 7, 20x8. Jernigan is regulated by the SEC. Min served as controller of Jernigan Corporation from December 1, 20x2, until April 10, 20x7, at which time she terminated her employment with Jernigan. Rule: ________ Violation? Yes No Explanation: Answer: a. Violation of the Form of Organization and Name rule (Rule 505). A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its owners are members of the Institute. b. Violation of the Acts Discreditable rule (Rule 501). Felonies are considered acts discreditable. c. Violation of the Independence rule (Rule 101). According to the Code, Kelly's sister is a "close relative" and she occupies a key position at an audit client. Because Kelly is a partner in the office that provides the audit services to Dane, the firm is not independent. d. No violation of the Independence rule (Rule 101). While Sarah's father occupies a key position with an audit client of the firm, there is no independence violation as long as Sarah is not a member of the engagement team. The firm may provide the audit services. e. Violation of the Independence rule (Rule 101). Since Min had an employment relationship with the client during part of the period covered by the financial statements, her independence is impaired. Terms: Violations of Rules of AICPA Code of Professional Conduct Difficulty: Challenging Objective: LO 4-5, LO 4-6, and LO 4-7 AACSB: Ethical understanding and reasoning

36) The scenarios below all involve a possible violation of the AICPA's Code of Professional Conduct. 1. Using the list below, indicate which of the Code of Conduct Rules applies to the scenario. a. Independence b. Integrity and Objectivity c. Contingent Fees d. Acts Discreditable e. Commissions and Referral Fees f. Form of Organization and Name 2. State if the scenario is a violation of the Code. Scenario: 1. Margaret Henry is a partner in the Tupelo office of Jenkins & Thorn, CPAs. Margaret's father is the controller at Markrich Sporting Supplies, Inc., a publicly held company in Tupelo. Markrich is one of Jenkins & Thorn's audit clients. Margaret is not involved in the audit of Markrich. 2. Jason Alexander is an audit manager with Reese & Co., CPAs. Jason owns 100 shares of common stock in one of the firm's audit clients, but he does not provide any audit or non-audit services to the company. 3. The accounting firm of Fine & Herman, CPAs, provides bookkeeping and tax services for Henderson Corporation, a privately held company. Mr. Herman also performs the annual audit of Henderson Corporation. 4. Elaine Cooper, CPA, is the auditor of Paula's Pizza. Toward the end of the audit, Paula gave Elaine her estimate of receivable collectability and Elaine accepted it without any testing. 5. Charley Ray, CPA, is a member of the engagement team that performs the audit of Desiree Corporation. Charley's five-year-old daughter, Becky, received ten shares of Desiree common stock for her fifth birthday in a trust fund established by Becky's grandmother. 6. Freeman and Johnson formed a successful CPA practice ten years ago. In the current year, they approached Adam Sawtooth, a surgeon and medical expert, and asked him to assist them with their growing medical consulting practice. Sawtooth agreed, but only after he was given an ownership interest in the firm. Sawtooth does intend to reduce his private practice hours and spend 40% of his working hours devoted to the Freeman & Johnson practice. 7. Sally Preen has a successful computer network consulting business. Sally has recommended one of her clients to Sam Walton, CPA. To show gratitude for the referral, Sam has agreed to pay Sally a token gift of $50. Sam has not disclosed the payment arrangement to his new clients. 8. The accounting firm of Smith & Black, CPAs, is negotiating a fee with a new audit client where the client will pay $50,000 if the client obtains the line of credit needed for working capital purposes. Otherwise, the fee will be $40,000. 48 Copyright © 2023 Pearson Education, Inc.

9. Brad Barns, CPA, was traveling from Las Vegas to the Grand Canyon when he was pulled over by a police officer for suspicion of driving under the influence. He was convicted in court of driving under the influence of alcohol and received six months' probation. 10. Manuel Lopez, CPA, is a senior in a small, local, CPA firm that audits Childress, Inc., a closely held corporation. Manuel's sister was recently appointed as the controller for Childress, Inc. Answer: Part 1: 1. a 6. f 2. a 7. e 3. a 8. c 4. b 9. d 5. a 10. a Part 2: 1. Yes 6. Yes 2. No 7. Yes 3. No 8. Yes 4. Yes 9. No 5. Yes 10. Yes Terms: AICPA Code of Professional Conduct; Ethical rulings; Interpretations of rules Difficulty: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning

4.8 Learning Objective 4-8 1) If the board of accountancy in the state in which a CPA firm is licensed has rules that are different than the AICPA's rules, the CPA firm must follow A) whichever rules are less restrictive. B) whichever rules are more restrictive. C) the rules of the AICPA. D) the rules of the state's board of accountancy. Answer: B Terms: State rules which differ from AICPA rules Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking 2) Which of the following is a true statement regarding the enforcement mechanism for CPA conduct? A) The PCAOB has the authority to investigate and discipline registered public accounting firms. B) All disciplinary action by the AICPA must go through the Joint Trial Board. C) Disciplinary actions taken by the AICPA are not disclosed to the public. D) Only a few states have adopted the AICPA rules of conduct. Answer: A Terms: Enforceability of Interpretations of the Rules of Conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Ethical understanding and reasoning 3) Which of the following is a true statement regarding an action which the PCAOB can take if it finds a public accounting firm or an individual has violated the SEC rules governing the audit of a public company? A) The PCAOB cannot impose appropriate sanctions—only the respective state Board of Accountancy is allowed to impose sanctions. B) The PCAOB cannot suspend or revoke the firm's registration allowing it to audit public companies. C) The PCAOB can suspend or impose appropriate sanctions on the firm and on the individual. D) The PCAOB cannot impose any type of monetary penalties. Answer: C Terms: PCAOB Enforcement Actions Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking

4) Expulsion from the AICPA for failing to follow the rules of conduct is, by itself, sufficient to prevent a CPA from practicing public accounting. Answer: FALSE Terms: Expulsion from AICPA for failing to follow rules of conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking 5) Describe the methods used by the AICPA and State Boards of Accountancy to enforce the rules of conduct. Answer: The AICPA uses two levels of disciplinary action. For less serious, and probably unintentional, violations of Rules of Conduct, the division limits the discipline to a requirement of remedial or corrective action. For more serious violations, the level of disciplinary action goes before the Joint Trial Board. The violator may be suspended or expelled from membership in the AICPA. Violation of a State Board's rules of conduct is punishable by loss of the violator's CPA certificate and license to practice. Terms: Methods to enforce the rules conduct Difficulty: Moderate Objective: LO 4-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 5 Legal Liability 5.1 Learning Objective 5-1 1) Which of the following factors does not contribute to the number of lawsuits against auditors? A) large civil court judgments against CPA firms awarded in a few cases B) the difficulty judges and juries have understanding technical accounting matters C) the simplicity of auditing and accounting functions D) many CPA firms are willing to settle out of court to avoid legal fees and adverse publicity Answer: C Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 2) Which of the following does not contain provisions that may serve as a basis for legal actions against auditors? A) the Sarbanes-Oxley Act of 2002 B) the Securities Act of 1933 C) the Securities Act of 1934 D) the Dodd-Frank Wall Street Reform and Consumer Protection Act Answer: D Terms: Government legislation serving as a basis for legal actions against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 3) Which of the following factors does not explain why the number of lawsuits and the sizes of awards to plaintiffs in cases involving CPA firms remain high even today? A) Attorneys are willing to take these types of lawsuits on a contingent-fee basis. B) Economic changes often result in an increase in the number of business failures. C) The deep-pocket concept of liability refers to higher damage awards rendered by certain juries. D) All of the above explain why the number of lawsuits and the sizes of the awards remain high. Answer: D Terms: Major factors that have contributed to the continued high number of lawsuits against auditors Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking

4) The auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is "foreseen" by the auditor. Answer: TRUE Terms: Liability to clients under common law Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 5) Auditors have generally not been held liable for criminal acts in the courts. Answer: TRUE Terms: Liability to clients under statutory and common laws Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 6) Since the Sarbanes-Oxley Act of 2002, both the number of lawsuits and the sizes of awards to plaintiffs in the courts have been reduced against auditors. Answer: FALSE Terms: Liability to clients under statutory and common statutory laws Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking 7) Many CPA firms have strategically decided to settle lawsuits brought against them out of court in order to avoid adverse publicity and costly legal fees. Answer: TRUE Terms: CPA firm's strategies in court to settle lawsuits brought against them Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking 8) There have been, and continue to be, legislative efforts to control litigation costs against CPA firms by discouraging nonmeritorious lawsuits. Answer: TRUE Terms: Legislative efforts to control litigation costs against CPA firms Difficulty: Easy Objective: LO 5-1 AACSB: Reflective thinking

9) Discuss at least three major factors that have contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs. Answer: Major factors include: • The growing awareness of the responsibilities of public accountants by users of financial statements • The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations and financing transactions • The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with joint and several liability doctrine • The global recession and tough economic times result in business failures, which prompt stakeholders to seek restitution from others, including external auditors • Large civil court judgments against CPA firms awarded in a few cases • The willingness of CPA firms to settle legal problems out of court to avoid costly legal fees and adverse publicity, rather than pursuing resolution through the judicial process • The difficulty judges and jurors have understanding and interpreting technical accounting and auditing matters Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Difficulty: Moderate Objective: LO 5-1 AACSB: Reflective thinking

5.2 Learning Objective 5-2 1) A(n) ________ failure occurs when an auditor issues an erroneous opinion because it failed to comply with requirements of auditing standards. A) business B) audit C) ethics D) process Answer: B Terms: Failure which occurs when an auditor issues an erroneous opinion Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking 2) The expectation gap A) exists between the auditor and the SEC. B) exists because auditors guarantee the accuracy of the financial statements. C) often results in unwarranted lawsuits against the auditor. D) is a legal concept supported by the federal courts. Answer: C Terms: Expectation gap Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 3) Which of the following is an accurate statement regarding audit risk, audit failure, and business failure? A) Audit risk is always avoidable if the audit is conducted in accordance with generally accepted auditing standards. B) Because auditors gather evidence on a test basis, and because well-concealed frauds are difficult to detect, audit risk is unavoidable. C) Legal precedent makes it easy to determine who has the right to recover losses in the event of an audit failure. D) A business failure will always result in an audit failure. Answer: B Terms: Distinguish among business failure, audit failure, and audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 4) Audit risk is the risk there will be an audit failure for a given audit engagement. Answer: FALSE Terms: Audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 4 Copyright © 2023 Pearson Education, Inc.

5) The term "audit failure" refers to the situation when the auditor has followed auditing standards yet still fails to discover that the client's financial statements are materially misstated. Answer: FALSE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 6) The term "audit failure" refers to the situation when the auditor issues an incorrect audit opinion that a qualified auditor, following auditing standards, would have not issued. Answer: TRUE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 7) The term "business failure" has basically the same meaning as "audit failure" as they pertain the auditing profession. Answer: FALSE Terms: Audit failure compared to business failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 8) Audit risk is avoidable, as long as the auditor performs the audit in accordance with auditing standards. Answer: FALSE Terms: Audit risk Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 9) When an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is not appropriate to question whether the auditor exercised due professional care in the performance of the audit. Answer: FALSE Terms: Audit failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking

10) There is a public perception that auditors guarantee the accuracy of the financial statements they have audited and guarantee the financial viability of the business. Answer: TRUE Terms: Audit failure and business failure Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 11) The term "expectation gap" refers to the difference in the results of an audit between what an auditor expects and what users of the financial statements audited by the auditor expect. Answer: TRUE Terms: Expectation gap Difficulty: Moderate Objective: LO 5-2 AACSB: Reflective thinking 12) The legal issue with regards to the Big Four CPA firms being required to comply with the Fair Labor Standards Act with regards to overtime pay policies and procedures is settled. Answer: FALSE Terms: Fair Labor Standards Act Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking 13) Distinguish between what is meant by business failure and audit failure. Answer: Business failure occurs when a business is unable to repay its lenders or meet expectations of its investors because of economic or business conditions, such as recession, poor management decisions, or unexpected competition in the industry. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards. Terms: Business failure and audit failure Difficulty: Easy Objective: LO 5-2 AACSB: Reflective thinking

5.3 Learning Objective 5-3 1) In the performance of an audit, a CPA A) is legally liable for detecting an immaterial client fraud. B) must strictly follow GAAP for privately held clients. C) must exercise constructive professional care in the performance of their audit responsibilities. D) must exercise due professional care in the performance of their audit responsibilities. Answer: D Terms: Prudent person concept; due professional care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 2) If an auditor fails to fulfill a certain requirement in the contract, they may be guilty of A) contract fraud. B) breach of contract. C) constructive fraud. D) criminal neglect. Answer: B Terms: Liability when auditors fail to exercise due care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 3) In the case of an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intent to deceive financial statement users. This is a description of the legal term A) ordinary negligence. B) gross negligence. C) constructive fraud. D) fraud. Answer: C Terms: Prudent person concept; due professional care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

4) The standard of due care to which the auditor is expected to adhere in the performance of the audit is referred to as the A) prudent person concept. B) common law doctrine. C) constructive care concept. D) vigilant person concept. Answer: A Terms: Standard of due care Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 5) Auditors may be liable to their clients if they are found guilty of A) Ordinary negligence Gross negligence Yes Yes B) Ordinary negligence No

Gross negligence No

Ordinary negligence Yes

Gross negligence No

Ordinary negligence No

Gross negligence Yes

Answer: A Terms: Auditor liability to clients Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 6) Under the laws of agency, partners of a CPA firm may be liable for the work of others on whom they rely. This would not include A) employees of the CPA firm. B) employees of the audit client. C) other CPA firms engaged to do part of the audit work. D) specialists employed by the CPA firm to provide technical advice on the audit. Answer: B Terms: Liability for the acts of others Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

7) "Absence of reasonable care that can be expected of a person in a set of circumstances" defines A) pecuniary negligence. B) gross negligence. C) extreme negligence. D) ordinary negligence. Answer: D Terms: Absence of reasonable care Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 8) An example of a breach of contract would likely include A) an auditor's refusal to return the client's general ledger book until the client paid last year's audit fees. B) a bank's claim that an auditor had a duty to uncover material errors in financial statements that had been relied on in making a loan. C) a CPA firm's failure to complete an audit on the agreed-upon date because the firm had a backlog of other work which was more lucrative. D) an auditor's claim that the client staff is unqualified. Answer: C Terms: Breach of contract Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 9) Privity of contract exists between A) auditor and the federal government. B) auditor and third parties. C) auditor and client. D) auditor and client attorney. Answer: C Terms: Privity of contract Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

10) An individual who is not party to the contract between a CPA and the client, but who is known by both and is intended to receive certain benefits from the contract is known as A) a third party. B) a common law inheritor. C) a tort. D) a third-party beneficiary. Answer: D Terms: Individual who is not a party to the contract between a CPA and client Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 11) Laws that have been passed by the U.S. Congress and other governmental units are A) statutory laws. B) judicial laws. C) federal laws. D) common laws. Answer: A Terms: Laws passed through governmental units Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 12) The assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing is called A) separate and proportionate liability. B) shared liability. C) unitary liability. D) joint and several liability. Answer: D Terms: Assessment against a defendant of the full loss suffered by a plaintiff Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 13) The assessment against a defendant of that portion of the damage caused by the defendant's negligence is called A) separate and proportionate liability. B) joint and several liability. C) shared liability. D) unitary liability. Answer: A Terms: Assessment against a defendant of that portion of the damages Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 10 Copyright © 2023 Pearson Education, Inc.

14) Fraud occurs when A) a misstatement is made and there is both knowledge of its falsity and the intent to deceive. B) a misstatement is made and there is knowledge of its falsity but no intent to deceive. C) the auditor lacks even slight care in the performance in performing the audit. D) the auditor has an absence of reasonable care in the performance of the audit. Answer: A Terms: Fraud and errors Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 15) Which of the following most accurately describes constructive fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: D Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 16) Which of the following most accurately describes fraud? A) absence of reasonable care B) lack of slight care C) knowledge and intent to deceive D) extreme or unusual negligence without the intent to deceive Answer: C Terms: Fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 17) A third-party beneficiary is one which A) has failed to establish legal standing before the court. B) does not have privity of contract and is unknown to the contracting parties. C) does not have privity of contract, but is known to the contracting parties and intended to benefit under the contract. D) may establish legal standing before the court after a contract has been consummated. Answer: C Terms: Third-party beneficiary Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

18) If the CPA negligently failed to properly prepare and file a client's tax return, the CPA may be liable for A) the penalties the client owes the IRS. B) the penalties and interest the client owes. C) the penalties and interest the client owes, plus the tax preparation fee the CPA charged. D) the penalties and interest, the tax preparation fee, and the amount of tax that was underpaid. Answer: C Terms: Liability when a CPA negligently failed to properly prepare and file tax return Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 19) Constructive fraud A) is also known as recklessness. B) requires an intent to deceive. C) involves collusion with the client. D) is also known as breach of contract. Answer: A Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Analytic thinking

20) Which of the following statements is true? A) Gross negligence Fraud requires the All fraud should be may constitute intent to deceive detected during audit constructive fraud Yes Yes No B) Gross negligence may constitute constructive fraud No C) Gross negligence may constitute constructive fraud Yes D) Gross negligence may constitute constructive fraud No

Fraud requires the intent to deceive

All fraud should be detected during audit

Yes

Fraud requires the intent to deceive

All fraud should be detected during audit

Yes

Fraud requires the intent to deceive

All fraud should be detected during audit

Answer: A Terms: Gross negligence, fraud, and constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 21) The laws that have been developed through court decisions are called A) common laws. B) criminal laws. C) statutory laws. D) civil laws. Answer: A Terms: Common law Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

22) Which of the following is a true statement regarding CPAs' liability? A) The amounts assessed under joint and several liability will not differ significantly from the amounts assessed under separate and proportionate liability. B) When lawsuits are brought under the federal securities laws, the joint and several liability approach will always apply. C) If one owner was directly involved in the actions of the owner causing the liability, the personal assets of neither owner can be subject to the damages that arise. D) Under the federal statutes, the amount of damages under separate and proportionate liability can be increased if the main defendant is insolvent. Answer: D Terms: Assessment against a defendant of that portion of the damages Difficulty: Challenging Objective: LO 5-3 AACSB: Reflective thinking 23) The legal term for when an auditor issues an audit opinion, knowing that an adequate audit was not performed, is a A) breach of contract. B) tort action for negligence. C) constructive fraud. D) fraud. Answer: C Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 24) The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept. Answer: TRUE Terms: Standard of due care; Prudent person concept Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 25) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions does not extend to another partner's personal assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking

26) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions extends to the firm's assets. Answer: TRUE Terms: CPA firm operating as a limited liability partnership Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 27) Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units. Answer: FALSE Terms: Statutory laws Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 28) When an auditor has failed to conduct an adequate audit, liability may depend on the level of negligence. Answer: TRUE Terms: Liability and level of negligence Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 29) Several states have statutes that permit privileged communication between the client and auditor, allowing a CPA to refuse to testify in state and federal courts. Answer: FALSE Terms: CPA and privileged communication Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 30) Gross negligence is the existence of extreme or unusual negligence with the intent to deceive. Answer: FALSE Terms: Gross negligence Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 31) Under common law, CPAs have the right to withhold information from the courts on the grounds that such information is privileged. Answer: FALSE Terms: Lack of privileged communication Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 15 Copyright © 2023 Pearson Education, Inc.

32) Under Federal statutes, the amount of damages under separate and proportionate liability can be increased to 200 percent of the amount determined to be proportionate to the CPA's degree of fault when the main defendant is insolvent. Answer: FALSE Terms: Separate and proportionate liability Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 33) Define ordinary negligence, gross negligence, and constructive fraud. Answer: Ordinary negligence is the absence of reasonable care that can be expected of a person is a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation. Gross negligence is the lack of even slight care, tantamount to reckless behavior, that can be expected of a person in a set of circumstances. Some states do not distinguish between ordinary and gross negligence. Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or to do harm. It is also termed recklessness. In an audit, recklessness is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users. Terms: Ordinary negligence, gross negligence, and constructive fraud Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 34) An important concept in contract law for accountants to understand is the "third-party beneficiary doctrine." Explain and give an example. Answer: A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. Example: bank has a large loan outstanding at the balance sheet date and requires an audit as part of the loan agreement. Terms: Contract law; Third-party beneficiary doctrine Difficulty: Easy Objective: LO 5-3 AACSB: Reflective thinking 35) Distinguish between constructive fraud and fraud. Answer: Constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. In contrast, fraud occurs when a misstatement is made and there is both knowledge of its falsity and the intent to deceive. Terms: Constructive fraud Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

36) Distinguish between "joint and several liability" and "separate and proportionate liability." Answer: Under joint and several liability, the defendant can be assessed the full loss suffered by the plaintiff, regardless of the extent to which other parties shared in the wrongdoing. In contrast, under separate and proportionate liability, the defendant is assessed that portion of the damage caused by the defendant's negligence. Terms: Joint and several liability and separate and proportionate liability Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

37) Match seven of the legal terms (a-j) with the definitions provided below (1-7). a. b. c. d. e. f. g. h. i. j.

common law constructive fraud breach of contract joint and several liability ordinary negligence third-party beneficiary gross negligence statutory law fraud separate and proportionate liability

________ 1.

laws that have been passed by the U.S. Congress and other governmental units

________ 2. absence of reasonable care that can be expected of a person in a set of circumstances ________ 3. lack of even slight care, tantamount to reckless behavior that can be expected of a person ________ 4. the assessment against a defendant of that portion of the damage caused by the defendant's negligence ________ 5. failure of one or both parties in a contract to fulfill the requirements of the contract ________ 6. the assessment against a defendant of the full loss suffered by a plaintiff regardless of the extent to which other parties shared in the wrongdoing ________ 7. existence of extreme or unusual negligence even though there was no intent to deceive or do harm; also termed recklessness Answer: 1. h 2. e 3. g 4. j 5. c 6. d 7. b Terms: Constructive fraud; Breach of contract; Joint and several liability; Separate and proportionate liability; Gross negligence; Ordinary negligence; Statutory law Difficulty: Moderate Objective: LO 5-3 AACSB: Reflective thinking

5.4 Learning Objective 5-4 1) The principal issue in cases involving alleged negligence is usually A) if an engagement letter was issued. B) the level of care required. C) if fraud was committed by upper-level management. D) whether the auditor is liable under civil or criminal laws. Answer: B Terms: Level of care; Negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 2) Which of the auditor's defenses against client suits contends no implied or expressed contract? A) lack of duty B) non-negligent performance C) contributory negligence D) absence of causal connections Answer: A Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 3) In connection with the audit of financial statements, an independent auditor could be responsible for failure to detect a material fraud if A) statistical sampling techniques were not used on the audit engagement. B) the auditor planned the audit in a negligent manner. C) accountants performing important parts of the work failed to discover a close relationship between the treasurer and the cashier. D) the fraud was perpetrated by one employee who circumvented the existing system of internal controls. Answer: B Terms: Independent auditor could be responsible for failure to detect material fraud Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking

4) Which of the following is an illustration of liability to clients under common law? A) A client sues the auditor for not discovering a theft of assets by an employee. B) A bank sues the auditor for not discovering that the borrower's financial statements are misstated. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements. D) The federal government prosecutes the auditor for knowingly issuing an incorrect audit report. Answer: A Terms: Liability to clients under common law Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 5) Which of the following is an illustration of civil liability under the federal securities laws? A) A client sues the auditor for not discovering a theft of assets by an employee. B) A bank sues the auditor for not discovering that the borrower's financial statements are misstated. C) A combined group of stockholders sues the auditor for not discovering materially misstated financial statements. D) The auditor sues a client for not cooperating during the engagement. Answer: C Terms: Liability under federal securities acts Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 6) A CPA firm normally uses one or a combination of four defenses when there are legal claims by clients. Which one of the following is generally not a defense? A) lack of duty B) nonnegligent performance C) contributory negligence D) foreseeable users Answer: D Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

7) Tort actions against CPAs are more common than breach of contract actions because A) there are more torts than contracts. B) the burden of proof is on the auditor rather than on the person suing. C) the person suing need prove only negligence. D) the amounts recoverable are normally larger. Answer: D Terms: Tort actions against CPAs Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 8) The principal issue to be resolved in cases involving alleged negligence is usually A) the amount of the damages suffered by plaintiff. B) whether to impose punitive damages on defendant. C) the level of care exercised by the CPA. D) whether defendant was involved in fraud. Answer: C Terms: Principal issue to be resolved in cases involving alleged negligence Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 9) In the auditing environment, failure to meet auditing standards is often A) an accepted practice. B) a suggestion of negligence. C) conclusive evidence of negligence. D) tantamount to criminal behavior. Answer: C Terms: Failure to meet auditing standards Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 10) A common way for a CPA firm to demonstrate a lack of duty by a client to perform is by use of a(n) A) expert witness' testimony. B) engagement letter. C) management representation letter. D) confirmation letter. Answer: B Terms: Common way to demonstrate lack of duty to perform Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

11) To succeed in an action against the auditor, the client must be able to show that A) the auditor was fraudulent. B) the auditor was grossly negligent. C) there was a written contract. D) there is a close causal connection between the auditor's failure to follow auditing standards and the damages suffered by the client. Answer: D Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 12) Which of the following is a true statement regarding auditors' liability? A) The level of care is easy to determine in a review or compilation. B) Engagement letters will relieve the auditor of all liability. C) An auditor will always be guilty of negligence if they fail to uncover fraud. D) The most common source of lawsuits against CPAs is from clients. Answer: D Terms: Auditors' liability to clients Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 13) One of the changes in auditing procedures which was brought about as a result of the 1136 Tenants case was that auditors were encouraged to begin using A) letters of representation. B) confirmation letters. C) engagement letters. D) billet doux letters. Answer: C Terms: Audit procedure brought about by 1136 Tenants case Difficulty: Challenging Objective: LO 5-4 AACSB: Reflective thinking

14) The King Surety Company wrote a general fidelity bond covering thefts of assets by the employees of Wilson, Inc. Thereafter, Cooney, an employee of Wilson, embezzled $17,200 of company funds. When the activities were discovered, King paid Wilson the full amount in accordance with the terms of the fidelity bond, and then sought recovery against Wilson's auditors, Lynch & Merritt, CPAs. Which of the following would be Lynch & Merritt's best defense? A) King is not in privity of contract. B) The shortages were the result of clever forgeries and collusive fraud which would not be detected by an examination made in accordance with generally accepted auditing standards. C) Lynch & Merritt were not guilty either of gross negligence or fraud. D) Lynch & Merritt were not aware of the King-Wilson surety relationship. Answer: B Terms: Defense in recovery against auditors with employee theft Difficulty: Challenging Objective: LO 5-4 AACSB: Analytic thinking 15) An auditor working for a CPA firm was found to be guilty of extreme or unusual negligence, though it was not proven that the auditor intended to deceive or do harm in the performance of an audit. Which of the terms related to negligence and fraud is this situation describing? A) fraud B) ordinary negligence C) constructive fraud D) gross negligence Answer: C Terms: Terms related to negligence and fraud Difficulty: Challenging Objective: LO 5-4 AACSB: Analytic thinking 16) Which of the following auditor's defenses usually means nonreliance on the financial statements by the user? A) lack of duty B) non-negligent performance C) absence of causal connections D) contributory negligence Answer: C Terms: Auditor defenses against third party suits Difficulty: Easy Objective: LO 5-4 AACSB: Analytic thinking

17) An example of auditor legal liability to third parties under common law would be the federal government prosecuting an auditor for knowingly issuing an incorrect audit report. Answer: FALSE Terms: Four major sources of auditors' legal liability Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 18) The 1136 Tenants case was a criminal case concerning a CPA's failure to uncover fraud during a financial statement audit. Answer: FALSE Terms: 1136 Tenants case Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 19) Many litigation experts believe that a well written engagement letter significantly reduces the likelihood of adverse legal actions. Answer: TRUE Terms: Reasons for an audit and audit evidence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 20) Constructive fraud is also termed recklessness as it pertains to CPAs' potential liability. Answer: TRUE Terms: Constructive fraud Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 21) The Sarbanes-Oxley Act of 2002 is an example of a statutory law passed by the U.S. Congress which affects auditors. Answer: TRUE Terms: Statutory law Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking

22) An example of a third-party beneficiary under contract law includes a bank having a large loan with a client which requires an audit as part of the loan agreement. In these cases, though the contract for the audit engagement is between the auditor and the client, both the auditor and the client are aware that the bank will be relying on the audited financial statements. Answer: TRUE Terms: Contract law and third-party beneficiaries Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 23) In audits, failure of the auditor to meet auditing standards are not, by themselves, conclusive evidence of negligence. Answer: FALSE Terms: Audits and evidence of negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 24) The question of level of care is similar where the auditor is involved in a compilation or a review of financial statements. Answer: FALSE Terms: Level of care Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 25) A CPA firm is sued after performing a review of a client's financial statements for not uncovering a material misstatement. The CPA firm in this situation can claim lack of duty as a legal defense. Answer: TRUE Terms: Lack of duty Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 26) Even if the auditor conducts an audit properly, the auditor can be held legally responsible if subsequently there are undiscovered misstatements in the financial statements. Answer: FALSE Terms: Nonnegligent performance Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

27) A CPA firm notifies their audit client of a material weakness in internal controls in the warehouse storing inventories. Subsequently, the client discovers a large theft of inventory in the warehouse. In this case, the CPA firm would have the defense of contributor negligence. Answer: TRUE Terms: Contributory negligence Difficulty: Easy Objective: LO 5-4 AACSB: Reflective thinking 28) Assume that an auditor failed to complete an audit for a client on an agreed-upon date. The client files a lawsuit against the auditor, claiming that this delay caused the client to delay a public offering of common stock. A potential defense for the auditor is that the public offering was delayed by the underwriters due to the weakening financial condition of the client. Answer: TRUE Terms: Absence of casual connection Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking 29) There are four major sources of an auditor's legal liability. One source is liability to the audit client. List the other three sources. Answer: The other three sources of auditor's legal liability are: • liability to third parties under common law • civil liability under federal securities laws • criminal liability Terms: Sources of auditor's legal liability Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

30) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Answer: Lack of duty. The CPA firm claims that there was no implied or expressed contract. Non-negligent performance. The CPA firm claims that the audit was performed in accordance with auditing standards. Contributory negligence. The CPA firm claims that the client's own actions resulted in the loss that is the basis for the damages, or interfered with the conduct of the audit in such a way that prevented that auditor from discovering the cause of the loss. This defense is not available in third-party suits. Absence of causal connection. The CPA firm claims that the auditor's failure to follow auditing standards did not cause the damages suffered by the client. Terms: Auditors' defenses against lawsuits Difficulty: Moderate Objective: LO 5-4 AACSB: Reflective thinking

5.5 Learning Objective 5-5 1) A financial institution sues the audit firm for failure to discover that a borrower's financial statements are materially misstated. This is an example of which of the following legal liability concepts? A) liability to clients B) liability to third parties under common law C) civil liability under federal securities law D) criminal liability Answer: B Terms: Liability to third parties under common law Difficulty: Easy Objective: LO 5-5 AACSB: Reflective thinking 2) A group typically included as "third parties" in common law is A) Actual and potential stockholders Employees of client Yes Yes B) Actual and potential stockholders No

Employees of client No

C) Actual and potential stockholders Yes

Employees of client No

D) Actual and potential stockholders No Answer: A Terms: Third parties in common law Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking

Employees of client Yes

3) The major conclusion of the 1931 Ultramares case was that A) ordinary negligence is insufficient for liability to third parties. B) third parties must file criminal charges, not civil charges, against the auditor. C) fraud or gross negligence is sufficient for liability to third parties. D) auditors have no liabilities to third parties. Answer: A Terms: Major conclusion of 1931 Ultramares case Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

4) Under common law, a foreseen user would be treated the same as A) A primary beneficiary A known third party Yes Yes B) A primary beneficiary No

A known third party No

A primary beneficiary Yes

A known third party No

D) A primary beneficiary A known third party No Yes Answer: A Terms: Foreseen user under common law treated the same as Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 5) A broad interpretation of the rights of third-party beneficiaries holds that users whom the auditor should have been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. This is known as the concept of A) foreseen users. B) foreseeable users. C) expected users. D) four-party contracts. Answer: B Terms: Rights of third-party beneficiaries; Privity of contract Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 6) Which of the auditor's defenses is ordinarily not available when lawsuits are filed by a third party? A) absence of causal connections B) contributory negligence C) nonnegligent performance D) lack of duty Answer: B Terms: Auditor defenses against third party suits Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

7) According to the principle established by the Restatement of Torts, foreseen users must be members of A) any potential user group. B) a legally protected class. C) a reasonably limited and identifiable user group. D) a reasonably limited and established user group. Answer: C Terms: Principle established by Restatement of Torts Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 8) Under the Ultramares doctrine, ordinary negligence is insufficient for liability to third parties unless the third party is A) a primary beneficiary. B) an injured party. C) a foreseen user. D) a bank. Answer: A Terms: Ultramares doctrine Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 9) Under common law, an individual or company that (1) does not have a contract with an auditor, (2) is known by the auditor in advance of the audit, and (3) will use the auditor's report to make decisions about the client company has A) no rights unless an auditor is grossly negligent. B) no rights unless an auditor is fraudulent. C) no rights against an auditor. D) the same rights against an auditor as a client. Answer: D Terms: Common law third-party rights Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking

10) The basic legal concept which was affirmed in the 1986 New York case, Credit Alliance, was that A) the auditor's defense of privity of contract is still valid. B) the auditor is liable for ordinary negligence to specifically foreseen third parties. C) the auditor is liable for ordinary negligence to reasonably foreseeable third parties. D) the auditor's defense of contributory negligence is no longer valid. Answer: A Terms: Basic legal concept affirmed in 1986 case, Credit Alliance Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 11) As a consequence of his failure to adhere to generally accepted auditing standards in the course of his examination of the Lamp Corp., Harrison, CPA, did not detect the embezzlement of a material amount of funds by the company's controller. As a matter of common law, to what extent would Harrison be liable to the Lamp Corp. for losses attributable to the theft? A) He would have no liability, since the ordinary examination cannot be relied upon to detect thefts of assets by employees. B) He would have no liability because privity of contract is lacking. C) He would be liable for losses attributable to his negligence. D) He would be liable only if it could be proven that he was grossly negligent. Answer: C Terms: Under common law, extent of liability where auditor failed to adhere to generally accepted auditing standards in examination of client and failed to detect employee embezzlement Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 12) If an auditor is unsuccessful in using the lack of duty defense to have a case dismissed in a third-party suit, the preferred defense is A) lack of duty to perform. B) nonnegligent performance. C) absence of causal connection. D) client fraud. Answer: B Terms: Preferred defense in third-party suits Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking

13) In the Rusch Factors v. Levin (1968) case, which of the following approaches did the court take to assign third-party liability under common law? A) primary beneficiary B) foreseeable user C) foreseen user D) identified user Answer: C Terms: Under common law, extent of third-party liability Difficulty: Challenging Objective: LO 5-5 AACSB: Analytic thinking 14) Although there is confusion caused by the differing views of liability to third parties under common law, the movement is clearly away from the foreseeable user approach. Answer: TRUE Terms: Foreseeable user approach Difficulty: Moderate Objective: LO 5-5 AACSB: Reflective thinking 15) The broadest interpretation of the right of third-party beneficiaries is the primary user concept. Answer: FALSE Terms: Third-party liability under common law Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking 16) The Credit Alliance approach to the concept of foreseen users states that to be liable to third parties, an auditor (1) must know and intend that the work product would be used by the thirdparty for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct. Answer: TRUE Terms: Credit Alliance approach Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking

17) Three approaches to the application of the foreseen users' concept are (1) the Credit Alliance approach, (2) the Restatement of Torts approach, and (3) the foreseeable user approach. Summarize each of these three approaches. Answer: The Credit Alliance approach upholds the concept of privity of contract established by the Ultramares Corporation v. Touche case. Under this approach, for an auditor to be liable to third parties, the auditor (1) must know and intend that the work product would be used by the third-party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor's conduct. Under the Restatement of Torts approach, foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA's work, such as creditors, even though those persons were not specifically known to the CPA at the time the work was done. Under the foreseeable user approach, any users that the auditor should have reasonably been able to foresee as likely users of the client's financial statements have the same rights as those with privity of contract. Terms: Three approaches to the application of foreseen users' concepts Difficulty: Challenging Objective: LO 5-5 AACSB: Reflective thinking

5.6 Learning Objective 5-6 1) An adequate system of internal control for SEC registrants was originally required by the A) Sarbanes-Oxley Act of 2002. B) Securities Act of 1933. C) Foreign Corrupt Practices Act of 1977. D) Securities Act of 1934. Answer: C Terms: Required an adequate system of internal control for SEC registrants Difficulty: Easy Objective: LO 5-6 AACSB: Reflective thinking 2) The increased litigation under the federal securities laws has resulted from A) The availability of class- The strict liability standards An excess of attorneys action litigation imposed on CPAs by the securities laws Yes Yes Yes B) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws Yes No C) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws Yes Yes D) The availability of class- The strict liability standards action litigation imposed on CPAs by the securities laws No No

An excess of attorneys

Answer: C Terms: Increased litigation under federal securities law Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

3) Under the Securities Act of 1933, the auditor's responsibility for making sure the financial statements were fairly stated extends to A) the date of the financial statements. B) the date the registration statement becomes effective. C) the date of the audit report. D) one year beyond the date of the financial statements. Answer: B Terms: Securities Act of 1933 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 4) Under the Securities Exchange Act of 1934, which type of organization is required to submit audited financial statements to the SEC? A) every company with securities traded on national and over-the-counter exchanges B) every corporation C) every company issuing new securities D) every corporation which is chartered by a state government Answer: A Terms: Securities Act of 1934; Organizations required to submit audited financial statements Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 5) The Securities and Exchange Commission can impose all but which of the following sanctions? A) suspend a CPA from auditing SEC clients B) prohibit a CPA from accepting new SEC clients for a period of time C) require a CPA to participate in continuing-education programs and make changes in their practice D) revoke a CPA license Answer: D Terms: Securities and Exchange Commission can impose sanctions Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

6) The Foreign Corrupt Practices Act (FCPA) of 1977 A) requires auditors to review and evaluate system of internal control as a part of an audit. B) requires SEC registrants to maintain a reasonably complete and accurate set of records and an adequate system of internal control. C) requires auditors to review client's internal control system in a manner which is thorough enough to judge whether client meets the requirements of the FCPA. D) requires auditors to file a report with the SEC if client's internal control system is inadequate. Answer: B Terms: Foreign Corrupt Practices Act of 1977 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 7) While the Foreign Corrupt Practices Act of 1977 remains in effect, its internal control provisions have been largely superseded by which of the following? A) Sarbanes-Oxley Act of 2002 B) Racketeer Influenced and Corrupt Organization Act C) Federal False Statements Statute D) Federal Mail Fraud Statute Answer: A Terms: Foreign Corrupt Practices Act of 1977; Internal control provisions Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 8) Which of the following is an accurate statement regarding recent actions brought against accountants by clients and third parties? A) Litigants will first seek state remedies because of the availability of class-action litigation. B) Gross negligence by the auditor must be proven under the Securities Acts of 1933 and 1934. C) The greatest growth in CPA liability litigation has been under the federal securities laws. D) The amount of damages that plaintiffs can receive is greater under common law than under the federal securities laws. Answer: C Terms: Factor in increase in number of lawsuits and sizes of awards Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

9) A major purpose of federal securities regulations is to A) provide sufficient reliable information to the investing public who purchase securities in the marketplace. B) establish the qualifications for accountants who are members of the profession. C) eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public. D) provide a set of uniform standards and tests for accountants, attorneys, and others who practice before the Securities and Exchange Commission. Answer: A Terms: Major purpose of federal securities regulations Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 10) The 2020 case charging Goldman Sachs in a massive bribery scheme brought charges against the company under the A) Securities Act of 1933. B) Securities Act of 1934. C) Foreign Corrupt Practices Act of 1977. D) Sarbanes-Oxley Act of 2002. Answer: C Terms: Foreign Corrupt Practices Act of 1977 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 11) Which of the following statements about the Securities Act of 1933 is not true? A) A third party that purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in the audited financial statements. B) A third-party user does not have the burden of proof that he/she relied on the financial statements. C) A third-party user has the burden of proof that the auditor was either negligent or fraudulent in doing the audit. D) A third-party user does not have the burden of proof that the loss was caused by the misleading statements. Answer: C Terms: Securities Act of 1933 Difficulty: Challenging Objective: LO 5-6 AACSB: Analytic thinking

12) The most significant audit issue that came as a result of the court decision in the Escott et al. v. BarChris Construction Corporation case in 1968 was A) the court's reaffirmation that the burden of proof was on the plaintiff to prove the auditor was negligent. B) the affirmation of an increase in the auditor's responsibility when performing a review of events subsequent to the balance sheet date (S-1 review) for registration statements. C) the increased auditor responsibility when associated with unaudited financial statements. D) the court's refusal to allow the percentage-of-completion method of accounting for revenues. Answer: B Terms: Significant audit issue from Escott et al v. BarChris Construction Corporation case Difficulty: Challenging Objective: LO 5-6 AACSB: Reflective thinking 13) One significant result of the Escott et al. v. BarChris Construction Corporation case was A) a greater emphasis on subsequent events procedures. B) new standards for unaudited statements. C) a broader definition of third-party beneficiaries. D) a requirement that more companies file annual reports with the SEC. Answer: A Terms: Significant result from Escott et al v. Bar Chris Construction Corporation case Difficulty: Challenging Objective: LO 5-6 AACSB: Reflective thinking 14) Under the Securities Exchange Act of 1934, most of the litigation against the auditor has been generated because of the auditor's involvement with the A) 8-K form. B) 10-K form. C) 10-Q form. D) S-1 form. Answer: B Terms: Securities Exchange Act of 1934 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 15) Section 10 and Rule 10b-5 of the Securities Exchange Act of 1934 are often referred to as A) the antifraud provisions. B) the new issues provisions. C) the full employment act for accountants. D) the RICO provisions. Answer: A Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 38 Copyright © 2023 Pearson Education, Inc.

16) The U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst that before CPAs could be held liable for Rule 10b-5 of the Securities Exchange Act of 1934, the auditor's ________ would be required to be shown to the court. A) ordinary negligence B) gross negligence C) knowledge and intent to deceive D) financial gain at the expense of the plaintiff Answer: C Terms: Securities Exchange Act of 1934 Rule 10b-5; U.S. Supreme Court ruled in 1976 in Hochfelder v. Ernst & Ernst Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 17) Under the Securities Act of 1933, A) any party who relies on the company's audited financial statements can recover from the auditors. B) third-party users must prove that the auditor was negligent. C) the burden of proof is on the defendant. D) auditors face potential legal exposure for information contained in the Form 10-Q. Answer: C Terms: Securities and Exchange Commission Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 18) Which of the following is an accurate statement regarding Rule 10b-5 of the Securities Exchange Act of 1934? A) The Supreme Court has ruled that liability under Rule 10b-5 does not extend to aiders or abettors who participated in financial statement misstatements that were not the primary defendants. B) Federal court decisions have clarified that Rule 10b-5 applies only to direct sellers. C) Hochfelder and subsequent court decisions have increased the liability of auditors under Rule 10b-5. D) According to most recent court decisions, poor judgment is proof of fraud. Answer: A Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Difficulty: Moderate Objective: LO 5-6 AACSB: Analytic thinking

19) One result from the Escott et al. v. BarChris case was a greater emphasis being placed on the audit staff's understanding of the client's business and industry. Answer: TRUE Terms: Escott et al. v. BarChris Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 20) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities. Answer: TRUE Terms: Securities Act of 1933 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 21) Under the Securities Act of 1933, a third-party plaintiff does not have the burden of proof that he or she relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Rather, the plaintiff need only prove that the audited financial statements contained a material misrepresentation or omission. Answer: TRUE Terms: Securities Act of 1933; Burden of proof Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 22) Companies with securities traded on national and over-the-counter exchanges are required to submit audited financial statements once every three years to the Securities and Exchange Commission. Answer: FALSE Terms: Securities Act Commission; Securities traded on national exchanges Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 23) The same three defenses available to auditors in common lawsuits by third parties— nonnegligent performance, lack of duty, and absence of causal connection—are also available for suits under the Securities Exchange Act of 1934. Answer: TRUE Terms: Securities Act of 1934; Defenses available to auditors in common law suits by third parties Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

24) The defense of contributory negligence by a third party is often used by auditors if charged with a violation of the 1934 Securities Act. Answer: FALSE Terms: Securities Exchange Act of 1934 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 25) The Sarbanes-Oxley Act requires the CEO and CFO of a public company to certify the annual and quarterly financial statements filed with the PCAOB. Answer: FALSE Terms: Sarbanes-Oxley Act Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 26) Auditors do not face legal exposure related to their client's filings of Form 10-Q quarterly information or Form 8-K unusual events with the Securities and Exchange Commission like they do for annual report filings under the Securities Exchange Act of 1934. Answer: FALSE Terms: Securities Exchange Act of 1934 auditor responsibilities Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 27) The same defenses available to auditors under common-law suits filed by third parties— nonnegligent performance, lack of duty, and absence of causal connection—are not available to auditors for lawsuits under the Securities Act of 1934. Answer: FALSE Terms: Auditor defenses — 1934 Act Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 28) Little enforcement of the provisions of the Foreign Corrupt Practices Act (FCPA) has been required since management's responsibilities were reinforced and extended by the SarbanesOxley Act of 2002. Answer: FALSE Terms: Enforcement of FCPA Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking

29) Discuss the sanctions the Securities and Exchange Commission can impose on auditors. Answer: The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. The SEC's Rules of Practice permit them to temporarily or permanently deny a CPA or CPA firm from being associated with financial statements of public companies, either because of lack of appropriate qualifications or having engaged in unethical or improper professional conduct. In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits of SEC clients. It has also prohibited a number of CPA firms from accepting any new SEC clients for a period. In some cases, the SEC has required an extensive review of a major CPA firm's practices by another CPA firm, or made CPA firms make changes in their practices. Individual CPAs and their firms have also been required to participate in continuing education programs. Sanctions such as these are published by the SEC and are often reported in the business press, making them a significant embarrassment to those involved. Terms: Securities Exchange Act of 1934 Section 10 and Rule 10b-5 Difficulty: Moderate Objective: LO 5-6 AACSB: Reflective thinking 5.7 Learning Objective 5-7 1) In which case were auditors prosecuted for filing false financial statements for a client with the government? A) United States v. Natelli B) United States v. Simon C) Escott et al. v. BarChris D) ESM Government Securities v. Alexander Grant & Co. Answer: B Terms: Case where auditors were prosecuted for filing false financial statements Difficulty: Moderate Objective: LO 5-7 AACSB: Reflective thinking 2) A CPA is subject to criminal liability to defraud another person if the CPA A) refuses to turn over requested audit documentation to a client. B) performs an audit in a negligent manner. C) is knowingly involved with false financial statements. D) willfully breaches a contract with a client. Answer: C Terms: CPA subject to criminal liability Difficulty: Moderate Objective: LO 5-7 AACSB: Reflective thinking

3) Critical lessons learned after analyzing major criminal cases against auditors include the fact that A) the partner, but not the audit staff, must be independent. B) transactions with related parties are an indication of fraud. C) an investigation of the integrity of management is an important part of deciding whether to accept a new client. D) accounting principles can be relied on exclusively in deciding if the financial statements are fairly presented. Answer: C Terms: CPAs held liable for criminal activity and federal laws; Infamous cases Difficulty: Moderate Objective: LO 5-7 AACSB: Reflective thinking 4) The Sarbanes-Oxley Act of 2002 makes it a felony to destroy or create documents to impede or obstruct a federal investigation. Those provisions were adopted following which of the following legal cases? A) United States v. Natelli B) United States v. Andersen C) ESM Government Securities v. Alexander Grant & Co. D) United States v. Simon Answer: B Terms: CPAs held liable for criminal activity and federal laws; Infamous cases Difficulty: Moderate Objective: LO 5-7 AACSB: Analytic thinking 5) With regards to the three major criminal cases (United States v. Natelli (1985); United States v. Weiner (1975); and ESM Government Securities v. Alexander Grant & Co. (1986)), which of the following is not a critical lesson learned from these cases? A) Transactions with related parties require special scrutiny by the auditor. B) Accounting principles can be relied upon exclusively by the auditor in deciding whether financial statements are fairly presented. C) Independence by all individuals involved on the audit engagement is essential. D) An investigation by the auditor of the integrity of management is important. Answer: B Terms: CPAs held liable for criminal activity and federal laws; Infamous cases Difficulty: Challenging Objective: LO 5-7 AACSB: Analytic thinking

6) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to 10 years in prison. Answer: FALSE Terms: Sarbanes-Oxley Act of 2002; Destruction of audit documentation punishable Difficulty: Challenging Objective: LO 5-7 AACSB: Reflective thinking 7) CPAs can be held liable for criminal activity under both state and federal laws. Infamous cases include United States vs. Natelli and ESM Government Securities v. Alexander Grant & Co. Discuss what occurred in each case. Answer: Natelli — two auditors were convicted of criminal liability under the 1934 act for certifying financial statements of National Student Marketing Corporation that contained inadequate disclosures. ESM — management revealed to the partner in charge of the audit of ESM that the previous year's financial statements contained a material misstatement. Rather than complying with the profession and firm standards, the partner agreed to say nothing in the hope that management would work its way out of the problem during the current year. The partner was convicted of criminal charges for his role in sustaining the fraud. Terms: CPAs held liable for criminal activity and federal laws; Infamous cases Difficulty: Moderate Objective: LO 5-7 AACSB: Reflective thinking

5.8 Learning Objective 5-8 1) Which of the following resulted in a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation? A) Private Securities Litigation Reform Act B) Public Securities Damages and Settlements Act C) Racketeer Influenced and Corrupt Organization Act D) U.S. Securities Claims Reform Act Answer: A Terms: Federal law passed in 1995 significantly reduced potential damages Difficulty: Moderate Objective: LO 5-8 AACSB: Reflective thinking 2) In order to protect themselves from legal liability, it is important that CPAs A) are organized as sole-proprietors. B) accept client representations. C) understand the client's business. D) use engagement letters, not representation letters. Answer: C Terms: Protecting individual CPAs from legal liability Difficulty: Moderate Objective: LO 5-8 AACSB: Reflective thinking 3) The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to the amount of the audit fees charged. Answer: FALSE Terms: Private Securities Litigation Reform Act of 1995 Difficulty: Easy Objective: LO 5-8 AACSB: Reflective thinking 4) Discuss at least 3 steps the AICPA and the accounting profession as a whole are taking to reduce the practitioner's exposure to lawsuits. Answer: Steps the profession is taking to reduce practitioners' exposure to lawsuits include: • Set standards and revise them to meet the changing needs of auditing. • Oppose lawsuits. • Educate investors and other users of financial statements as to the meaning of an auditor's opinion and the extent and nature of the auditor's work. • Sanction members for improper conduct and performance. • Lobby for changes in laws. Terms: Steps the AICPA and accounting profession taking to reduce practitioner's exposure to lawsuits Difficulty: Moderate Objective: LO 5-8 AACSB: Reflective thinking 45 Copyright © 2023 Pearson Education, Inc.

5) Discuss at least three specific actions which practicing auditors can take to minimize their legal liability. Answer: Some of the more common actions practicing auditors can take to minimize their legal liability include: • Deal only with clients possessing integrity; clients lacking integrity in dealings with customers, suppliers, employees, and government-related officials and entities should be avoided. • Maintain independence. • Understand the client's business including industry practices and the client's operations. • Perform quality audits including obtaining appropriate evidence and make appropriate judgments about the evidence. • Document their work properly, including an engagement and a representation letter. • Exercise professional skepticism. Terms: Three specific actions auditors take to minimize legal liability Difficulty: Moderate Objective: LO 5-8 AACSB: Reflective thinking

6) Match eight of the following terms (a-n) with the definitions provided below (1-8). a. Foreign Corrupt Practices Act b. Securities Exchange Act of 1934 c. Securities Litigation Uniform Standards Act of 1998 d. Securities Act of 1933 e. Ultramares doctrine f. audit risk g. audit failure h. standards failure i. business failure j. absence of causal connection k. contributory negligence l. lack of duty to perform m. nonnegligent performance ________ 1. a situation in which an incorrect audit opinion is issued because it failed to comply with the requirements of auditing standards ________ 2. a federal statute dealing with companies that trade securities on national and overthe-counter exchanges. Auditors are involved because the annual reporting requirements include audited financial statements. ________ 3. an auditor's legal defense under which the auditor claims that the client's own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss ________ 4. a federal statute that makes it illegal to offer a bribe to an official of a foreign country ________ 5. a common-law approach to third-party liability in which ordinary negligence is insufficient for liability to third parties, because of the lack of privity of contract between the third-party and the auditor unless the third-party is a primary beneficiary ________ 6. a federal statute designed to significantly reduce the potential damages in federal securities-related litigation by providing for proportionate liability in most cases ________ 7. an auditor's legal defense under which the auditor claims that the audit was performed in accordance with generally accepted auditing standards ________ 8. an auditor's legal defense under which the auditor claims that the failure to follow auditing standards did not cause the damages suffered by the client

Answer: 1. g 2. b 3. k 4. a 5. e 6. c 7. m 8. j Terms: Audit failure; Securities Exchange Act of 1934; Contributory negligence; Foreign Corrupt Practices Act; Securities Litigation Uniform Standards Act of 1998; Ultramares doctrine; Nonnegligent performance; Absence of causal connection Difficulty: Moderate Objective: LO 5-8 AACSB: Reflective thinking 7) Discuss some of the steps practicing auditors can take to minimize their legal liability. Answer: There are many steps individual practitioners can take to minimize legal liability including: • Deal only with clients possessing integrity • Maintain independence • Understand the client's business • Perform quality audits • Document the work properly • Obtain an engagement letter and a representation letter • Exercise professional skepticism • Carry adequate insurance • Choose a form of organization that provides some form of legal liability protection to owners • Consult with experienced legal counsel in the event of actual or threatened litigation Terms: Steps auditors can take to minimize legal liability Difficulty: Easy Objective: LO 5-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 6 Audit Responsibilities and Objectives 6.1 Learning Objective 6-1 1) The objective of an audit of the financial statements is an expression of an opinion on A) the fairness of the financial statements in all material respects. B) the accuracy of the financial statements. C) the accuracy of the annual report. D) the accuracy of the balance sheet and income statement. Answer: A Terms: Objective of ordinary audit of financial statements Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking 2) If the auditor believes that the financial statements are not fairly stated or is unable to reach a conclusion because of insufficient evidence, the auditor A) should withdraw from the engagement. B) should request an increase in audit fees so that more resources can be used to conduct the audit. C) has the responsibility of notifying financial statement users through the auditor's report. D) should notify regulators of the circumstances. Answer: C Terms: Auditor believes that financial statements are nor fairly presented Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking 3) Auditors accumulate evidence to A) defend themselves in the event of a lawsuit. B) determine if the financial statements are correct. C) satisfy the requirements of the Securities Acts of 1933 and 1934. D) reach a conclusion about the fairness of the financial statements. Answer: D Terms: Auditors accumulate evidence Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking

4) Which of the following is not one of the steps used to develop audit objectives? A) know the proper type of audit opinion to issue B) divide the financial statements into cycles C) know management assertions about the financial statements D) know the specific audit objectives for classes of transactions Answer: A Terms: Steps the AICPA and accounting profession taking to reduce practitioner's exposure to lawsuits Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking 5) For publicly listed companies, the auditor also issues which of the following reports in addition to a report containing the auditor's opinion? A) a report on system of internal control over financial reporting B) a report on compliance with the Foreign Corrupt Practices Act (FCPA) C) a report on compliance with generally accepted accounting principles only D) a report on compliance with the Federal Securities Act Answer: A Terms: Objective of ordinary audit of publicly listed companies Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking 6) When developing the audit objectives, the first step is to divide the financial statements into cycles. Answer: FALSE Terms: Steps to develop audit objectives Difficulty: Easy Objective: LO 6-1 AACSB: Reflective thinking 7) One of the steps the auditor considers in developing the audit objectives is design the audit to provide users of the financial statements with absolute assurance that the statements are presented fairly in all material respects. Answer: FALSE Terms: Objective of ordinary audit of financial statements Difficulty: Moderate Objective: LO 6-1 AACSB: Reflective thinking

6.2 Learning Objective 6-2 1) The responsibility for adopting sound accounting policies and maintaining adequate system of internal control rests with the A) board of directors. B) company management. C) financial statement auditor. D) company's internal audit department. Answer: B Terms: Responsibility for adopting sound accounting policies and maintaining adequate system of internal controls Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 2) If management insists on financial statement disclosures that the auditor finds unacceptable, the auditor can withdraw from the engagement or A) Issue an adverse opinion Issue a qualified opinion Yes Yes B) Issue an adverse opinion No

Issue a qualified opinion No

Issue an adverse opinion Yes

Issue a qualified opinion No

Issue an adverse opinion No

Issue a qualified opinion Yes

Answer: A Terms: Auditor insists on financial statement disclosures that management finds unacceptable Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking

3) In certifying their annual financial statements, the CEO and CFO of a public company certify that the financial statements comply with the requirements of A) GAAP. B) the Sarbanes-Oxley Act. C) the Securities Exchange Act of 1934. D) GAAS. Answer: C Terms: Certifying annual financial statements by CEO and CFO Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 4) Which of the following statements is true of a public company's financial statements? A) Sarbanes-Oxley requires only the CEO to certify the financial statements. B) Sarbanes-Oxley requires only the CFO to certify the financial statements. C) Sarbanes-Oxley requires both the CEO and CFO to certify the financial statements. D) Sarbanes-Oxley requires neither the CEO nor the CFO to certify the financial statements. Answer: C Terms: Public company's financial statements Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 5) The responsibility for the preparation of the financial statements and the accompanying footnotes belongs to A) the auditor. B) management. C) both management and the auditor equally. D) management for the statements and the auditor for the notes. Answer: B Terms: Responsibility for preparation of the financial statements and the accompanying footnotes Difficulty: Moderate Objective: LO 6-2 AACSB: Reflective thinking 6) Management is not responsible for which of the following? A) adopting sound accounting policies B) issuing their own opinion on the fairness of the financial statements C) maintaining an effective system of internal controls D) making fair representations in the financial statements Answer: B Terms: Management's responsibilities Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 4 Copyright © 2023 Pearson Education, Inc.

7) Because they operate the business on a daily basis, a company's management knows more about the company's transactions and related assets, liabilities, and equity than the auditors. Answer: TRUE Terms: Responsibility for fair presentation of financial statements Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 8) The annual reports of many public companies include a statement about management's responsibilities and relationship with the CPA firm. Answer: TRUE Terms: Management's responsibility and relationship with CPA firm Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 9) The auditors determine which disclosures must be presented in the financial statements. Answer: FALSE Terms: Responsibility for fair presentation of financial statements Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 10) The Sarbanes-Oxley Act provides for criminal penalties for anyone who knowingly falsely certifies the financial statements. Answer: TRUE Terms: Sarbanes-Oxley Act Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 11) The auditor knows more about an audit client's transactions than management does. Answer: FALSE Terms: Management's Responsibilities Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 12) Annual reports of many public companies contain a statement about management's responsibilities for the financial statements and their relationship with the CPA firm. Answer: TRUE Terms: Management's responsibilities Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking

13) The Sarbanes-Oxley Act requires the auditor to certify the quarterly and the annual financial statements required to be filed by publicly listed firms with the Securities and Exchange Commission. Answer: FALSE Terms: Management's responsibilities Difficulty: Easy Objective: LO 6-2 AACSB: Reflective thinking 14) In signing the quarterly and the annual financial statements filed with the Securities and Exchange Commission, management certifies the financial statements comply with the Securities Exchange Act of 1933. Answer: FALSE Terms: Management's responsibilities Difficulty: Moderate Objective: LO 6-2 AACSB: Reflective thinking 15) The Report of Management regarding Management's Responsibility for Financial Information requires the signature of the CEO and the CFO as well as the certification of the auditing firm on the bottom of this Report. Answer: FALSE Terms: Management's responsibilities Difficulty: Moderate Objective: LO 6-2 AACSB: Reflective thinking; Analytic thinking

6.3 Learning Objective 6-3 1) The auditor's best defense when material misstatements are not uncovered is to have conducted the audit A) in accordance with generally accepted auditing standards. B) as effectively as reasonably possible. C) in a timely manner. D) only after an adequate investigation of the management team. Answer: A Terms: Auditors' best defense when material misstatements are not uncovered Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 2) Which of the following is not one of the reasons that auditors provide only reasonable assurance on the financial statements? A) The auditor commonly examines a sample, rather than the entire population of transactions. B) Accounting presentations contain complex estimates which involve uncertainty. C) Fraudulently prepared financial statements are often difficult to detect. D) Auditors believe that reasonable assurance is sufficient in the vast majority of cases. Answer: D Terms: Reasons auditors provide only reasonable assurance on financial statements Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 3) Which of the following statements is the most correct regarding errors and fraud? A) An error is unintentional, whereas fraud is intentional. B) Frauds occur more often than errors in financial statements. C) Errors are always fraud and frauds are always errors. D) Auditors have more responsibility for finding fraud than errors. Answer: A Terms: Errors and fraud Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 4) When an auditor believes that an illegal act may have occurred, the auditor should first A) obtain an understanding of the nature and circumstances of the act. B) consult with legal counsel or others knowledgeable about the illegal act. C) discuss the matter with the audit committee. D) withdraw from the engagement. Answer: A Terms: Auditor believes an illegal act may have occurred Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 7 Copyright © 2023 Pearson Education, Inc.

5) The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements that are not ________ are detected. A) important to the financial statements B) statistically significant to the financial statements C) material to the financial statements D) identified by the client Answer: C Terms: Auditor has no responsibility to plan and perform audit to obtain reasonable assurance Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 6) Fraudulent financial reporting is most likely to be committed by whom? A) line employees of the company B) outside members of the company's board of directors C) company management D) the company's auditors Answer: C Terms: Fraudulent financial reporting Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 7) Which of the following would most likely be deemed a direct effect illegal act? A) violation of federal employment laws B) violation of federal environmental regulations C) violation of federal income tax laws D) violation of civil rights laws Answer: C Terms: Direct-effect illegal act Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 8) The concept of reasonable assurance indicates that the auditor is A) not a guarantor of the correctness of the financial statements. B) not responsible for the fairness of the financial statements. C) responsible only for issuing an opinion on the financial statements. D) responsible for finding all misstatements. Answer: A Terms: Concept of reasonable assurance Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking

9) Which of the following is the auditor least likely to do when aware of an illegal act? A) discuss the matter with the client's legal counsel B) obtain evidence about the potential effect of the illegal act on the financial statements C) contact the local law enforcement officials regarding potential criminal wrongdoing D) consider the impact of the illegal act on the relationship with the company's management Answer: C Terms: Illegal acts Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 10) An auditor discovers that the company's bookkeeper unintentionally made a mistake in calculating the amount of the quarterly sales. This is an example of A) employee fraud. B) an error. C) misappropriation of assets. D) a defalcation. Answer: B Terms: Errors and fraud Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 11) An auditor has a duty to A) provide reasonable assurance that material misstatements will be detected. B) be a guarantor of the fairness in the statements. C) be equally responsible with management for the preparation of the financial statements. D) be an insurer of the fairness in the statements. Answer: A Terms: Auditor responsibility for notifying users as to whether statements are properly stated Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 12) If the auditor were responsible for making certain that all of management's assertions in the financial statements were absolutely correct, A) bankruptcies could no longer occur. B) bankruptcies would be reduced to a very small number. C) audits would be much easier to complete. D) audits would not be economically practical. Answer: D Terms: Auditor responsible for making certain that all of management's assertions were absolutely correct Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 9 Copyright © 2023 Pearson Education, Inc.

13) When dealing with laws and regulations that do not have a direct effect on the financial statements, the auditor A) should inquire of management about whether the entity is in compliance with such laws and regulations. B) has no responsibility to determine if any violations of these laws has occurred. C) must report all violations, including inconsequential violations, to the audit committee. D) should perform the same procedures as for violations having a direct effect on the financial statements. Answer: A Terms: Indirect-effect illegal acts Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 14) Which of the following statements is usually true? A) Materiality is easy to quantify. B) Fraudulent financial statements are often easy for the auditor to detect, especially when there is collusion among management. C) Reasonable assurance is a low level of assurance that the financial statements are free from material misstatement. D) An item is considered material if it would likely have changed or influenced the decisions of a reasonable person using the statements. Answer: D Terms: Materiality Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 15) Auditing standards make ________ distinction(s) between the auditor's responsibilities for searching for errors and fraud. A) little B) a significant C) no D) various Answer: C Terms: Auditor responsibility for searching for errors and fraud Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking

16) In comparing management fraud with employee fraud, the auditor's risk of failing to discover the fraud is A) greater for management fraud because managers are inherently more deceptive than employees. B) greater for management fraud because of management's ability to override existing system of internal controls. C) greater for employee fraud because of the higher crime rate among blue collar workers. D) greater for employee fraud because of the larger number of employees in the organization. Answer: B Terms: Management fraud vs. employee fraud and auditor failure to detect both Difficulty: Challenging Objective: LO 6-3 AACSB: Reflective thinking 17) Misappropriation of assets A) is generally committed by company management. B) harms the users of the financial statements by providing them incorrect financial data for their decision making. C) causes harm to stockholders because the assets are no longer available to their rightful owners. D) causes the financial statements to be misstated since the misappropriation usually involves material amounts. Answer: C Terms: Misappropriation of assets Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 18) When comparing the auditor's responsibility for detecting employee fraud and for detecting errors, the profession has placed the responsibility A) more on discovering errors than employee fraud. B) more on discovering employee fraud than errors. C) equally on discovering material errors and employee fraud. D) on the senior auditor for detecting errors and on the manager for detecting employee fraud. Answer: C Terms: Fraud and errors Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking

19) If there is collusion among management, the chance a normal audit would uncover such acts is A) very low. B) very high. C) zero. D) none of the above. Answer: A Terms: Employees collude to falsify documents Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 20) When the auditor becomes aware of or suspects noncompliance with laws and regulations, A) the auditor should evaluate the effects of the noncompliance on other aspects of the audit. B) the auditor should discuss the matter with management at a level above those suspected of the noncompliance. C) the auditor should obtain additional information to evaluate the possible effects on the financial statements. D) all of the above. Answer: D Terms: Audit procedures when noncompliance is identified or suspected Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 21) When the auditor identifies or suspects noncompliance with laws and regulations, the auditor A) should discuss the matter with those whom they believe committed the illegal act. B) should begin communication with the FASB in accordance with regulations. C) may disclaim an opinion on the basis of scope limitations if he or she is precluded by management from obtaining sufficient appropriate evidence. D) should withdraw from the engagement. Answer: C Terms: Noncompliance with laws and regulations Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 22) When an auditor knows that an illegal act has occurred, he or she must A) report it to the proper governmental authorities. B) consider the effects on the financial statements, including the adequacy of disclosure. C) withdraw from the engagement. D) issue an adverse opinion. Answer: B Terms: Auditor knows illegal act occurred Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 12 Copyright © 2023 Pearson Education, Inc.

23) Which of the following is an accurate statement concerning the auditor's responsibility to consider laws and regulations? A) Auditors can follow an easy, step-by-step procedure to determine how laws and regulations impact the financial statements. B) The auditor's responsibility will depend on whether the laws or regulations are expected to have a direct impact on the financial statements. C) It is the responsibility of the auditor to determine if an act constitutes noncompliance. D) The auditor must inform an outside party if management has knowingly not complied with a law or regulation. Answer: B Terms: Illegal acts, effect on financial statements Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 24) Which of the following statements best describes the auditor's responsibility with respect to illegal acts that do not have a material effect on the client's financial statements? A) Generally, the auditor is under no obligation to notify parties other than personnel within the client's organization. B) Generally, the auditor is under an obligation to inform the PCAOB. C) Generally, the auditor is obligated to disclose the relevant facts in the auditor's report. D) Generally, the auditor is expected to compel the client to adhere to requirements of the Foreign Corrupt Practices Act. Answer: A Terms: Auditor responsibility with respect to illegal acts Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 25) Which of the following statements best describes the auditor's responsibility regarding the detection of fraud? A) The auditor is responsible for the failure to detect fraud only when such failure clearly results from nonperformance of audit procedures specifically described in the engagement letter. B) The auditor is required to provide reasonable assurance that the financial statements are free of both material errors and fraud. C) The auditor is responsible for detecting material financial statement fraud, but not a material misappropriation of assets. D) The auditor is responsible for the failure to detect fraud only when an unqualified opinion is issued. Answer: B Terms: Auditor responsibility regarding detection of fraud Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking

26) When reporting identified or suspected noncompliance, A) the auditor must report inconsequential noncompliance to the audit committee. B) the auditor should communicate all material noncompliance matters to those charged with governance. C) any intentional noncompliance must be reported to local law enforcement. D) all noncompliance, whether material or not, must result in a disclaimer of opinion. Answer: B Terms: Reporting of identified or suspected noncompliance Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 27) Another term for misappropriation of assets is A) management fraud. B) collusion. C) employee fraud. D) illegal acts. Answer: C Terms: Misappropriation of assets Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 28) The provisions of many laws and regulations affect the financial statements A) directly. B) only indirectly. C) both directly and indirectly. D) materially if direct; immaterially if indirect. Answer: B Terms: Illegal acts, effect on financial statements Difficulty: Challenging Objective: LO 6-3 AACSB: Reflective thinking 29) If a client has violated federal tax laws, A) the auditor must notify the IRS. B) and the amount is significant, the auditor should communicate with those charged with governance. C) the noncompliance generally will not impact the financial statements. D) the auditor does not need to evaluate the effects of the noncompliance on other aspects of the audit. Answer: B Terms: Illegal acts, effect on financial statements Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 14 Copyright © 2023 Pearson Education, Inc.

30) In which of the following situations were the financial statements not misstated? A) Assets were taken, but the asset misappropriation was discovered and appropriately disclosed in the financial statements. B) Assets were taken, and the theft was covered by misstating the related assets. C) Assets were taken, and the theft was covered by understating revenues. D) Assets were taken, and the theft was covered by overstating expenses. Answer: A Terms: Misappropriation of assets Difficulty: Easy Objective: LO 6-3 AACSB: Analytic thinking 31) Errors are usually more difficult for an auditor to detect than frauds. Answer: FALSE Terms: Auditor detection of errors and frauds Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 32) Other than inquiring of management about policies they have established to prevent illegal acts and whether management knows of any laws or regulations that the company has violated, the auditor should not search for illegal acts that do not have a direct effect on the financial statements unless there is reason to believe they may exist. Answer: TRUE Terms: Auditor responsibility for searching for illegal acts that do not have a direct effect on the financial statements Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 33) When an auditor believes that an illegal act may have occurred, the first step he or she should take is to gather additional evidence to determine the extent of the illegality and if there is a direct impact on the financial statements. Answer: TRUE Terms: Auditor believes an illegal act may have occurred Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 34) Audits are expected to provide a higher degree of assurance for the detection of material frauds than is provided for an equally material error. Answer: FALSE Terms: Degree of assurance for detection of material frauds and errors Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 15 Copyright © 2023 Pearson Education, Inc.

35) Auditors have a higher degree of responsibility for detecting illegal acts that have a direct effect on the financial statements than illegal acts that do not have a direct effect on the financial statements. Answer: TRUE Terms: Auditor degree of responsibility for detecting illegal acts Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 36) The auditor's first course of action when an illegal act is uncovered should be to immediately notify the appropriate authorities, including but not limited to, law enforcement and the Securities and Exchange Commission. Answer: FALSE Terms: Illegal act uncovered Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 37) An audit generally provides no assurance that illegal acts that do not have a direct effect on the financial statements will be detected. Answer: TRUE Terms: Indirect-effect illegal acts; No assurance Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 38) Auditing standards indicate that reasonable assurance is a moderate, but not absolute, level of assurance that the financial statements are free of material misstatement. Answer: FALSE Terms: Moderate or high risk of management fraud Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 39) In obtaining reasonable assurance that the financial statements are free of material misstatement, the auditor does not need to consider the applicable legal and regulatory framework relevant to the client. Answer: FALSE Terms: Auditor's responsibility for year-end inventory procedures Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking

40) The objective of the audit of financial statements by an independent auditor is to verify that the financial statements are free of misstatements and accurately represent the company's financial position and results of operations. Answer: FALSE Terms: Objective of audit of financial statements Difficulty: Challenging Objective: LO 6-3 AACSB: Reflective thinking 41) As the impact from noncompliance is further removed from affecting the financial statements, the less likely the auditor is to become aware of or recognize noncompliance when auditing the financial statements. Answer: TRUE Terms: Auditor responsibility for searching for illegal acts that do not have a direct effect on the financial statements Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 42) The overall objectives of the auditor including reporting on the financial statements and communicating, as required by accounting standards, must be in accordance with the auditor's findings. Answer: TRUE Terms: Auditor's overall objectives Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 43) One of the paragraphs of the auditor's report includes a paragraph addressing the auditor's responsibility for not detecting material misstatements in the financial statements, as this is management's responsibility, not the auditors. Answer: FALSE Terms: Auditor responsibility for detecting material misstatements Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 44) It is not difficult for the auditor to quantify a measure of materiality while performing the audit. Answer: FALSE Terms: Auditor responsibility for defining materiality in an audit Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking

45) It is possible that an audit performed in accordance with generally accepted auditing standards may fail to detect a material misstatement in the financial statements. Answer: TRUE Terms: Concept of reasonable assurance in auditing Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 46) Statistical sampling is an example of a specially designed auditing approach taken by the auditor designed to provide absolute assurance that the financial statements are free of material misstatements. Answer: FALSE Terms: Auditor responsibility for providing reasonable assurance Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 47) The preparation of the financial statements by management contain complex estimates; therefore, the auditor has to rely upon evidence which is convincing, not just persuasive. Answer: FALSE Terms: Auditor responsibility for providing reasonable assurance Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 48) Auditing standards make a distinction between the auditor's responsibility for searching for errors and searching for fraud. Answer: FALSE Terms: Auditor responsibility for detecting fraud Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 49) Misappropriation of assets are, generally, in dollar amounts which are never material to the financial statements. Answer: FALSE Terms: Misappropriation of assets Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking

50) An audit client is notified that the client is not in compliance with a number of pension laws and regulations. In this situation, the auditor is not required to obtain sufficient appropriate evidence of the impact of this noncompliance on the financial statements. Answer: FALSE Terms: Violations of laws and regulations Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking 51) Discuss the differences between errors, frauds, and illegal acts. Give an example of each. Answer: The primary difference between errors and frauds is that errors are unintentional misstatements of the financial statements, whereas frauds are intentional misstatements. Illegal acts are violations of laws or government regulations, other than frauds. An example of an error is a mathematical mistake when footing the columns in the sales journal. An example of a fraud is the creation of fictitious accounts receivable. An example of an illegal act is the dumping of toxic waste in violation of the federal environmental protection laws. Terms: Errors, frauds, and illegal acts Difficulty: Easy Objective: LO 6-3 AACSB: Reflective thinking

52) Discuss the actions an auditor should take when an illegal act is identified or suspected. Answer: When an auditor discovers or suspects noncompliance with a law or regulation (illegal act), unless the matters involved are inconsequential, the auditor should: 1. Obtain an understanding of the nature and circumstances of the act. Additional information should be obtained to evaluate the possible effects on the financial statements. The auditor should discuss the matter with management at a level above those involved with the suspected noncompliance, and, when appropriate, those charged with governance. If the auditor is precluded by management or those charged with governance from obtaining sufficient appropriate evidence to provide sufficient information that supports that the entity is in compliance with the laws and regulations, and the auditor believes the effect of the noncompliance may be material to the financial statements, the auditor should consider the need to obtain legal advice. The auditor should also evaluate the effects of the noncompliance on other aspects of the audit. 2. Communicate with those charged with governance matters involving noncompliance with laws and regulations that came to the auditor's attention during the course of the audit. If the matter is believed to be intentional and material, it should be communicated to those charged with governance, such as the board of directors, as soon as practicable. 3. Identify whether a responsibility exists to report the identified or suspected noncompliance to parties outside the entity, such as regulatory authorities. 4. If the noncompliance has a material effect and has not been adequately reflected in the financial statements, the auditor should express a qualified or adverse opinion. If the auditor has been precluded by management from obtaining sufficient appropriate evidence to determine if the noncompliance is material, the auditor should express a qualified opinion or disclaim an opinion. Terms: Actions auditor should take when auditor discovers illegal act Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 53) Discuss three reasons why auditors are responsible for "reasonable" but not "absolute" assurance. Answer: • Most audit evidence results from testing a sample of a population. Sampling involves some risk of not uncovering material misstatements. • Accounting presentations contain complex estimates, which inherently involve uncertainty and can be affected by future events. As a result, the auditor has to rely on evidence that is persuasive but not convincing. • Fraudulently prepared financial statements are often very difficult for the auditor to detect, especially when there is collusion among management. Terms: Reasons auditors are responsible for reasonable but not absolute assurance Difficulty: Moderate Objective: LO 6-3 AACSB: Reflective thinking 20 Copyright © 2023 Pearson Education, Inc.

54) Discuss the differences in the auditor's responsibilities for discovering (1) material errors, (2) material fraud, (3) illegal acts having a direct effect on the financial statements, and (4) illegal acts that do not have a direct effect on the financial statements. Answer: Auditing standards make no distinction between the auditor's responsibilities for searching for errors and fraud. In either case, the auditor must obtain reasonable assurance about whether the statements are free of material misstatements. The standards also recognize that fraud is often more difficult to detect because management or the employees perpetrating the fraud attempt to conceal the fraud. Still, the difficulty of detection does not change the auditor's responsibility to properly plan and perform the audit to detect material misstatements, whether caused by error or fraud. The auditor's responsibility for uncovering illegal acts that have a direct effect on the financial statements is the same as for errors and fraud. However, the auditor is not required to search for illegal acts that do not have a direct effect on the financial statements unless there is reason to believe they exist. Terms: Auditor responsibilities for discovering material errors, material fraud, direct-effect illegal acts, and indirect-effect illegal acts Difficulty: Challenging Objective: LO 6-3 AACSB: Reflective thinking 6.4 Learning Objective 6-4 1) An audit must be performed with an attitude of professional skepticism. Professional skepticism consists of two primary components: a questioning mind and A) the assumption that upper-level management is dishonest. B) a critical assessment of the audit evidence. C) the assumption that all employees are motivated by greed. D) verification of all critical information by independent third parties. Answer: B Terms: Attitude of professional skepticism Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking 2) Which of the following is an accurate statement about professional skepticism? A) Professional skepticism involves a critical assessment of the evidence. B) Professional skepticism is easy to implement in practice. C) It is easy for auditors to understand that their clients may try to deceive them throughout the audit process. D) Professional skepticism is only necessary for the audits of public companies. Answer: A Terms: Professional skepticism Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking 21 Copyright © 2023 Pearson Education, Inc.

3) One of the characteristics of professional skepticism is ________, which is the conviction to decide for oneself, rather than accepting the claims of others. A) interpersonal understanding B) autonomy C) suspension of judgment D) self-esteem Answer: B Terms: Characteristics of professional skepticism Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 4) A questioning mindset A) means the auditor must prove every statement that management makes to them. B) means the auditor should approach the audit with a "do not trust anyone" mental outlook. C) assures that the auditor will only accept honest clients. D) means the auditor should approach the audit with a "trust but verify" mental outlook. Answer: D Terms: Professional skepticism Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 5) One of the characteristics of professional skepticism is ________, which is a desire to investigate beyond the obvious. A) self-esteem B) an interpersonal understanding C) a search for knowledge D) a questioning mindset Answer: C Terms: Professional skepticism Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 6) ________ is the self-confidence to resist persuasion and to challenge assumptions or conclusions. A) Self-esteem B) Interpersonal understanding C) Suspension of judgment D) Autonomy Answer: A Terms: Professional skepticism Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

7) An auditor should recognize that the application of auditing procedures may produce evidence indicating the possibility of errors of fraud and therefore should A) plan and perform the engagement with an attitude of professional skepticism. B) not rely on system of internal controls that are designed to prevent or detect errors or fraud. C) design audit tests to detect unrecorded transactions. D) extend the work to audit the majority of the recorded transactions and records of an entity. Answer: A Terms: Professional skepticism when auditing a client Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 8) Which of the following is not a characteristic of skepticism found in academic research on this subject? A) depending upon others to decide for oneself B) searching for knowledge C) suspending judgement until evidence is obtained D) inquiring with a sense of doubt Answer: A Terms: Professional skepticism when auditing a client Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 9) Which of the following is not true regarding elements of professional skepticism? A) The risk of material misstatements is not present in all audits. B) Auditors are human and are therefore subject to natural biases. C) Auditors sometimes convince themselves to only accept clients they can trust. D) It is often difficult for auditors to accept the possibility their clients lack competence. Answer: A Terms: Professional skepticism when auditing a client Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 10) Auditors often convince themselves that they only accept clients they can trust and who have high integrity. Answer: TRUE Terms: Professional skepticism Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking

11) A suspension of judgment is the recognition that people's motivations and perceptions can lead them to provide biased or misleading information. Answer: FALSE Terms: Professional skepticism; interpersonal understanding; suspension of judgment Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking 12) An exception is permissible with regards to displaying professional skepticism in audit is understandable if the auditor has experienced integrity and honesty of client management in the past. Answer: FALSE Terms: Professional skepticism Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking 13) A suspension of judgment is the recognition that people's motivations and perceptions can lead them to provide biased or misleading information. Answer: FALSE Terms: Professional skepticism; interpersonal understanding; suspension of judgment Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking 14) An auditor embracing the responsibility during the audit of maintaining a questioning mind and critically evaluating evidence significantly reduces the likelihood of audit failure throughout the audit. Answer: TRUE Terms: Professional skepticism Difficulty: Easy Objective: LO 6-4 AACSB: Reflective thinking

15) Recent academic research on the topic of professional skepticism suggests that there are six characteristics to skepticism. List and briefly describe each of these characteristics. Answer: The six characteristics of skepticism are: 1. Questioning mindset — a disposition to inquiry with some sense of doubt 2. Suspension of judgment — withholding judgment until appropriate evidence is obtained 3. Search for knowledge — a desire to investigate beyond the obvious, with a desire to corroborate 4. Interpersonal understanding — recognition that people's motivations and perceptions can lead them to provide biased or misleading information 5. Autonomy — the self-direction, moral independence, and conviction to decide for oneself, rather than accepting the claims of others 6. Self-esteem — the self-confidence to resist persuasion and to challenge assumptions or conclusions. Terms: Professional skepticism Difficulty: Moderate Objective: LO 6-4 AACSB: Reflective thinking 6.5 Learning Objective 6-5 1) The starting point to effective professional judgment begins with A) gathering the facts. B) identifying alternatives. C) identifying relevant literature. D) identifying and defining the issue. Answer: D Terms: Professional judgment process Difficulty: Easy Objective: LO 6-5 AACSB: Reflective thinking 2) Which of the following is not a step in the professional judgment process? A) make the decision B) perform the analysis C) determine the type of audit opinion D) review and document the rationale for the conclusion Answer: C Terms: Professional judgment process Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking

3) ________ is the tendency to use an initial piece of evidence which subsequent information is then inadequately assessed against. A) Anchoring B) Availability C) Overconfidence D) Confirmation Answer: A Terms: Common judgment tendencies Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 4) When the auditor considers whether he or she understands the form and substance of the transaction or event, and whether the relevant authoritative literature has been applied consistently by the client, he or she is performing which step in the professional judgment process? A) identifying and defining the issue B) performing the analysis and identifying potential alternatives C) making the decision D) gathering the facts Answer: B Terms: Professional judgment process Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 5) When performing the review and completing the documentation and rationale for the conclusion step of the professional judgment process, auditors will A) consider the accounting and auditing standards relevant to the issues. B) articulate in written form the rationale of their judgment. C) identify the issue. D) gather the facts. Answer: B Terms: Professional judgment process Difficulty: Easy Objective: LO 6-5 AACSB: Reflective thinking 6) The profession has developed professional judgment frameworks that illustrate an effective decision-making process. Answer: TRUE Terms: Professional judgment process Difficulty: Easy Objective: LO 6-5 AACSB: Reflective thinking

7) During the professional judgment process, the analysis may identify only one appropriate response to the issue. Answer: FALSE Terms: Professional judgment process Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 8) During the professional judgment process, it is not important that the auditor considers other financial reporting framework requirements outside of generally accepted accounting principles. Answer: FALSE Terms: Gathering the facts and identifying the relevant literature Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 9) In a situation where the auditor is evaluating a decision made with regards to the recording of an unusual revenue transaction, the auditor should step back and determine if the recording of the revenue is in accordance with accounting standards. Answer: TRUE Terms: Professional judgment process-making the decision Difficulty: Easy Objective: LO 6-5 AACSB: Reflective thinking 10) Overconfidence is the tendency to put more weight on information that is consistent with the initial beliefs or preferences. Answer: FALSE Terms: Professional judgment process Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 11) In order to mitigate availability, the auditor should consult with others and make the opposing case. Answer: TRUE Terms: Professional judgment; strategies to mitigate common judgment tendencies Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking

12) In order to mitigate confirmation, the auditor should make the opposing case and consider alternative explanations, potentially disconfirming or conflicting information. Answer: TRUE Terms: Professional judgment; strategies to mitigate common judgment tendencies Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 13) In order to mitigate overconfidence, the auditor should challenge the opinions of experts and the underlying evidence. Answer: TRUE Terms: Professional judgment; strategies to mitigate common judgment tendencies Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking 14) In order to mitigate anchoring, the auditor should consult with others, but not consider management bias. Answer: FALSE Terms: Professional judgment; strategies to mitigate common judgment tendencies Difficulty: Moderate Objective: LO 6-5 AACSB: Reflective thinking

15) Auditors should be alert for potential judgment tendencies, traps, and biases that may impact their decision-making process. Identify and define four of these judgment tendencies. Then, for each judgment tendency, suggest a way to avoid or mitigate the tendency. Answer: The judgment tendencies and strategies to avoid or mitigate the tendencies are: 1. Confirmation: the tendency to put more weight on information that is consistent with initial beliefs or preferences 2. Overconfidence: the tendency to overestimate one's own abilities to perform tasks or to make accurate assessments of risks or other judgments and decisions 3. Anchoring: the tendency to make assessments by starting from an initial value and then adjusting insufficiently away from the initial value 4. Availability: the tendency to consider information that is easily retrievable or what's easily accessible as being more likely or more relevant 5. Automation. The tendency to favor output generated from automated systems. Strategy to avoid or mitigate the tendency: 1. Confirmation: Make the opposing case and consider alternative explanations. Consider potentially disconfirming or conflicting information. 2. Overconfidence: Challenge opinions and experts. Challenge underlying assumptions. 3. Anchoring: Solicit input from others. Consider management bias, including the potential for fraud or material misstatement. 4. Availability: Consider why something comes to mind. Obtain and consider objective data. Consult with others and take the opposing case. 5. Automation: Emphasize the need for professional skepticism when using automated tools and techniques. Design technological resources to require auditor evaluation and explanation of the output. Terms: Professional judgment; strategies to mitigate common judgment tendencies Difficulty: Challenging Objective: LO 6-5 AACSB: Reflective thinking

6.6 Learning Objective 6-6 1) Why does the auditor divide the financial statements into smaller segments? A) Using the cycle approach makes the audit more manageable. B) Most accounts have few relationships with others and so it is more efficient to break the financial statements into smaller pieces. C) The cycle approach is used because auditing standards require it. D) All of the above are correct. Answer: A Terms: Reason auditor divides financial statements into smaller segments Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 2) Why does the auditor divide the financial statements into segments around the financial statement cycles? A) Most auditors are trained to audit cycles as opposed to entire financial statements. B) The approach aids in the assignment of tasks to different members of the audit team. C) The cycle approach is required by auditing standards. D) The cycle approach allows the auditor to detect illegal acts. Answer: B Terms: Reason auditor divides financial statements into smaller segments Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 3) The most important general ledger account included in and affecting several cycles is the A) cash account. B) inventory account. C) income tax expense and liability accounts. D) retained earnings account. Answer: A Terms: Account included in and affected several cycles Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking

4) When using the cycle approach to segmenting the audit, the reason for treating capital acquisition and repayment separately from the acquisition of goods and services is that A) the transactions are related to financing a company rather than to its operations. B) most capital acquisition and repayment cycle accounts involve few transactions, but each is often highly material and therefore should be audited extensively. C) Both A and B are correct. D) Neither A nor B is correct. Answer: C Terms: Cycle approach to segmenting an audit Difficulty: Challenging Objective: LO 6-6 AACSB: Reflective thinking 5) In describing the cycle approach to segmenting an audit, which of the following statements is not true? A) All general ledger accounts and journals are included at least once. B) Some journals and general ledger accounts are included in more than one cycle. C) The "capital acquisition and repayment" cycle is closely related to the "acquisition of goods and services and payment" cycle. D) The "inventory and warehousing" cycle may be audited at any time during the engagement since it is unrelated to the other cycles. Answer: D Terms: Cycle approach to segmenting an audit Difficulty: Challenging Objective: LO 6-6 AACSB: Reflective thinking 6) The cycle approach to auditing A) ties to the way transactions are recorded in journals and then summarized in the general ledger and financial statements. B) cannot combine transactions recorded in different journals with the general ledger balances that result from those transactions. C) is the only way of segmenting an audit. D) assumes that each account has two or more cycles associated with it. Answer: A Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking

7) Which balance sheet accounts are included in the payroll and personnel cycle? A) cash in bank, accrued payroll, trade accounts receivable B) accrued payroll, notes payable, and deferred tax C) accrued payroll, cash in bank, and accrued payroll taxes D) salaries and commissions, cash in bank, accrued payroll taxes Answer: C Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 8) Under the cycle approach to segmenting an audit, transactions recorded in different journals should never be combined with the general ledger balances that result from those transactions. Answer: FALSE Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 9) Under the cycle approach, the only accounts that have two or more cycles associated with them are cash and accounts receivable. Answer: FALSE Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 10) Although auditors need to consider the interrelationships between cycles, they typically treat cycles independently to the extent practical to manage complex audits effectively. Answer: TRUE Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 11) When examining the relationships of the five cycles and general cash, the cycles have no beginning or end except at the origin or final disposition of the company. Answer: TRUE Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking

12) Under the cycle approach, the capital acquisition and repayment cycle is closely related to the acquisition and payment cycle. Answer: TRUE Terms: Cycle approach to segmenting an audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 13) Auditors generally use a financial statement cycle approach when performing a financial statement audit. Describe the transaction flow, using specific examples, from journals to financial statements that produce financial statements. Answer: Transactions—sales, cash receipts, acquisition of goods/services, cash disbursements, payroll services and disbursements, and allocation and adjustments Journals—sales, cash receipts, acquisitions, cash disbursements, payroll, and general General ledger and subsidiary ledgers to General ledger trial balance to financial statements Terms: Financial statement cycle approach when performing a financial statement audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking 14) Listed below are several accounts listed from a company's trial balance. Next to each account put the letter corresponding to the transaction cycle used to audit the account. S = Sales and collection cycle I = Inventory and warehousing cycle A = Acquisition and payment cycle C = Capital acquisition and repayment cycle P = Payroll and personnel cycle 1. ________ Sales returns and allowances 5. ________ Salaries and commissions 2. ________ Capital stock 6. ________ Cost of goods sold 3. ________ Buildings 7. ________ Trade accounts receivable 4. ________ Notes payable 8. ________ Rent Answer: 1. S, 2. C, 3. A, 4. C, 5. P, 6. I, 7. S, 8. A Terms: Financial statement cycle approach when performing a financial statement audit Difficulty: Moderate Objective: LO 6-6 AACSB: Reflective thinking

6.7 Learning Objective 6-7 1) Auditors have found that generally the most efficient and effective way to conduct audits is to A) obtain complete assurance about the correctness of each class of transactions affecting the account. B) obtain some combination of assurance for each class of transactions and for the ending balance in the related accounts. C) obtain assurance about the ending balance of the account only. D) verify each entry that was made into an account. Answer: B Terms: Setting audit objectives Difficulty: Moderate Objective: LO 6-7 AACSB: Reflective thinking 2) The term audit objective refers to all of the following except for A) transaction-related audit objectives. B) presentation and disclosure-related audit objectives. C) balance-related audit objectives. D) cycle-related audit objectives. Answer: D Terms: Setting audit objectives Difficulty: Easy Objective: LO 6-7 AACSB: Reflective thinking 3) When an auditor is determining what information to include in the notes to the financial statements relating to bonds payable, he or she is concerned with the transaction-related audit objectives. Answer: FALSE Terms: Setting audit objectives Difficulty: Moderate Objective: LO 6-7 AACSB: Reflective thinking 4) It is generally impractical for the auditor to obtain complete assurance about the correctness of each class of transactions. Answer: TRUE Terms: Setting audit objectives Difficulty: Easy Objective: LO 6-7 AACSB: Reflective thinking

5) An audit objective focused on the balance in accounts receivable or accounts payable is a transaction-related audit objective. Answer: FALSE Terms: Transaction and balance-related audit objectives Difficulty: Easy Objective: LO 6-7 AACSB: Reflective thinking 6) An audit objective focused on transactions in the sales journal is a balance-related audit objective. Answer: FALSE Terms: Transaction and balance-related audit objectives Difficulty: Easy Objective: LO 6-7 AACSB: Reflective thinking 6.8 Learning Objective 6-8 1) Which of the following is not one of the AICPA categories of assertions? A) assertions about classes of transactions and events for the period under audit B) assertions about financial statements and correspondence to GAAP C) assertions about account balances at period end D) assertions about presentation and disclosure Answer: B Terms: Categories of assertions Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking 2) If a short-term note payable is included in the accounts payable balance on the financial statement, there is a violation of the A) completeness assertion. B) existence assertion. C) cutoff assertion. D) classification assertion. Answer: D Terms: Violation of assertions Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking

3) International auditing standards and U.S. GAAP classify assertions into three categories. Which of the following is not a category of assertions that management makes about the accounting information in financial statements? A) assertions about classes of transactions for the period under audit B) assertions about account balances at period end C) assertions about the quality of source documents used to prepare the financial statements D) assertions about presentation and disclosure Answer: C Terms: Management assertions Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking 4) Management assertions are A) directly related to the financial reporting framework used by the company, usually U.S. GAAP or IFRS. B) stated in the footnotes to the financial statements. C) explicitly expressed representations about the financial statements. D) provided to the auditor in the assertions letter, but are not disclosed on the financial statements. Answer: A Terms: Management assertions Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 5) Management makes the following assertions about account balances: A) existence or occurrence, completeness, classification, and cutoff. B) existence or occurrence, accuracy, classification, and rights and obligations. C) existence or occurrence, completeness, valuation or allocation, and rights and obligations. D) existence or occurrence, completeness, rights and obligations, and cutoff. Answer: C Terms: Management assertions Difficulty: Challenging Objective: LO 6-8 AACSB: Reflective thinking

6) Management's disclosure of the amount of unfunded pension obligations and the assumptions underlying these amounts is an example of the ________ assertion. A) completeness B) existence C) accuracy and valuation D) rights and obligations Answer: C Terms: Accuracy and valuation assertion Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 7) Which of the following assertions is described as "this assertion addresses whether all transactions that should be included in the financial statements are in fact included"? A) occurrence B) completeness C) rights and obligations D) existence Answer: B Terms: Assertion which addresses whether all transactions that should be included are included Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 8) Which of the following management assertions is not associated with classes of transactions and events? A) occurrence B) classification C) accuracy D) rights and obligations Answer: D Terms: Management assertion not associated with transaction-related audit objectives Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 9) With increases in the complexity of transactions and the need for expanded disclosures about these transactions, assertions about the ________ have increased in importance. A) existence B) account balances C) presentation and disclosures D) classes of transactions Answer: C Terms: Management assertions Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking 37 Copyright © 2023 Pearson Education, Inc.

10) Determining that the footnote disclosures related to long-term debt are accurate is an example of the ________ audit objective. A) occurrence B) completeness C) presentation and disclosures D) classification and understandability Answer: C Terms: Presentation and disclosure-related objectives Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking 11) Relevant assertions made by management have a meaningful bearing on whether an account is fairly stated. Which of the following would likely be a relevant assertion for accounts receivable under PCAOB Auditing Standards? A) valuation or allocation B) accuracy C) classification D) cutoff Answer: A Terms: Management assertions Difficulty: Challenging Objective: LO 6-8 AACSB: Reflective thinking 12) Relevant assertions have a meaningful bearing on whether the account is fairly stated and are used to assess the risk of material misstatement and the design and performance of audit procedures. Answer: TRUE Terms: Management assertions Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 13) The auditor's audit objectives follow and are closely related to management assertions. Answer: TRUE Terms: Management assertions Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking

14) The presentation and disclosure-related audit objectives are identical to the management assertions for presentation and disclosure. Answer: TRUE Terms: Presentation and disclosure-related objectives Difficulty: Easy Objective: LO 6-8 AACSB: Reflective thinking 15) Briefly explain each management assertion related to classes of transactions and events for the period under audit. Answer: • Occurrence. Transactions and events that have been recorded have occurred and pertain to the entity. • Completeness. All transactions and events that should have been recorded have been recorded. • Accuracy. Amounts and other data relating to recorded transactions and events have been recorded appropriately. • Classification. Transactions and events have been recorded in the proper accounts. • Cutoff. Transactions and events have been recorded in the correct accounting period. Terms: Management assertions related to classes of transactions Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 16) Briefly explain each management assertion related to account balances at period end. Answer: • Existence. Assets, liabilities, and equity interests exist. • Completeness. All assets, liabilities, and equity interests that should have been recorded have been recorded. • Valuation and allocation. Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation adjustments are appropriately recorded. • Rights and obligations. The entity holds or controls the rights to assets, and liabilities are the obligation of the entity. Terms: Management assertions related to account balances at period end Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking

17) Briefly explain each management assertion related to presentation and disclosure. Answer: • Occurrence and rights and obligations. Disclosed events and transactions have occurred and pertain to the entity. • Completeness. All disclosures that should have been included in the financial statements have been included. • Accuracy and valuation. Financial and other information are disclosed appropriately and at appropriate amounts. • Classification and understandability. Financial and other information is appropriately presented and described and disclosures are clearly expressed. Terms: Management assertions related to presentation and disclosure Difficulty: Moderate Objective: LO 6-8 AACSB: Reflective thinking 6.9 Learning Objective 6-9 1) Which of the following statements is true regarding the distinction between general audit objectives and specific audit objectives for each class of transactions? A) The specific audit objectives are applicable to every class of transactions. B) The general audit objectives are applicable to every class of transactions. C) Once the specific transaction-related audit objectives are established, they can be used to develop the general transaction-related objectives. D) For any given class of transactions, usually only one audit objective must be met to conclude the transactions are properly recorded. Answer: B Terms: Difference between general and specific audit objectives Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 2) The auditor is determining that the correct selling price was used for billing and that the quantity of goods shipped was the same as the quantity billed. She or he is gathering evidence about which transaction-related audit objective? A) existence B) completeness C) accuracy D) cutoff Answer: C Terms: Evidence for transaction-related audit objective if recorded sales are for amount shipped and correctly billed and recorded Difficulty: Moderate Objective: LO 6-9 AACSB: Analytic thinking

3) The posting and summarization audit objective are the auditor's counterpart to management's assertion of A) occurrence. B) completeness. C) accuracy. D) classification. Answer: C Terms: Transaction-related audit objectives Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 4) ________ deals with potential overstatement and ________ deals with understatements (unrecorded transactions). A) Occurrence; completeness B) Completeness; occurrence C) Accuracy; classification D) Classification; accuracy Answer: A Terms: General and specific audit objectives Difficulty: Challenging Objective: LO 6-9 AACSB: Reflective thinking 5) General transaction-related audit objectives vary from audit to audit, depending on the nature and characteristics of the client's business and industry. Answer: FALSE Terms: General transaction-related audit objectives Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 6) The audit objective of posting and summarization is associated with the management assertion of accuracy. Answer: TRUE Terms: Audit objective of posting and summarization; Accuracy management assertion Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 7) The transaction-related audit objective of timing is related to the assertion of cutoff. Answer: TRUE Terms: Transaction-related audit objective of timing; Cutoff assertion Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 41 Copyright © 2023 Pearson Education, Inc.

8) If a sale was for a valid shipment, but the amount of the sales invoice was calculated incorrectly, the accuracy objective was violated. Answer: TRUE Terms: General transaction-related audit objectives Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 9) The effect of a violation of the completeness transaction-related audit objective for cash disbursements transactions would be an overstatement of cash disbursements. Answer: FALSE Terms: Completeness transaction-related audit objective Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 10) The transaction-related audit objective that deals with whether recorded transactions have actually occurred is the completeness objective. Answer: FALSE Terms: Transaction-related audit objective; Completeness objective Difficulty: Moderate Objective: LO 6-9 AACSB: Reflective thinking 11) In the context of the audit of sales, distinguish between the occurrence and completeness transaction-related audit objectives. State the effect on the sales account (overstatement or understatement) of a violation of each objective. Answer: When testing the occurrence objective for sales, the auditor's focus is on whether the sales that have been recorded in the sales journal actually occurred. In contrast, tests of the completeness objective are concerned with determining whether all sales that actually occurred have been recorded in the sales journal. Violations of the occurrence objective result in overstatements of sales; violations of the completeness objective result in understatements of sales. Terms: General and specific audit objectives Difficulty: Challenging Objective: LO 6-9 AACSB: Reflective thinking

12) Below are five audit procedures, all of which are tests of transactions associated with the audit of the sales and collection cycle. Also, below are the six general transaction-related audit objectives and the five management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested. Audit Objectives A. occurrence B. completeness C. accuracy D. posting and summarization E. classification F. timing

Assertions V. occurrence W. completeness X. accuracy Y. classification Z. cutoff

1. Vouch recorded sales from the sales journal to the file of bills of lading. (1) ________ (2) ________ 2. Compare dates on the bill of lading, sales invoices, and sales journal to test for delays in recording sales transactions. (1) ________ (2) ________ 3. Account for the sequence of prenumbered bills of lading and sales invoices. (1) ________ (2) ________ 4. Trace from a sample of prelistings of cash receipts to the cash receipts journal, testing for names, amounts, and dates. (1) ________ (2) ________ 5. Examine customer order forms for credit approval by the credit manager. (1) ________ (2) ________ Answer: 1. (1) A (2) V 2. (1) F (2) Z 3. (1) B (2) W 4. (1) B, C (2) W, X 5. (1) A (2) V Terms: Management assertions and transaction-related audit objectives Difficulty: Challenging Objective: LO 6-9 AACSB: Analytic thinking

13) Below are five audit procedures, all of which are tests of transactions associated with the audit of the acquisition and payment cycle. Also, below are the six general transaction-related audit objectives and the five management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested. Audit Objectives A. occurrence B. completeness C. accuracy D. posting and summarization E. classification F. timing

Assertions V. occurrence W. completeness X. accuracy Y. classification Z. cutoff

1. Foot the purchases journal and trace the totals to the related general ledger accounts. (1) ________ (2) ________ 2. Recompute the cash discounts taken by the client. (1) ________ (2) ________ 3. Compare dates on cancelled checks with the bank cancellation date. (1) ________ (2) ________ 4. Trace from a sample of cancelled checks to the cash disbursements journal. (1) ________ (2) ________ 5. Examine supporting documentation for a sample of transactions for authorized payee and amount and to determine services or goods were received. (1) ________ (2) ________ Answer: 1. (1) D (2) X 2. (1) C (2) X 3. (1) F (2) Z 4. (1) B (2) W 5. (1) A (2) V Terms: Management assertions and transaction-related audit objectives Difficulty: Challenging Objective: LO 6-9 AACSB: Analytic thinking

6.10 Learning Objective 6-10 1) In testing for cutoff, the objective is to determine A) whether all of the current period's transactions are recorded. B) whether transactions are recorded in the correct accounting period. C) the proper cutoff between capitalizing and expensing expenditures. D) the proper cutoff between disclosing items in footnotes or in account balances. Answer: B Terms: Objective in testing cutoff Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 2) The detail tie-in objective is not concerned that the details in the account balance A) agree with related subsidiary ledger amounts. B) are properly disclosed in accordance with GAAP. C) foot to the total in the account balance. D) agree with the total in the general ledger. Answer: B Terms: Detail tie-in objective Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 3) The detail tie-in is part of the ________ assertion for account balances. A) classification B) valuation and allocation C) rights and obligations D) completeness Answer: B Terms: Detail tie-in is and assertion for account balances Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 4) The classification balance-related audit objective A) involves determining if items included on a client's listing are included in the correct general ledger accounts. B) is the counterpart to the management assertion of completeness. C) involves determining if items included on a client's listing are disclosed properly in the financial statements. D) involves tying in the account balances to the general ledger. Answer: A Terms: Balance-related audit objectives Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 45 Copyright © 2023 Pearson Education, Inc.

5) Balance-related audit objectives A) are never applied to income statement accounts. B) are designed to detect fraud. C) provide a framework to help the auditor accumulate sufficient appropriate evidence related to account balances. D) can have only one specific-related audit objective. Answer: C Terms: Balance-related audit objectives Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 6) Which of the following statements is not true? A) Balance-related audit objectives are applied to ending account balances. B) Transaction-related audit objectives are applied to classes of transactions. C) Balance-related audit objectives are applied to the ending balance in balance sheet accounts. D) Balance-related audit objectives are applied to both beginning and ending balances in balance sheet accounts. Answer: D Terms: Balance-related and transaction-related audit objectives Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 7) Balance-related audit objectives follow from management assertions. Answer: TRUE Terms: Balance-related audit objectives Difficulty: Easy Objective: LO 6-10 AACSB: Reflective thinking 8) Balance-related audit objectives are usually applied to the ending balance in income statement accounts; transaction-related audit objectives are usually applied to transactions reflected in balance sheet accounts. Answer: FALSE Terms: Balance-related audit objectives; Transaction-related audit objectives Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking

9) Tests of details of balances typically involve the use of comparisons and relationships to assess the overall reasonableness of account balances. Answer: FALSE Terms: Tests of details of balances Difficulty: Easy Objective: LO 6-10 AACSB: Reflective thinking 10) The general balance-related audit objective that deals with determining that details in the account balance agree with related master file amounts, foot to the total in the account balance, and agree with the total in the general ledger is the detail tie-in objective. Answer: TRUE Terms: Detail tie-in objective; General balance-related objective Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 11) The cutoff objective, "transactions near the balance sheet date are recorded in the proper period," is a balance-related audit objective. Answer: TRUE Terms: Cutoff objective; Balance-related audit objective Difficulty: Moderate Objective: LO 6-10 AACSB: Reflective thinking 12) An important balance-related audit objective is realizable value. Describe the purpose of this audit objective, what it is concerned with, and give an example. Answer: The purpose of this audit objective is to make sure that assets are included on the balance sheet at the amounts estimated to be realized. It is concerned with whether an account balance has been reduced for declines from historical cost or when accounting standards require a fair value accounting treatment for the account. It is concerned with valuation and allocation. It generally applies only to asset accounts, although some liabilities are recorded at fair value. Examples include the allowance for uncollectible accounts, and write-downs of inventory for obsolescence. Terms: Balance-related objective of realizable value Difficulty: Challenging Objective: LO 6-10 AACSB: Reflective thinking

13) Below are five audit procedures, all of which are tests of balances associated with the audit of accounts receivable. Also, below are the eight general balance-related audit objectives and the four management assertions. For each audit procedure, indicate (1) its audit objective, and (2) the management assertion being tested. Audit Objectives A. existence B. completeness C. accuracy D. classification E. cutoff F. detail tie-in G. realizable value H. rights and obligations

Assertions V. existence W. completeness X. valuation and allocation Y. rights and obligations

1. Obtain an aged listing of accounts receivable. For a sample of individual customers on the listing, agree the customer's name, amount, and other information with the corresponding information in the accounts receivable master file. (1) ________ (2) ________ 2. Examine details of sales for five days before and five days after year-end to determine whether sales have been recorded in the proper period. (1) ________ (2) ________ 3. Assess the reasonableness of the balance in the allowance for doubtful accounts. (1) ________ (2) ________ 4. Inquire as to whether any accounts receivable have been factored or sold during the period. (1) ________ (2) ________ 5. Inquire as to whether there are any receivables from related parties. (1) ________ (2) ________ Answer: 1. (1) F (2) X 2. (1) E (2) X 3. (1) G (2) X 4. (1) H (2) Y 5. (1) D (2) X Terms: Management assertions and balance-related audit objectives Difficulty: Challenging Objective: LO 6-10 AACSB: Analytic thinking 48 Copyright © 2023 Pearson Education, Inc.

6.11 Learning Objective 6-11 1) The procedures used to test the effectiveness of the internal controls are known as A) tests of transactions. B) tests of controls. C) substantive analytical procedures. D) control risk. Answer: B Terms: Tests of controls Difficulty: Easy Objective: LO 6-11 AACSB: Reflective thinking 2) Which of the following statements is not correct? A) There are many ways an auditor can accumulate evidence to meet overall audit objectives. B) Sufficient appropriate evidence must be accumulated to meet the auditor's professional responsibility. C) It is appropriate to minimize the cost of accumulating evidence. D) Gathering evidence and minimizing costs are equally important considerations that affect the approach the auditor selects. Answer: D Terms: Considerations for accumulating evidence Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 3) Two overriding considerations affect the many ways an auditor can accumulate evidence: 1. Sufficient appropriate evidence must be accumulated to meet the auditor's professional responsibility. 2. Cost of accumulating evidence should be minimized. In evaluating these considerations A) the first is more important than the second. B) the second is more important than the first. C) they are equally important. D) it is impossible to prioritize them. Answer: A Terms: Considerations for accumulating evidence Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking

4) If the auditor has obtained a reasonable level of assurance about the fair presentation of the financial statements through understanding internal control, assessing control risk, testing controls, and analytical procedures, then the auditor A) can issue an unqualified opinion. B) can significantly reduce other substantive tests. C) can write the engagement letter. D) needs to perform additional tests of controls so that the assurance level can be increased. Answer: B Terms: Auditor obtained reasonable level of assurance about fair presentation Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 5) After the auditor has completed all audit procedures, it is necessary to combine the information obtained to reach an overall conclusion as to whether the financial statements are fairly presented. This is a highly subjective process that relies heavily on A) generally accepted auditing standards. B) the AICPA's Code of Professional Conduct. C) generally accepted accounting principles. D) the auditor's professional judgment. Answer: D Terms: After auditor completed all audit procedures Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 6) Direct, written communication with the client's customers to identify whether a receivable exists is an example of a(n) A) substantive test of transactions. B) test of controls. C) analytical procedure. D) test of details of balances. Answer: D Terms: Tests of details of balances Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking

7) ________ are used as evidence to provide assurance about an account balance. A) Substantive analytical procedures B) Tests of transactions C) Audit risks D) Tests of details of balances Answer: A Terms: Analytical procedures; Substantive tests Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 8) When an auditor has reduced assessed control risk based on tests of controls, he or she may then reduce the extent to which the accuracy of the financial statement information directly related to those controls must be supported through the accumulation of evidence using substantive tests. Answer: TRUE Terms: Tests of controls; Assessed control risk Difficulty: Easy Objective: LO 6-11 AACSB: Reflective thinking 9) For a private company audit, tests of controls are normally performed only on those internal controls the auditor believes have not been operating effectively during the period under audit. Answer: FALSE Terms: Tests of controls Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 10) Rights and obligations are the only balance-related assertion without a similar transactionrelated assertion. Answer: TRUE Terms: Audit process Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 11) The audit objectives are the well-defined methodology for organizing an audit to ensure that the evidence gathered is sufficient and appropriate. Answer: FALSE Terms: Audit process Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking

12) Obtaining an understanding of the entity and its environment is part of the analytical procedures phase of the audit. Answer: FALSE Terms: Audit process Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 13) An auditor assesses the risk of material misstatement to determine the impact on the audit plan and to determine the nature, extent, and timing of the audit procedures. Answer: TRUE Terms: Audit process Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 14) List the four phases of a financial statement audit. Answer: 1. plan and design an audit approach based on risk assessment procedures 2. perform tests of controls and substantive tests of transactions 3. perform substantive analytical procedures and tests of details of balances 4. complete the audit and issue an audit report Terms: Phases of financial statement audit Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking 15) Describe what analytical procedures and tests of details of balances are and give an example of each. Answer: Analytical procedures consist of evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data. Analytical procedures use comparisons and relationships to assess whether account balances and other data appear reasonable. An example of an analytical procedure is to examine sales transactions in the sales journal for unusually large amounts and/or compare monthly sales with prior years. Tests of details of balances are specific procedures intended to test for monetary misstatements in balances in the financial statements. An example is direct written communication with the client's customers to identify any incorrect amounts. Terms: Analytical procedures and tests of balances Difficulty: Challenging Objective: LO 6-11 AACSB: Reflective thinking

16) Match seven of the terms (a-k) with the definitions provided below (1-7): a. b. c. d. e. f. g. h. i. j. k.

tests of details of balances tests of controls substantive tests of transactions analytical procedures transaction-related audit objectives management assertions balance-related audit objectives fraud illegal act error management fraud

________ 1. an intentional misstatement of the financial statements ________ 2. a set of six audit objectives the auditor must meet, including timing, posting and summarization, and accuracy ________ 3. implied or expressed representations made by the client about classes of transactions, account balances and disclosures in the financial statements ________ 4. audit procedures testing for monetary misstatements to determine whether the balance-related audit objectives have been satisfied for each significant account balance ________ 5. a set of nine audit objectives the auditor must meet, including completeness, detail tie-in, and rights and obligations ________ 6. audit procedures designed to test the effectiveness of control policies and procedures ________ 7. use of comparisons and relationships to assess whether account balances or other data appears reasonable Answer: 1. h, 2. e, 3. f, 4. a, 5. g, 6. b, 7. d Terms: Tests of balances; Tests of controls; Substantive tests of transactions; Analytical procedures; Management assertions; Balance-related audit objectives; Fraud Difficulty: Moderate Objective: LO 6-11 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 7 Audit Evidence 7.1 Learning Objective 7-1 1) Which of the following is an accurate statement regarding audit evidence? A) Responses to the auditor's questions by client employees are considered highly persuasive evidence. B) Audit evidence should provide an absolute level of assurance. C) The auditor uses evidence to determine whether the financial statements are fairly presented. D) All evidence must be highly persuasive. Answer: C Terms: Nature of audit evidence Difficulty: Easy Objective: LO 7-1 AACSB: Reflective thinking 2) All evidence must have the same level of persuasiveness. Answer: FALSE Terms: Nature of audit evidence Difficulty: Easy Objective: LO 7-1 AACSB: Reflective thinking 3) Auditors use evidence to help them draw conclusions on which the auditor's opinion is based. Answer: TRUE Terms: Nature of audit evidence Difficulty: Easy Objective: LO 7-1 AACSB: Reflective thinking 4) An example of less persuasive evidence to an auditor is the observation of the physical inventory taken by an audit client. Answer: TRUE Terms: Nature of audit evidence Difficulty: Easy Objective: LO 7-1 AACSB: Reflective thinking 5) An example of highly persuasive evidence to an auditor is the responses to questions on a questionnaire by audit client employees. Answer: FALSE Terms: Nature of audit evidence Difficulty: Easy Objective: LO 7-1 AACSB: Reflective thinking 1 Copyright © 2023 Pearson Education, Inc.

6) Name three characteristics of evidence from the perspective of a scientist doing an experiment, a lawyer prosecuting an accused thief, and an auditor of financial statements. For the three characteristics that you name, describe briefly the similarities and the differences among these three professions. Answer: Use of the evidence. Scientist: Determine the effects of using the medicine; Lawyer: Decide guilt or innocence of the accused; Auditor: To arrive at a conclusion on which the auditor's opinion is based. Nature of the evidence used. Scientist: Results of repeated experiments; Lawyer: Direct evidence and testimony by witnesses and the parties involved; Auditor: Various types of audit evidence generated by the auditor, third parties, and the client. Party or parties evaluating evidence. Scientist: Scientist; Lawyer: Jury and judge; Auditor: Auditor. Certainty of conclusions from evidence. Scientist: Vary from uncertain to near certainty; Lawyer: Required guilt beyond a reasonable doubt; Auditor: High level of assurance. Nature of conclusions. Scientist: Recommend or not recommend use of medicine; Lawyer: Innocence or guilt of the party; Auditor: Issue one of several alternative types of audit reports. Typical consequences of incorrect conclusions from evidence. Scientist: Society uses ineffective or harmful medicine; Lawyer: Guilty party is not penalized or innocent party is found guilty; Auditor: Statement users make incorrect decisions and auditor may be sued. Terms: Nature of audit evidence Difficulty: Moderate Objective: LO 7-1 AACSB: Reflective thinking

7.2 Learning Objective 7-2 1) Auditors must make decisions regarding what evidence to gather and how much to accumulate. Which of the following is a decision that must be made by auditors related to evidence? A) Sample size Timing of audit procedures Yes Yes B) Sample size No

Timing of audit procedures No

Sample size Yes

Timing of audit procedures No

Sample size No

Timing of audit procedures Yes

Answer: A Terms: Audit evidence decisions Difficulty: Easy Objective: LO 7-2 AACSB: Reflective thinking

2) When can audit procedures be performed? A) Prior to the fiscal year- Subsequent to the fiscal yearend of the client end of the client Yes Yes B) Prior to the fiscal year- Subsequent to the fiscal yearend of the client end of the client No No C) Prior to the fiscal year- Subsequent to the fiscal yearend of the client end of the client Yes No D) Prior to the fiscal year- Subsequent to the fiscal yearend of the client end of the client No Yes Answer: A Terms: Timing of audit procedures Difficulty: Easy Objective: LO 7-2 AACSB: Reflective thinking 3) An ________ is an act the auditor performs during the course of an audit to comply with auditing standards. A) audit objective B) audit procedure C) audit assertion D) audit program Answer: B Terms: Audit evidence and audit procedures Difficulty: Easy Objective: LO 7-2 AACSB: Analytic thinking

4) Which of the following is not one of the three decisions about what evidence to gather and how much of it to accumulate to satisfy the audit objectives and support the audit opinion? A) which audit procedures to use B) which accounts must agree to the general ledger C) when to perform the audit procedures D) what sample size to select for a given audit procedure Answer: B Terms: Audit evidence and audit procedures Difficulty: Easy Objective: LO 7-2 AACSB: Analytic thinking 5) When making audit evidence decisions, A) the auditor decides which items in the population to test before determining the sample size. B) the sample size for any given procedure must remain constant from audit to audit. C) audit engagement software can assist the auditor in making evidence decisions. D) the auditor is required to use the sample sizes that are determined by the PCAOB. Answer: C Terms: Audit evidence and sample size Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 6) Examine the cash receipts journal in the accounting system and compare the amounts received to the corresponding amounts invoiced in the revenue accounting system and to the bank statement evidencing the deposit. This is an example of which of the following? A) audit objective B) audit procedure C) audit assertion D) audit program Answer: B Terms: Audit evidence and audit procedures Difficulty: Moderate Objective: LO 7-2 AACSB: Analytic thinking 7) ________ often incorporate sample size, items to select, and timing into the procedure. A) Audit objectives B) Audit procedures C) Audit assertions D) Audit programs Answer: B Terms: Audit procedures and the timing of audit procedures Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

8) The ________ always includes a list of the ________, and it usually includes sample sizes, items to select, and the timing of the tests. A) audit program; audit objectives B) audit program; audit procedures C) audit assertion; audit programs D) audit assertion; audit objectives Answer: B Terms: Audit program and audit procedures Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 9) An audit program is the list of audit procedures for an audit area or an entire audit. Answer: TRUE Terms: Audit program Difficulty: Easy Objective: LO 7-2 AACSB: Reflective thinking 10) It is important for the auditor to standardize the sample size from client to client and from audit to audit. Answer: FALSE Terms: Audit program and sample size Difficulty: Easy Objective: LO 7-2 AACSB: Reflective thinking 11) The sample size generally does not depend on client circumstances such as the extent of automated controls in place in the client's accounting information system. Answer: FALSE Terms: Audit program and sample size Difficulty: Easy Objective: LO 7-2 AACSB: Reflective thinking 12) After deciding on the sample size for a particular audit procedure, the auditor is then restricted in deciding which items in the population to test. Answer: FALSE Terms: Audit program, sample size, and sample items to select Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking

13) After deciding on the sample size for a particular audit procedure, the auditor has a choice of several different methods to select the specific population items to test. Answer: TRUE Terms: Audit program, sample size, and sample items to select Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 14) Timing is an important factor for the auditor to take into consideration in gathering audit evidence. For example, auditors often prefer to do test counts of the inventory as close as possible to the date of the audit opinion. Answer: FALSE Terms: Audit program and sample size Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 15) The audit program for inventories should be the same as the audit program for account receivables. Answer: FALSE Terms: Audit program design Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking 16) Normally, there is an audit program including several audit procedures, for each component of the audit. Answer: TRUE Terms: Audit program design Difficulty: Moderate Objective: LO 7-2 AACSB: Reflective thinking; Analytic thinking

7.3 Learning Objective 7-3 1) Audit evidence has two primary qualities for the auditor: relevance and reliability. Given the choices below, which provides the auditor with the most reliable audit evidence? A) general ledger account balances B) confirmation of accounts receivable balance received from a customer C) internal memo explaining the issuance of a credit memo D) copy of month-end adjusting entries Answer: B Terms: Audit evidence qualities of relevance and reliability Difficulty: Easy Objective: LO 7-3 AACSB: Analytic thinking 2) Which of the following is not a characteristic of the reliability of evidence? A) effectiveness of client system of internal controls B) education of auditor C) independence of information provider D) timeliness Answer: B Terms: Characteristics of reliable evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 3) The auditor must gather sufficient and appropriate evidence during the course of the audit. Sufficient evidence must A) be well documented and cross-referenced in the audit documents. B) be based on sources that are external to company. C) provide evidence that prove or disprove an audit objective/assertion. D) be persuasive enough to enable the auditor to issue an audit report. Answer: D Terms: Sufficient evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 4) Audit evidence obtained directly by the auditor will not be reliable if A) the auditor lacks the competence to evaluate the evidence. B) it is provided by the client's attorney. C) the client denies its veracity. D) it is impossible for the auditor to obtain additional corroboratory evidence. Answer: A Terms: Audit evidence obtained directly by auditor Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

5) Appropriateness of evidence is a measure of the A) quantity of evidence. B) quality of evidence. C) sufficiency of evidence. D) meaning of evidence. Answer: B Terms: Appropriateness of audit evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 6) Which of the following statements regarding the relevance of evidence is correct? A) To be relevant, evidence must pertain to the audit objective of the evidence. B) To be relevant, evidence must be persuasive. C) To be relevant, evidence must relate to multiple audit objectives. D) To be relevant, evidence must be derived from a system including effective system of internal controls. Answer: A Terms: Relevance of evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 7) Two determinants of the persuasiveness of evidence are A) competence and sufficiency. B) relevance and reliability. C) appropriateness and sufficiency. D) independence and effectiveness. Answer: C Terms: Determinants of persuasiveness of evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 8) The two characteristics of the appropriateness of evidence are A) relevance and timeliness. B) relevance and accuracy. C) relevance and reliability. D) reliability and accuracy. Answer: C Terms: Appropriateness of audit evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking

9) Which of the following forms of evidence would be least persuasive in forming the auditor's opinion about marketable securities and other investments held by the company? A) responses to auditor's questions by the president and controller regarding the investments account B) correspondence with a stockbroker regarding the quantity of client's investments held in street name by the broker C) minutes of the board of directors authorizing the purchase of stock as an investment D) the auditor's count of marketable securities Answer: A Terms: Least persuasive form of evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 10) Which of the following statements is not correct? A) It is possible to vary the sample size from one unit to 100% of the items in the population. B) Cost is an adequate justification for not gathering an adequate sample size. C) The decision of how many items to test must be made by the auditor for each audit procedure. D) The sample size for any given procedure is likely to vary from audit to audit. Answer: B Terms: Persuasive audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 11) For audit evidence to be compelling to the auditor it must be sufficient and appropriate. Which statement below is not correct regarding the appropriateness of audit evidence? A) The more effective the system of internal control, the more assurance it provides the auditor about the reliability of financial reporting by the client. B) An auditor's opinion, to be economically useful and profitable to the auditing firm, needs to be formed within a reasonable time and based on evidence obtained that assures profits for the auditing firm. C) Evidence obtained from independent sources outside the entity is generally more reliable than evidence secured solely within the entity. D) The independent auditor's direct personal knowledge, obtained through inquiry, observation and inspection, is generally more persuasive than information obtained indirectly. Answer: B Terms: Appropriateness of audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

12) Which of the following is a correct statement regarding audit evidence? A) A large sample of evidence provided by an independent party is always considered persuasive evidence. B) A small sample of only one or two pieces of highly appropriate evidence is always considered persuasive evidence. C) The auditor must obtain a sufficient amount of relevant and reliable evidence to form an opinion on the fairness of the financial statements. D) Evidence is usually more reliable for balance sheet accounts when it is obtained within six months of the balance sheet date. Answer: C Terms: Audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 13) Which of the following is the most objective type of evidence? A) a letter written by the client's attorney discussing the likely outcome of outstanding lawsuits B) the physical count of securities and cash C) inquiries of the credit manager about the collectability of noncurrent accounts receivable D) observation of cobwebs on some inventory bins Answer: B Terms: Most objective type of audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

14) Which items affect the sufficiency of evidence when choosing a sample? A) Selecting items with a high The randomness of the items likelihood of misstatement selected Yes Yes B) Selecting items with a high The randomness of the items likelihood of misstatement selected No No C) Selecting items with a high The randomness of the items likelihood of misstatement selected Yes No D) Selecting items with a high The randomness of the items likelihood of misstatement selected No Yes Answer: C Terms: Sufficiency of evidence when choosing a sample Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 15) Determine which of the following is the most correct statement regarding the reliability of audit evidence. A) Information that is indirectly obtained from external sources is the most reliable audit evidence. B) Reliability of audit evidence is dependent upon the evidence being subjective. C) Reliability of evidence refers to the amount of evidence obtained. D) If system of internal controls are effective, evidence obtained is more reliable than when the controls are not effective. Answer: D Terms: Reliability of audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

16) Evidence is generally considered appropriate when A) it has been obtained by random selection. B) there is enough of it to afford a reasonable basis for an opinion on financial statements. C) it is relevant to the audit objective being tested. D) it consists of written statements made by managers of the company under audit. Answer: C Terms: Evidence considered appropriate Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 17) Given the economic and time constraints in which auditors can collect evidence regarding management assertions about the financial statements, the auditor normally gathers evidence that is A) irrefutable. B) conclusive. C) persuasive. D) completely convincing. Answer: C Terms: Persuasive audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 18) Which of the following statements is not a correct statement regarding audit evidence? A) Evidence obtained from an independent source outside the client organization is more reliable than that obtained from within. B) Documentary evidence is more reliable when it is received by the auditor indirectly rather than directly. C) Documents that originate outside the company are considered more reliable than those that originate within the client's organization. D) External evidence, such as communications from banks, is generally regarded as more reliable than answers obtained from inquiries of the client. Answer: B Terms: Audit evidence Difficulty: Challenging Objective: LO 7-3 AACSB: Reflective thinking

19) Evidence is usually more persuasive for balance sheet accounts when it is obtained A) as close to the balance sheet date as possible. B) only from transactions occurring on the balance sheet date. C) from various times throughout the client's year. D) from the time period when transactions in that account were most numerous during the fiscal period. Answer: A Terms: Evidence is more persuasive for balance sheet accounts Difficulty: Challenging Objective: LO 7-3 AACSB: Reflective thinking 20) Which of the following statements is true? A) Evidence must be relevant to all of the audit objectives. B) If evidence is subjective, it cannot be reliable. C) Evidence obtained directly by the auditor may not be reliable if the auditor lacks the qualifications to evaluate the evidence. D) The persuasiveness of evidence can be evaluated after considering its sufficiency. Answer: C Terms: Audit process Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 21) Which of the following statements relating to the competence of evidential matter is always true? A) Evidence from outside an enterprise is always reliable. B) Accounting data developed under satisfactory conditions of system of internal control is not reliable. C) Oral representations made by management are not reliable evidence. D) Evidence must be both reliable and relevant to be considered appropriate. Answer: D Terms: Competence of evidential matter Difficulty: Challenging Objective: LO 7-3 AACSB: Reflective thinking

22) With regards to the persuasiveness of audit evidence, which of the following statements is not true? A) The auditor should be completely convinced the audit opinion is correct. B) Audit standards require the auditor to accumulate sufficient evidence. C) Audit standard require the auditor to accumulate appropriate evidence. D) The auditor must be persuaded that the audit opinion is correct with a high level of assurance. Answer: A Terms: Persuasive audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Analytic thinking 23) Audit evidence to support an opinion about the fairness of a client's financial statements consists entirely of written information. Answer: FALSE Terms: Audit evidence to support an opinion Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 24) The relevance of audit evidence depends on the audit objective being tested. Answer: TRUE Terms: Relevance of audit evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 25) Inquiries of the client are usually sufficient to provide appropriate evidence to satisfy an audit objective. Answer: FALSE Terms: Inquiries of client; Appropriate evidence Difficulty: Easy Objective: LO 7-3 AACSB: Reflective thinking 26) Objective evidence is more reliable, and hence more persuasive, than subjective evidence. Answer: TRUE Terms: Objective evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

27) The two most important factors when determining the appropriate sample size in an audit are the auditor's expectation of misstatements and the objectivity of the evidence. Answer: FALSE Terms: Sufficiency of evidence and sample size Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 28) Most auditors usually consider samples sufficient that contain only the largest dollar items from the population. Answer: FALSE Terms: Sufficiency of evidence and sample size Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 29) In addition to sample size, the individual population items tested affect the sufficiency of audit evidence gathered by the auditor. Answer: TRUE Terms: Sufficiency of evidence and sample size Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 30) Assume the auditor determines that verifying marketable securities is a major and material item to the financial statements of an audit client. The auditor must therefore obtain a sufficient amount of relevant and reliable evidence about marketable securities for this audit client. The audit must also result in gathering sufficiently persuasive evidence satisfying the auditor that marketable securities are materially correct. Answer: TRUE Terms: Combined effect of appropriateness and sufficiency of audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

31) Discuss three of the following characteristics of relevant evidence. 1. Independence of provider 2. Effectiveness of client's system of internal controls 3. Auditor's direct knowledge 4. Qualification of individuals providing the information 5. Degree of objectivity 6. Timeliness Answer: 1. Independence of provider — Evidence obtained from a source outside the entity is more reliable and persuasive than that obtained from within. 2. Effectiveness of client's system of internal controls — When a client's system of internal controls are effective, evidence obtained is more reliable than when the controls are not effective. 3. Auditor's direct knowledge — Evidence obtained directly by the auditor through physical examination, observation, computation and inspection is more reliable than information obtained indirectly. 4. Qualification of individuals providing the information — Although the source of information is independent, the evidence will not be reliable unless the individual providing it is qualified to do so. Communications from attorneys and bank confirmations are typically more highly regarded than accounts receivable confirmations from persons not familiar with the business world. Also, evidence obtained directly by the auditor may not be reliable if the auditor lacks the qualifications to evaluate the evidence. 5. Degree of objectivity — Objective evidence is more reliable than evidence that requires considerable judgment to determine whether it is correct. 6. Timeliness — The timeliness of audit evidence can refer either to when it is accumulated or to the period covered by the audit. Evidence is usually more reliable for balance sheet accounts when it is obtained as close to the balance sheet date as possible. Terms: Characteristics of reliable evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking 32) Why is the appropriateness of audit evidence obtained by the auditor important in forming an audit opinion? Describe the qualities information should have to be considered appropriate by the auditor. Answer: Appropriateness is a measure of the quality of evidence. Audit evidence that is considered appropriate contains the characteristics of relevance and reliability. Relevant evidence relates to the assertion being tested. Reliability refers to the degree to which evidence can be believable or worthy of trust. Terms: Appropriateness of audit evidence Difficulty: Moderate Objective: LO 7-3 AACSB: Reflective thinking

33) The reliability of evidence refers to the degree to which evidence is considered believable or trustworthy. There are six factors that affect the reliability of audit evidence. One factor is the independence of the provider; i.e., evidence obtained from a source outside the client company is more reliable than that obtained within. Identify and discuss any two of the remaining five factors. Answer: The remaining four factors that affect the reliability of evidence are: • Effectiveness of client's system of internal control. When a client's system of internal controls are effective, evidence obtained from the client is more reliable than when controls are not effective. • Auditor's direct knowledge. Evidence obtained directly by the auditor is more reliable than information obtained indirectly. • Qualifications of individuals providing the information. Although the source of the information may be independent, the evidence will not be reliable unless the individual providing it is qualified to do so. Also, evidence obtained directly by the auditor many not be reliable if the auditor lacks the qualifications to evaluate the evidence. • Degree of objectivity. Objective evidence is more reliable than evidence that requires considerable judgment to determine whether it is correct. • Timeliness – The timeliness of audit evidence can refer either to when it is accumulated or to the period covered by the audit. Evidence is usually more reliable for balance sheet accounts when it is obtained as close to the balance sheet date as possible. Terms: Reliability of evidence Difficulty: Challenging Objective: LO 7-3 AACSB: Reflective thinking

7.4 Learning Objective 7-4 1) Calculating the gross margin for the current audit year as a percent of sales and comparing it with previous years is what type of evidence? A) physical examination B) analytical procedures C) observation D) inquiry Answer: B Terms: Vouching as an audit procedure Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 2) When the auditor uses supporting evidence for amounts posted to account balances with documentary evidence, that process is called A) inquiry. B) confirmation. C) vouching. D) physical examination. Answer: C Terms: Auditor develops supporting evidence for amounts posted with documentary evidence Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 3) An example of an external document that provides reliable information for the auditor is a(n) A) employees' time report. B) bank statement. C) purchase order for company purchases. D) carbon copy of a check. Answer: B Terms: External document Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking

4) An example of a document the auditor receives from the client, but which was prepared by someone outside the client's organization is a A) inventory reconciliation. B) sales invoice. C) vendor invoice. D) bank reconciliation. Answer: C Terms: External document Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 5) The evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data is the definition of A) analytical procedures. B) tests of transactions. C) tests of balances. D) auditing. Answer: A Terms: Types of audit evidence; analytical procedures Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking

6) Audit procedures can result in significant, unexpected differences. The auditor should investigate further if A) Significant differences are Significant differences are not expected but do exist expected but do not exist Yes Yes B) Significant differences are Significant differences are not expected but do exist expected but do not exist No No C) Significant differences are Significant differences are not expected but do exist expected but do not exist Yes No D) Significant differences are Significant differences are not expected but do exist expected but do not exist No Yes Answer: A Terms: Audit procedures result in significant differences Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 7) When the auditor uses tracing as an audit procedure for tests of transactions, he or she is primarily concerned with which audit objective? A) occurrence B) completeness C) cutoff D) classification Answer: B Terms: Tracing as an audit procedure Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

8) When the auditor uses the audit procedure vouching, he or she is primarily concerned with which of the following audit objectives when testing classes of transactions? A) occurrence B) completeness C) authorization D) classification Answer: A Terms: Vouching as an audit procedure Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 9) When auditors use documentation to support recorded transactions and amounts, the process is usually called A) tracing. B) confirmations. C) vouching. D) reperformance. Answer: C Terms: Vouching as an audit procedure Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 10) Analytical procedures must be used during which phase(s) of the audit? A) Test of Controls Planning Completion Yes Yes Yes B) Test of Controls No

Planning Yes

Completion Yes

C) Test of Controls Yes

Planning No

Completion No

D) Test of Controls No

Planning No

Completion No

11) Auditors may decide to replace tests of details with analytical procedures when possible because the A) analytical procedures are more reliable. B) analytical procedures are considerably less expensive. C) analytical procedures are more persuasive. D) tests of details are more difficult to interpret. Answer: B Terms: Tests of details of balances; Substantive analytical procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 12) Factors that determine the auditor's willingness to accept a document as reliable evidence include A) whether it is internal or external. B) whether it was created and processed under conditions of effective system of internal control. C) whether it is an original document or a photocopy. D) all of the above. Answer: D Terms: Documents as reliable audit evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 13) "Physical examination" is the inspection or count by the auditor of items such as A) cash, inventory, and payroll timecards. B) cash, inventory, canceled checks, and sales documents. C) cash, inventory, canceled checks, and tangible fixed assets. D) cash, inventory, securities, notes receivable, and tangible fixed assets. Answer: D Terms: Types of audit evidence; physical examination Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 14) The primary purpose of audit procedures is to A) detect all errors or fraudulent activities as well as illegal activities. B) comply with auditing standards promulgated by the PCAOB for publicly held clients. C) gather corroborative audit evidence about management's assertions regarding the client's financial statements. D) determine the amount of errors in the balance sheet accounts in order to adjust the accounts to actual. Answer: C Terms: Primary purpose of audit procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 23 Copyright © 2023 Pearson Education, Inc.

15) ________, generally, provide the most reliable evidence. A) Confirmations B) Recalculations C) Reperformances D) Observations Answer: A Terms: Audit process Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 16) When practical and reasonable, U.S. auditing standards require the confirmation of a sample of A) individual transactions between organizations, such as sales transactions. B) accounts receivable. C) fixed asset additions. D) payroll expenses. Answer: B Terms: Confirmations Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 17) To be considered reliable evidence, confirmations must be controlled by A) the client's employee responsible for accounts receivable. B) the external auditor. C) the client's internal audit department. D) the client's controller or CFO. Answer: B Terms: Confirmations controlled to be considered reliable evidence Difficulty: Challenging Objective: LO 7-4 AACSB: Reflective thinking

18) Indicate whether confirmation of accounts receivable and accounts payable, provided they each are significant accounts, is required or optional. A) Accounts Receivable Accounts Payable Required Required B) Accounts Receivable Required

Accounts Payable Optional

Accounts Receivable Optional

Accounts Payable Required

Accounts Receivable Optional

Accounts Payable Optional

Answer: B Terms: Confirmation of accounts receivable and accounts payable Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 19) Physical examination A) is a direct means of verifying that an asset really exists. B) is sufficient evidence to verify that the existing assets are owned by the client. C) can be used for both tangible assets and documents. D) is not generally a reliable type of audit evidence. Answer: A Terms: Types of audit evidence; physical examination Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 20) Which of the following is not a correct combination of terms and related type of audit evidence? A) inquire — inquiries of client B) count — physical examination C) recompute — recalculation D) read — documentation Answer: D Terms: Combination of terms and related audit evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 25 Copyright © 2023 Pearson Education, Inc.

21) Which of the following is a correct statement regarding confirmations? A) Confirmations can be in oral or written form. B) Electronic confirmations are not acceptable under generally accepted auditing standards. C) Confirmations are generally used in the audit of fixed asset additions. D) Auditors consider alternative evidence available when determining if confirmations should be used. Answer: D Terms: Types of audit evidence; confirmations Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 22) The auditor is concerned that a client is failing to bill customers for shipments. An audit procedure that would gather relevant evidence would be to A) select a sample of duplicate sales invoices and trace each to related shipping documents. B) trace a sample of shipping documents to related duplicate sales invoices. C) trace a sample of Sales Journal entries to the Accounts Receivable subsidiary ledger. D) compare the total of the Schedule of Accounts Receivable with the balance of the Accounts Receivable account in the general ledger. Answer: B Terms: Audit procedure to gather relevant evidence that client fails to bill Difficulty: Challenging Objective: LO 7-4 AACSB: Analytic thinking 23) ________ is the auditor's examination of the client's documents and records to substantiate that the information that is or should be included in the financial statements. A) Inspection B) Recalculation C) Observation D) Verification Answer: A Terms: Types of audit evidence; inspection Difficulty: Moderate Objective: LO 7-4 AACSB: Analytic thinking

24) When the auditor scans the sales journal looking for large and unusual transactions, he or she is gathering what type of evidence? A) inspection B) recalculation C) physical examination D) analytical procedures Answer: D Terms: Types of audit evidence; analytical procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 25) You are auditing the company's purchasing process for goods and services. You are primarily concerned with the company not recording all purchase transactions. Which audit procedure below would be the most effective audit procedure in this case? A) vouching from the accounts payable account to the vendor invoices B) tracing vendor invoices to recorded amounts in the accounts payable account C) confirming accounts payable recorded amounts D) reconciling the accounts payable subsidiary ledger to the accounts payable account Answer: B Terms: Audit procedure for recording all purchase transactions Difficulty: Challenging Objective: LO 7-4 AACSB: Analytic thinking 26) Which of the following discoveries through the use of analytical procedures would most likely indicate a relatively high risk of financial failure? A) a decline in gross margin percentages B) an increase in the balance in fixed assets C) an increase in the ratio of allowance for uncollectible accounts to gross accounts receivable, while at the same time accounts receivable turnover also decreased D) a higher than normal ratio of long-term debt to net worth as well as a lower than average ratio of profits to total assets Answer: D Terms: Analytical procedures Difficulty: Challenging Objective: LO 7-4 AACSB: Analytic thinking

27) Which of the following statements is correct regarding the costs involved in obtaining evidence? A) Physical examination is usually the Cost of obtaining evidence may be a least expensive type of audit factor in deciding whether to evidence obtain that evidence Yes Yes B) Physical examination is usually the Cost of obtaining evidence may be a least expensive type of audit factor in deciding whether to evidence obtain that evidence No No C) Physical examination is usually the Cost of obtaining evidence may be a least expensive type of audit factor in deciding whether to evidence obtain that evidence Yes No D) Physical examination is usually the Cost of obtaining evidence may be a least expensive type of audit factor in deciding whether to evidence obtain that evidence No Yes Answer: D Terms: Costs of obtaining audit evidence Difficulty: Challenging Objective: LO 7-4 AACSB: Reflective thinking 28) Confirmations are among the most expensive type of evidence to obtain. Answer: TRUE Terms: Confirmations; Cost of evidence Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 29) Whenever practical and reasonable, the confirmation of accounts receivable is required of CPAs. Answer: TRUE Terms: Confirmations of accounts receivable required of CPAs Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

30) Inquiries of clients and recalculations normally have a low cost associated with them. Answer: TRUE Terms: Inquiries of clients and reperformance have low cost Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 31) When analytical procedures reveal unusual fluctuations in an account balance, the auditor will probably perform fewer tests of details for that account and increase the tests of controls related to the account. Answer: FALSE Terms: Analytical procedures reveal unusual fluctuations Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 32) The type of audit evidence known as inquiry requires the auditor to obtain oral or written information from the client in response to questions. Answer: TRUE Terms: Audit evidence; Inquiry Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 33) Auditor judgment is the primary determinant in determining the amount of evidence gathered. Answer: TRUE Terms: Auditor judgment; Evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 34) Analytical procedures must be used in the planning and completion phases of the audit. Answer: TRUE Terms: Analytical procedures; Planning and completion phases of the audit Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 35) Confirmations are ordinarily used to verify account balances, but may be used to verify transactions. Answer: TRUE Terms: Confirmations to verify balances and transactions Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

36) Accounts receivable confirmations must be controlled by the client from the time they are prepared until the time they are returned to the auditor. Answer: FALSE Terms: Confirmations control Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 37) Cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size. Answer: TRUE Terms: Cost of audit procedures; Sample size Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 38) When the auditor foots the journals and the subsidiary ledgers, it is considered reperformance. Answer: FALSE Terms: Types of audit evidence; recalculation Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 39) Inspection consists of looking at a process or procedure being performed by others. Answer: FALSE Terms: Types of audit evidence; inspection Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking 40) A canceled check written by the client, made payable to a local supplier and drawn on the client's bank account is one type of internal document. Answer: FALSE Terms: Internal document Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 41) The use by auditors of drones is not yet acceptable as a form of gathering evidence in an audit. Answer: FALSE Terms: Using drones to capture audit evidence Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 30 Copyright © 2023 Pearson Education, Inc.

42) Analytical procedures are used extensively in practice, but they will not help the auditor in assessing an audit client's ability to continue as a going concern. Answer: FALSE Terms: Analytical procedures Difficulty: Easy Objective: LO 7-4 AACSB: Reflective thinking 43) One purpose of performing analytical procedures in the planning phase of an audit is to assess the client's financial condition. Explain how the assessment of a client's financial condition can affect the auditor's decisions concerning evidence accumulation in later phases of the audit. Answer: Auditors must obtain knowledge about a client's industry and business as a part of planning an audit. By conducting analytical procedures in which the current year's unaudited information is compared with prior years' audited information or industry data, changes are highlighted. These changes can represent important trends or specific events, all of which will influence audit planning. The use of analytical procedures is often a useful indicator for determining whether the client company has financial problems and if substantial doubt exists about the entity's ability to continue as a going concern. Certain analytical procedures can help the auditor assess the likelihood of failure. If a higher-than-normal ratio of long-term debt to net worth is combined with a lower-thanaverage ratio of profits to total assets, a relatively high risk of financial failure may be indicated. Not only will such conditions affect the audit plan, they may indicate that substantial doubt exists about the entity's ability to continue as a going concern, which requires an emphasis-of-matter explanatory paragraph in the audit report. Terms: Analytical procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

44) Define the following terms commonly used in audit procedures. 1. examine 2. scan 3. compute 4. foot 5. compare 6. count 7. vouch Answer: 1. examine — a reasonably detailed study of a document or record to determine specific facts about it 2. scan — a less detailed examination of a document or record to determine whether there is something unusual warranting further investigation 3. compute — a calculation done by the auditor independent of the client 4. foot — addition of a column of numbers to determine whether the total is the same as the client's 5. compare — a comparison of information in two different locations 6. count — a determination of assets on hand at a given time. This term should be associated only with the type of evidence defined as physical examination 7. vouch — the use of documents to verify recorded transactions or amounts Terms: Audit procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

45) Below are 12 audit procedures. Classify each procedure according to the following types of audit evidence: (1) physical examination, (2) confirmation, (3) documentation, (4) observation, (5) inquiry of the client, (6) reperformance, and (7) analytical procedure. Type of Evidence

Audit Procedures 1. Watch client employees count inventory to determine whether company procedures are being followed. 2. Count inventory items and record the amount in the audit files. 3. Trace postings from the sales journal to the general ledger accounts. 4. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to the preceding year. 5. Obtain information about the client's system of internal controls by asking questions of client personnel. 6. Trace column totals from the cash disbursements journal to the general ledger. 7. Examine a piece of equipment to make sure a recent purchase of equipment was actually received and is in operation. 8. Review the total of repairs and maintenance for each month to determine whether any month's total was unusually large. 9. Compare vendor names and amounts on purchase invoices with entries in the purchases journal. 10. Foot entries in the sales journal to determine whether they were correctly totaled by the client. 11. Make a surprise count of petty cash to verify that the amount of the petty cash fund is intact. 12. Obtain a written statement from the client's bank stating the client's year-end balance on deposit.

Answer: 1. observation 2. physical examination 3. reperformance 4. analytical procedure 5. inquiry of the client 6. reperformance 7. physical examination 8. analytical procedure 9. documentation 10. reperformance 11. physical examination 12. confirmation Terms: Audit evidence and audit procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

46) Match nine of the terms (a-k) with the definitions provided below (1-9). a. foot b. compute c. scan d. inquire e. count f. trace g. reperform h. read i. examine j. observe k. compare ________ 1. a calculation done by the auditor independent of the client ________ 2. addition of a column of numbers to determine if the total is the same as the client's ________ 3. a comparison of information in two different locations ________ 4. a use of the senses to assess certain activities ________ 5. following details of transactions from original documents to journals ________ 6. a less detailed examination of a document or record to determine if there is something unusual warranting further investigation ________ 7. obtaining information from the client in response to specific questions ________ 8. a determination of assets on hand at a given time ________ 9. an examination of written information to determine facts pertinent to the audit Answer: 1. b, 2. a, 3. k, 4. j, 5. f, 6. c, 7. d, 8. e, 9. h Terms: Audit procedures Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

47) Match five of the terms (a-h) with the definitions provided below (1-5). a. audit documentation b. audit procedures c. audit objectives d. analytical procedures e. budgets f. reliability of evidence g. sufficiency of evidence h. persuasiveness of evidence ________ 1. use of comparisons and relationships to assess the reasonableness of account balances ________ 2. detailed instructions for the collection of a type of audit evidence ________ 3. the degree to which evidence can be considered believable or trustworthy ________ 4. contains all the information that the auditor considers necessary to conduct an adequate audit and to provide support for the audit report ________ 5. this is determined by the amount of evidence obtained Answer: 1. d, 2. b, 3. f, 4. a, 5. g Terms: Audit procedures and audit evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

48) Below are 10 documents typically examined during an audit. Classify each document as either internal or external. Type of Document Documents 1. canceled checks for payments of accounts payable 2. payroll time cards 3. duplicate sales invoices 4. vendors' invoices 5. bank statements 6. minutes of the board of directors' meetings 7. signed lease agreements 8. notes receivable 9. subsidiary accounts receivable records 10. remittance advices Answer: 1. external 6. internal 2. internal 7. external 3. internal 8. external 4. external 9. internal 5. external 10. external Terms: Internal and external evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Analytic thinking 49) Distinguish between internal documentation and external documentation as types of audit evidence. Give two examples of each. Which type is considered more reliable? Answer: Internal documentation involves the auditor's examination of documents that have been prepared and used within the client's organization and are retained without ever going to an outside party. Examples would include duplicate sales invoices, employees' time reports, and inventory receiving reports. External documentation involves the auditor's examination of documents that have been in the hands of someone outside the client's organization. Examples include vendors' invoices, cancelled checks, cancelled notes payable, and insurance policies. External documents are regarded as more reliable evidence than internal documents. Terms: Internal and external documentation; Reliability of evidence Difficulty: Moderate Objective: LO 7-4 AACSB: Reflective thinking

7.5 Learning Objective 7-5 1) Analytical procedures are so important that they are required during the A) planning and test of control phases. B) planning and completion phases. C) test of control and completion phases. D) planning, test of control, and completion phases. Answer: B Terms: Analytical procedures required Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 2) A benefit obtained from using industry averages is that it provides a(n) A) benchmark to compare the company's results. B) indication where errors exist in the statements. C) benchmark to be used in evaluating a client's budgets. D) comparison of "what is" with "what should be." Answer: A Terms: Comparing client data with industry averages Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 3) Industry comparisons can be used as A) an aid to understanding the client's business. B) an indicator of errors. C) an indicator of fraud. D) an aid to system of internal controls. Answer: A Terms: Benefit of industry comparisons Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 4) Analytical procedures A) performed during the audit planning phase generally use aggregated data at a high level. B) are never performed during the testing phase of an audit. C) are declining in importance as a type of audit evidence. D) performed during the audit planning stage help the auditor take a final objective look at the audited financial statements. Answer: A Terms: Analytical procedures Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 38 Copyright © 2023 Pearson Education, Inc.

5) Analytical procedures performed during the planning phase of the audit A) are used as a substantive test in support of account balances. B) are used to assist in determining the nature, extent, and timing of audit procedures. C) are used to detect fraud. D) are mandatory only for public companies. Answer: B Terms: Analytical procedures in planning phase Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 6) Analytical procedures performed during the completion stage of the audit A) help the auditor understand the client's business and industry. B) are typically performed by a senior partner with extensive knowledge of the client's business. C) help the auditor identify significant matters requiring special attention later in the engagement. D) all of the above. Answer: B Terms: Analytical procedures; Completion stage of audit Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 7) Substantive analytical procedures performed during the testing phase of the audit A) are required under generally accepted auditing standards. B) are always done independently from other audit procedures. C) are used as a substantive test in support of account balances. D) do not need to be documented in the working papers. Answer: C Terms: Analytical procedures in stages of audit Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 8) Auditors compare client data with A) industry data. B) client-determined expected results. C) similar prior-period data. D) all of the above. Answer: D Terms: Analytical procedures Difficulty: Easy Objective: LO 7-5 AACSB: Reflective thinking

9) Which of the following is not a weakness of using industry averages for auditing? A) The industry data are broad averages. B) Different companies follow different accounting methods. C) They can be helpful in identifying potential misstatements. D) All of the above are weaknesses. Answer: C Terms: Analytical analysis; comparison of client and industry data Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 10) When comparing client data with similar prior-period data, A) if there have been no significant changes in the client's operations in the current year, much of the detail making up the totals in the financial statements should remain unchanged. B) comparison of details must take the form of details over time. C) comparing totals with previous years considers growth in the business activity. D) percent relationships fail to consider declines in the business activity. Answer: A Terms: Comparison of client data with similar prior-period data Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 11) Which of the following is accurate regarding the comparison of client data? A) Since budgets are only projections, auditors can ignore the differences between budgeted and actual results. B) One approach to overcome the limitations of industry averages is to compare the client to one or more benchmark firms in the industry. C) It is impractical to relate one account balance to another balance sheet or income statement account. D) It is extremely difficult to get industry data for comparative purposes. Answer: B Terms: Analytical analysis; comparison of client and industry data Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 12) Substantive analytical procedures performed in all phases of the audit generally use aggregate data to help understand where misstatements are more likely to occur. Answer: FALSE Terms: Analytical procedures; Substantive tests Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking

13) There has been an increased emphasis on the use of analytical procedures during an audit. Answer: TRUE Terms: Analytical procedures Difficulty: Easy Objective: LO 7-5 AACSB: Reflective thinking 14) The usefulness of analytical procedures as audit evidence depends significantly on appropriate comparison data. Answer: TRUE Terms: Analytical procedures Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 15) The most important benefits of industry comparisons are to aid in understanding the client's business and as an indication of the likelihood of financial failure. Answer: TRUE Terms: Analytical analysis; comparison of client and industry data Difficulty: Easy Objective: LO 7-5 AACSB: Reflective thinking 16) One substantive analytical procedure involves the auditor calculating an expected balance for an account and then comparing it to the actual account balance. Answer: TRUE Terms: Substantive analytical procedures Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 17) An example of an analytical procedure performed by the auditor includes an inventory pricing test which may identify the need for special care while performing substantive audit procedures on the inventory account balance. Answer: FALSE Terms: Analytical procedures in the planning stage of the audit Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking

18) As long as analytical procedures are performed during the planning and testing phase of the audit, it is not necessary for the auditor to perform analytical procedures during the completion phase of the audit. Answer: FALSE Terms: Analytical procedures in the completion stage of the audit Difficulty: Moderate Objective: LO 7-5 AACSB: Reflective thinking 19) State the three phases of the audit where analytical procedures can be performed and describe the specific procedures performed in each phase. Answer: Analytical procedures: can be performed during the following audit phases: • Planning phase — Auditing procedures are required during this phase. They are performed as part of the risk assessment procedures to understand the client's business and to assist in determining the nature, extent, and timing of audit procedures. • Testing phase — Analytical procedures done during this phase are substantive tests in support of account balances. These procedures are often done in conjunction with other audit procedures. • Completion phase — Analytical procedures are required to be performed during this phase. Such tests serve as a final review for material misstatements or financial problems and help the auditor take a final "objective look" at the audited financial statements. Terms: Purposes of analytical procedures Difficulty: Challenging Objective: LO 7-5 AACSB: Reflective thinking

7.6 Learning Objective 7-6 1) Financial ratios A) are used during the planning and final review phases of the audit. B) can be linked to the trial balance so that calculations are automatically updated as adjustments are made. C) should be compared to previous years and industry averages. D) all of the above. Answer: D Terms: Use of financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 2) Which of the following ratios is not a measure of a company's short-term debt paying ability? A) accounts receivable turnover B) cash ratio C) current ratio D) quick ratio Answer: A Terms: Financial ratios; short-term debt paying ability Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 3) Which financial ratio is computed by dividing current assets by current liabilities? A) quick ratio B) debt to equity C) accounts receivable turnover D) current ratio Answer: D Terms: Financial ratios; short-term debt paying ability Difficulty: Moderate Objective: LO 7-6 AACSB: Analytic thinking 4) Which account is used in the current ratio but not the quick ratio? A) marketable securities B) accounts payable C) accounts receivable D) inventory Answer: D Terms: Financial ratios; short-term debt paying ability Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 43 Copyright © 2023 Pearson Education, Inc.

5) To determine accounts receivable turnover, net sales are divided by A) beginning net accounts receivable. B) average gross receivables. C) cost of goods sold. D) 365 days. Answer: B Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Analytic thinking 6) A company's long-term solvency A) can be measured by the gross profit percentage. B) depends on the success of its operations and on its ability to raise capital for expansion. C) can be measured by the days to collect receivables ratio. D) depends on its ability to generate cash for the payment of dividends. Answer: B Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 7) Which of the following is an accurate statement regarding a company's ability to meet its long-term debt obligations? A) If the debt-to-equity ratio is too high, it may indicate that the company has used up its borrowing capacity. B) If the debt-to-equity ratio is too high, it may mean that available leverage is not being used to the owners' benefit. C) The times interest earned ratio indicates if a company can make its principal and interest payments. D) The key ratios that are used to measure a long-term solvency are debt to equity, return on assets, and times interest earned. Answer: A Terms: Common financial ratios; long-term debt obligations Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking

8) Which ratio do auditors find useful for assessing misstatements in sales, cost of goods sold, accounts receivable, and inventory? A) earnings per share B) profit margin C) gross profit percent D) current ratio Answer: C Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 9) Which ratio is computed by dividing operating income by net sales? A) gross profit percent B) profit margin C) return on sales D) return on assets Answer: B Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 10) Auditors use trends in the accounts receivable turnover ratio to assess the reasonableness of the company's credit policies. Answer: FALSE Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 11) Auditors use trends in the inventory turnover ratio to identify potential inventory obsolescence. Answer: TRUE Terms: Common financial ratios Difficulty: Easy Objective: LO 7-6 AACSB: Reflective thinking 12) The most widely used profitability ratio is the gross profit percent. Answer: FALSE Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking

13) Auditors use trends in the accounts receivable turnover ratio to assess the reasonableness of the allowance for doubtful accounts. Answer: TRUE Terms: Common financial ratios Difficulty: Moderate Objective: LO 7-6 AACSB: Reflective thinking 14) Auditors use trends in the inventory turnover ratio to identify potential errors in inventory pricing. Answer: FALSE Terms: Common financial ratios Difficulty: Easy Objective: LO 7-6 AACSB: Reflective thinking 15) The most important difference between the quick and the current ratios is the inclusion of inventory in current assets for the quick ratio. Answer: FALSE Terms: Common financial ratios Difficulty: Easy Objective: LO 7-6 AACSB: Reflective thinking 16) The times interest ratio helps the auditor determine if the client can comfortably make its interest payments required in the future on its long-term debts. Answer: TRUE Terms: Common financial ratios Difficulty: Easy Objective: LO 7-6 AACSB: Reflective thinking

7.7 Learning Objective 7-7 1) Which of the following best describes one of the primary objectives of audit documentation? A) defend against claims of a deficient audit B) provide a basis for reviewing the work of subordinates C) provide reasonable assurance that the audit was conducted in accordance with auditing standards D) provide additional support of recorded amounts to the client Answer: C Terms: Primary objective of audit documentation Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 2) Audit documents A) are kept by the client for easy reference for their accounting staff. B) should be considered as a substitute for the clients accounting records. C) are designed to facilitate the review and supervision of the work performed by the audit team by a reviewing partner. D) prepared during the engagement are the property of the client once the audit bill is paid. Answer: C Terms: Audit documentation Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 3) Audit documentation A) should identify the items tested when the audit procedures involve sampling of transactions or balances. B) does not aid in the preparation of the tax return since accounting and tax rules differ. C) is another term for the audit program. D) should not be given to anyone outside the audit firm, even if a subpoena has been issued. Answer: A Terms: Audit documentation Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking

4) Audit documentation of the evidence gathered by the auditor should meet which of the following criteria? A) Workpapers are prepared in sufficient detail so that they can be given to the client for future reference. B) The content is sufficient to provide support for the auditor's opinion, including the auditor's representation as to compliance with auditing standards. C) Audit evidence is principally gathered to determine if the client's financial statements, as prepared by management, can be relied upon to make managerial decisions about the firm. D) Audit evidence as displayed in the workpapers is primarily performed to protect the auditing firm in the case of a lawsuit by investors. Answer: B Terms: Audit evidence gathered by auditors meets which criteria Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 5) Audit documents are the joint property of the auditor and the audit client. Answer: FALSE Terms: Audit documentation Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 6) Auditing standards require that records for audits of private companies be retained for a minimum of seven years. Answer: FALSE Terms: Audit documentation; retention Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 7) The SEC requires the auditors of public companies to retain email correspondence related to the audit. Answer: TRUE Terms: Audit documentation; retention Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 8) Approved peer reviewers or regulatory inspectors do not have the right to inspect audit documentation prepared during an audit engagement. Answer: FALSE Terms: Audit documentation; ownership of the audit files Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 48 Copyright © 2023 Pearson Education, Inc.

9) The only time anyone else, including the client, has the legal right to examine the audit files is when they are subpoenaed by a court as legal evidence. Answer: FALSE Terms: Audit documentation; ownership of the audit files Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 10) The law makes the knowing and willing destruction of audit documentation for audits of public companies within the 7-year required retention period a criminal offense subject to financial fines and imprisonment up to 10 years. Answer: TRUE Terms: Requirements for retention of audit documentation Difficulty: Moderate Objective: LO 7-7 AACSB: Reflective thinking 11) Auditors of public companies are required to retain email correspondence related to public company audits meeting certain Securities and Exchange Commission rules. Answer: TRUE Terms: Requirements for retention of audit documentation Difficulty: Easy Objective: LO 7-7 AACSB: Reflective thinking

7.8 Learning Objective 7-8 1) When preparing and organizing audit files, A) the rules established by the SEC and PCAOB must be followed. B) a lead schedule contains the detailed accounts from the general ledger making up the line item total on the trial balance. C) a working trial balance is considered part of the permanent file. D) the audit program is not part of the audit files. Answer: B Terms: Audit files Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 2) Audit documentation should possess certain characteristics. Which of the following is true regarding those characteristics? A) Audit documentation should be Audit documentation should be indexed and cross-referenced organized to benefit the client's staff Yes Yes B) Audit documentation should be indexed and cross-referenced No

Audit documentation should be organized to benefit the client's staff No

Audit documentation should be indexed and cross-referenced Yes

Audit documentation should be organized to benefit the client's staff No

D) Audit documentation should be indexed and cross-referenced No

Audit documentation should be organized to benefit the client's staff Yes

Answer: C Terms: Audit documentation characteristics Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking

3) The permanent audit file would usually include the A) client's working trial balance. B) summary of the risk assessment procedures performed. C) organizational chart of the company's employees. D) summary of the auditor's test of controls for the current years audit. Answer: C Terms: Permanent file Difficulty: Challenging Objective: LO 7-8 AACSB: Reflective thinking 4) The permanent files included as part of audit documentation do not normally include A) a copy of the current and prior years' audit programs. B) copies of articles of incorporation, bylaws and contracts. C) information related to the understanding of system of internal control. D) results of analytical procedures from prior years. Answer: A Terms: Permanent file Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 5) Supporting schedules A) must be prepared by the auditor. B) make up the largest portion of audit documentation. C) must consist of either reconciliation of amounts or substantive analytical procedures. D) all of the above. Answer: B Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 6) What type of supporting schedule is designed to show detailed tests performed, does not tie in to the general ledger, but must state a positive or negative conclusion about the objective of the test? A) outside documentation B) reconciliation of amounts C) examination of supporting documents D) substantive analytical procedures Answer: C Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking

7) A(n) ________ is a supporting schedule that supports a specific amount and is normally expected to tie the amount recorded in the client's records to another source of information. A) reconciliation of amounts B) analysis C) summary of procedures D) informational document Answer: A Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 8) Which type of supporting schedule is designed to show the activity in a general ledger account during the entire period under audit? A) trial balance B) reconciliation of amounts C) summary of procedures D) analysis Answer: D Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 9) Auditors use tick marks, which are symbols adjacent to the detail on the body of the schedule. Answer: TRUE Terms: Audit documentation; tick marks Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 10) An example of a supporting schedule is a reconciliation of amounts, which consists of the details that make up a year-end balance. Answer: FALSE Terms: Supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 11) Since confirmation replies and copies of client agreements are not considered schedules in the usual sense, they are not indexed and filed. Answer: FALSE Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 52 Copyright © 2023 Pearson Education, Inc.

12) An auditor can use engagement management software to facilitate tracking audit progress. Answer: TRUE Terms: Technology and audit evidence Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 13) Auditors may download all transactions from the general ledger into the working trial balance file for subsequent audit testing and analysis. Answer: TRUE Terms: Working trial balance Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 14) Adjusting entries discovered in the audit are often prepared by the auditor; these adjusting entries do not have to be approved by the client. Answer: FALSE Terms: Adjusting entries discovered in the audit Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 15) It is not common nor required for an auditor to summarize all adjusting entries which have not been recorded before the audit is concluded. Answer: FALSE Terms: Adjusting entries discovered in the audit Difficulty: Easy Objective: LO 7-8 AACSB: Reflective thinking 16) It is essential that the detail on an audit schedule is designed to list the detail and show the verification of support for a balance sheet account, and that this schedule also reconciles with the trial balance. Answer: TRUE Terms: Audit documentation and audit schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking

17) When determining sufficient and appropriate audit evidence in order to form an opinion on the client's financial statements, the auditor compiles audit documentation to support the opinion. The largest portion of audit documentation will include detailed supporting schedules prepared by the client or the auditor in support of specific accounts on the financial statements. Two types of supporting schedules are analysis and reconciliation of amounts. Discuss those two schedules and give an example for each schedule. Answer: Analysis: designed to show the activity in a general ledger account during the entire period under audit, tying together the beginning and ending balances. Examples: marketable securities, property, plant and equipment, long-term debt, equity accounts. Reconciliation of amounts: Supports a specific amount and is normally expected to tie the amount recorded in the client's records to another source of information. Examples: the reconciliation of cash balances with bank statements, the reconciliation of subsidiary accounts receivable balances with confirmations from customers, and the reconciliation of accounts payable balances with vendors' statements. (Note: students were only required to give one example) Terms: Audit documentation; supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking 18) The basis for preparing financial statements for companies is the general ledger. As soon as possible the auditor obtains the general ledger accounts of the client and prepares a working trial balance. Discuss the audit documentation in the current file that relates to the working trial balance. Include a description of lead and support schedules in your answer. Answer: Lead Schedules—each line item on the working trial balance is supported by a lead schedule, containing the detailed accounts from the general ledger making up the line item in the working trial balance Support Schedules—each detailed account of the lead schedule is supported by proper schedules supporting the audit work performed and the conclusions reached by the auditors Terms: Supporting schedules Difficulty: Moderate Objective: LO 7-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 8 Audit Planning and Materiality 8.1 Learning Objective 8-1 1) A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued is the A) inherent risk. B) acceptable audit risk. C) statistical risk. D) financial risk. Answer: B Terms: Acceptable audit risk Difficulty: Easy Objective: LO 8-1 AACSB: Reflective thinking 2) The first phase in planning an audit and designing an audit approach is to A) accept the client and perform initial audit planning. B) set the preliminary judgment of materiality. C) understand the client's business and industry. D) perform preliminary audit procedures. Answer: A Terms: Steps in planning an audit and designing an audit approach Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 3) ________ is the risk that the financial statements contain a material misstatement due to fraud or error prior to the audit. A) Inherent risk B) Client business risk C) Acceptable audit risk D) Risk of material misstatement Answer: D Terms: Risk of material misstatements Difficulty: Easy Objective: LO 8-1 AACSB: Reflective thinking

4) In what order should the following steps occur? A. Set preliminary judgment about materiality and performance materiality. B. Understand the client's business and industry. C. Perform preliminary analytical procedures. D. Accept the client and perform initial audit planning. A) D, B, C, A B) B, A, C, D C) B, D, A, C D) D, C, B, A Answer: A Terms: Steps in planning an audit and designing an audit approach Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 5) The auditor uses knowledge gained from the understanding of the client's business and industry to assess A) client business risk. B) control risk. C) inherent risk. D) audit risk. Answer: A Terms: Client business risk Difficulty: Challenging Objective: LO 8-1 AACSB: Analytic thinking 6) When an auditor sets a low acceptable audit risk, it means that he or she wants to be more certain that the financial statements are not materially misstated. Answer: TRUE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 7) As acceptable audit risk is decreased, the likely cost of conducting an audit increases. Answer: TRUE Terms: Acceptable audit risk Difficulty: Challenging Objective: LO 8-1 AACSB: Reflective thinking

8) Assessing acceptable audit risk, client business risk, and risk of material misstatement helps determine the audit procedures that will be needed. Answer: TRUE Terms: Assessing risk and planning audit procedures Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 9) A 100% audit risk is complete certainty. Answer: FALSE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 10) Zero risk is certainty, and a 100% audit risk is complete uncertainty. Answer: TRUE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 11) Client business risk is the risk that the entity fails to achieve its objectives or execute its strategies. Answer: TRUE Terms: Client business risk Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 12) Client business risk includes the auditor identifying declines in economic conditions that adversely affect sales and the collectability of accounts receivable. Answer: TRUE Terms: Client business risk Difficulty: Easy Objective: LO 8-1 AACSB: Reflective thinking 13) The risk of material misstatement is the risk that the financial statements contain a material misstatement due to fraud or error prior to the audit. Answer: TRUE Terms: Risk of material misstatement Difficulty: Easy Objective: LO 8-1 AACSB: Reflective thinking

14) The risk of material misstatement is a function of the susceptibility of the financial statements to misstatement; the effectiveness of the client's controls in preventing or detecting these misstatements has no impact on the risk of material misstatement. Answer: FALSE Terms: Risk of material misstatement Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 15) Assume an audit client identified in the planning stage of the audit the risk of material misstatement for revenue recognition and accounts receivable due to complex valuation related issues; this situation warrants the auditor to accumulate additional audit evidence and to assign more experienced staff to perform the testing in this area. Answer: TRUE Terms: Risk of material misstatement Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking 16) There are three main reasons why an auditor should properly plan audit engagements. Discuss each of these reasons. Answer: Three reasons why an auditor should properly plan audit engagements are: • To enable the auditor to obtain sufficient competent evidence for the circumstances. This is essential for minimizing legal liability and maintaining a good reputation in the business community. • To help keep audit costs reasonable. Given the competitive auditing environment, keeping costs reasonable helps the firm obtain and retain clients. • To avoid misunderstandings with the client. This is important for good client relations. Terms: Reasons auditor should properly plan audit engagement Difficulty: Moderate Objective: LO 8-1 AACSB: Reflective thinking

8.2 Learning Objective 8-2 1) One of the purposes of an engagement letter is to avoid misunderstandings with the client. This is important for A) Engagement objectives Engagement limitations Yes Yes B) Engagement objectives No

Engagement limitations No

Engagement objectives Yes

Engagement limitations No

Engagement objectives No

Engagement limitations Yes

Answer: A Terms: Engagement letter Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking

2) The auditor is likely to accumulate more evidence when the audit is for a company A) Which has large amounts of debt Which is to be sold in the near future Yes Yes B) Which has large amounts of debt Which is to be sold in the near future No No C) Which has large amounts of debt Which is to be sold in the near future Yes No D) Which has large amounts of debt Which is to be sold in the near future No Yes Answer: A Terms: Reasons for an audit and audit evidence Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 3) Initial audit planning involves four matters. Which of the following is not one of these? A) Develop an overall audit strategy. B) Request that bank balances be confirmed. C) Schedule engagement staff and audit specialists. D) Identify the client's reason for the audit. Answer: B Terms: Initial audit planning Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 4) Smith, CPA, has requested permission to communicate with the predecessor auditor in order to review certain workpapers for high risk accounts for a new audit client. The new audit client's refusal to allow this communication to occur would impact Smith's decision concerning A) the auditor's ability to design audit tests. B) possible scope exception due to lack of access. C) the desirability of accepting the prospective engagement. D) violation of the GAAP rules concerning consistency and comparability of financial information. Answer: C Terms: New audit client's refusal to allow communication between predecessor and successor auditors Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

5) A successor auditor may perform which of the following for a new audit client? A) Speak to local attorneys, banks and other Speak to the predecessor auditors about businesses regarding the company's disagreements they had with management reputation Yes Yes B) Speak to local attorneys, banks and other Speak to the predecessor auditors about businesses regarding the company's disagreements they had with management reputation No No C) Speak to local attorneys, banks and other Speak to the predecessor auditors about businesses regarding the company's disagreements they had with management reputation Yes No D) Speak to local attorneys, banks and other Speak to the predecessor auditors about businesses regarding the company's disagreements they had with management reputation No Yes Answer: A Terms: Successor auditor may perform communication for new audit client Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 6) When dealing with audit risk, A) audit risk should not be a factor when determining if a new client should be accepted. B) audits with a low acceptable audit risk generally result in lower audit fees. C) if management of a company has a reputation of integrity, but is also known to take aggressive financial risks, the auditor should not accept the company as a new client. D) if the auditor concludes that acceptable audit risk is low, but the client is still acceptable, the auditor may still accept the engagement but increase the fee proposed to the client. Answer: D Terms: Lower acceptable audit risk Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking

7) A written understanding detailing what the auditor expects from the client in performing an audit will normally be expressed in the A) management letter requested by the auditor. B) engagement letter. C) audit plan. D) audit strategy for the client. Answer: B Terms: Written understanding detailing what auditor will do and what auditor expects from client in performing audit Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 8) For public companies, the ________ is responsible for hiring the auditor as required by the Sarbanes-Oxley Act. A) client's management B) client's chief executive officer C) client's chief financial officer D) client's audit committee Answer: D Terms: Responsibility for agreeing nonaudit services for a public company audit client Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 9) Which of the following statements is true regarding communications between predecessor and successor auditors? A) The burden of initiating the communication rests with the predecessor. B) The predecessor's response can be limited to stating that no information will be provided. C) The predecessor should communicate with the successor only if the client is public. D) The predecessor auditor of a public company does not need permission from the client before communicating with the successor auditor. Answer: B Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

10) The purpose of an engagement letter is to A) document the CPA firm's responsibility to external users of the audited financial statements. B) document the terms of the engagement. C) notify the audit staff of an upcoming engagement so that personnel scheduling can be facilitated. D) emphasize management's responsibility for approving the audit program. Answer: B Terms: Purpose of engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 11) The written communication stating the auditor cannot guarantee that all acts of fraud will be discovered is found in the A) engagement letter. B) representation letter. C) responsibility letter. D) client letter. Answer: A Terms: Reasons for an audit and audit evidence Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 12) Which of the following normally signs the engagement letter for an audit of a private company? A) management B) board of directors' representative C) audit committee representative D) corporate treasurer Answer: A Terms: Normally signs engagement letter for audit of private company Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 13) The two major factors affecting acceptable audit risk are A) inherent risk and the intended uses of the financial statements. B) control risk and the intended uses of the financial statements. C) the likely statement users and their intended uses of the statements. D) the audit firm and the intended uses of the statements. Answer: C Terms: Audit risk Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 9 Copyright © 2023 Pearson Education, Inc.

14) An engagement letter sent to a publicly held audit client usually would not include a(n) A) reference to the auditor's responsibility for the detection of errors or irregularities. B) estimation of the time to be spent on the audit work by audit staff and management. C) statement that management advisory services would be made available upon request. D) reference to management's responsibility for the financial statements. Answer: C Terms: Engagement letter sent to publicly held client Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking 15) The preliminary audit strategy A) is set before the auditor understands the client's reasons for the audit. B) guides the development of the audit plan. C) is determined after the engagement staffing is set. D) is the detailed steps to be followed for the substantive audit tests. Answer: B Terms: Audit strategy Difficulty: Moderate Objective: LO 8-2 AACSB: Analytic thinking 16) The purpose of the requirement in having communication between the predecessor and successor auditors is to A) allow the predecessor to disclose information which would otherwise be confidential. B) help the successor auditor to evaluate whether to accept the engagement. C) help the client by facilitating the change of auditors. D) ensure the predecessor collects all unpaid fees prior to a change in auditor. Answer: B Terms: Purpose of having communication between predecessor and successor audit Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking 17) The predecessor auditor is required to respond to the request of the successor auditor for information, but the response can be limited to stating that no information will be provided when A) the predecessor auditor has poor relations with the successor auditor. B) the client is dissatisfied with the predecessor's work. C) there are actual or potential legal problems between the client and the predecessor. D) the predecessor believes that the client lacks integrity. Answer: C Terms: Predecessor auditor respond to request of successor auditor for information Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking

18) Which of the following best expresses the understanding of the terms of the engagement that exist between the client and the CPA firm? A) Management asserts there are no errors, material or immaterial, in the general ledger. B) Auditors assert that the primary audit goal is audit efficiency. C) Auditors assert that their primary responsibility is to plan and perform the audit in order to provide reasonable assurance as to the detection of material misstatement due to error or fraud. D) Management asserts that they will provide the auditor with a risk assessment as to material misstatements due to errors or fraud in the company's financial statements. Answer: C Terms: Understand responsibilities of the auditor and company for the audit Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking 19) When selecting staff for the audit engagement, A) only staff members who are CPAs should be assigned to the audit. B) only managers and above need to have appropriate competence and capabilities to perform the audit. C) continuity of staff members from year to year should not be a factor. D) staff assigned to the audit must be knowledgeable about the client's industry. Answer: D Terms: Selection of audit staff for engagement Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 20) When developing the overall strategy for the audit, the auditor will A) decide whether to accept a new client. B) determine if any audit specialists will be required. C) identify why the auditor needs an audit. D) obtain an engagement letter. Answer: B Terms: Overall strategy for the audit Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking

21) Which of the following is not true regarding the auditor's use of a specialist? A) There is no need for the auditor to evaluate the specialist's objectivity as long as they have the required expertise. B) The auditor should evaluate the specialist's professional qualifications. C) The auditor should understand the objectives and the scope of the specialist's work. D) There is a need for the auditor to refer to the specialist's report if the auditor modified the audit opinion as a result of the specialist's report. Answer: A Terms: Overall strategy for the audit Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 22) Which is usually included in an engagement letter? A) Estimate of hours required to Dollar estimate of fees to be billed to complete audit the client Yes Yes B) Estimate of hours required to complete audit No

Dollar estimate of fees to be billed to the client No

Estimate of hours required to complete audit Yes

Dollar estimate of fees to be billed to the client No

Estimate of hours required to complete audit No

Dollar estimate of fees to be billed to the client Yes

Answer: D Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

23) Which is usually included in an engagement letter? A) The objectives of the Identification of the financial engagement reporting framework used by management Yes Yes B) The objectives of the engagement No

Identification of the financial reporting framework used by management No

C) The objectives of the engagement Yes

Identification of the financial reporting framework used by management No

D) The objectives of the engagement No

Identification of the financial reporting framework used by management Yes

Answer: A Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

24) Which is usually included in an engagement letter? A) The financial statements are Ratios to be used by the auditor in the responsibility of the the planning phase company's management Yes Yes B) The financial statements are the responsibility of the company's management No

Ratios to be used by the auditor in the planning phase

The financial statements are the responsibility of the company's management Yes

Ratios to be used by the auditor in the planning phase

The financial statements are the responsibility of the company's management No

Ratios to be used by the auditor in the planning phase

Yes

Answer: C Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

25) When may the auditor refer to a specialist in the audit report? A) Only if the specialist's report results in a modification of the Only if the specialist assisted in the audit audit of an account material to the opinion financial statements Yes Yes B) Only if the specialist's report results in a modification of the audit opinion No

Only if the specialist assisted in the audit of an account material to the financial statements No

Only if the specialist's report results in a modification of the audit opinion Yes

Only if the specialist assisted in the audit of an account material to the financial statements No

Only if the specialist's report results in a modification of the audit opinion No

Only if the specialist assisted in the audit of an account material to the financial statements Yes

Answer: C Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

26) Which is usually included in the engagement letter? A) The projected type of opinion on the Name(s) of the client personnel financial statement to be audited responsible for supplying the auditor with information Yes Yes B) The projected type of opinion on the Name(s) of the client personnel financial statement to be audited responsible for supplying the auditor with information No No C) The projected type of opinion on the Name(s) of the client personnel financial statement to be audited responsible for supplying the auditor with information Yes No D) The projected type of opinion on the Name(s) of the client personnel financial statement to be audited responsible for supplying the auditor with information No Yes Answer: B Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

27) Which is usually included in the engagement letter? A) List of audit procedures to be used The auditors' assessment of audit in inventory observation risk Yes Yes B) List of audit procedures to be used in inventory observation No

The auditors' assessment of audit risk No

C) List of audit procedures to be used in inventory observation Yes

The auditors' assessment of audit risk No

D) List of audit procedures to be used in inventory observation No

The auditors' assessment of audit risk Yes

Answer: B Terms: Engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 28) Before accepting a new client, most CPA firms investigate the company to determine its acceptability. However, AICPA confidentiality requirements prohibit CPA firms from contacting certain parties—namely the company's attorneys and bankers—during this investigation. Answer: FALSE Terms: Acceptance of new client Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 29) For prospective clients that have previously been audited by another CPA firm, the predecessor auditor must initiate the communication with the successor auditor. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking

30) When a successor auditor contacts a company's previous auditor, the predecessor auditor is required to respond fully and without limit to the request for information. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 31) A predecessor auditor who has been contacted by a successor auditor for information about the client does not have to obtain permission from the former client before providing any confidential information to the successor auditor because the confidentiality requirement does not extend to former clients. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 32) An auditor must evaluate a specialist's professional qualifications and understand the objectives of the specialist's work. Answer: TRUE Terms: Auditor evaluates specialist's work Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 33) Because of audit risk, some CPA firms now refuse any new clients in certain high-risk industries. Answer: TRUE Terms: Audit risk Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 34) An engagement letter establishes a clear understanding of the terms of the engagement between the client and the auditor. Answer: TRUE Terms: Engagement letter Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking

35) Because auditors are responsible for having appropriate competence and capabilities to perform an audit, auditors are not normally permitted to consult with outside specialists during an audit engagement. Answer: FALSE Terms: Use of outside specialists during audit engagement Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 36) If a prospective client has been audited in the past, the successor auditor will typically rely solely on the representations about the client by the predecessor auditor. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 37) A major consideration in audit staffing is the need for continuity from year to year. Answer: TRUE Terms: Consideration in assigning staff to audit engagement Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 38) When a successor auditor requests information from a company's previous auditor, and there are legal problems or disputes between the client and the predecessor auditor, the predecessor auditor's response to the new auditor may be limited to stating that no information will be provided. Answer: TRUE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 39) Staff assigned to an audit engagement must be knowledgeable about the client's industry. Answer: TRUE Terms: Selection of audit staff for engagement Difficulty: Challenging Objective: LO 8-2 AACSB: Reflective thinking

40) The burden of initiating communication with the successor audit rests with the predecessor auditor, especially in the event of legal problems or disputes between the client and the predecessor auditor. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 41) If the client will not permit the predecessor auditor to communicate with the successor auditor, or the predecessor does not provide a comprehensive response to the successor auditor, the successor auditor must not accept the audit engagement. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 42) A successor auditor must seek the written permission of a prospective audit client before making other investigations regarding the prospective audit client, including gathering information from local attorneys, other CPAs, banks, and other businesses. Answer: FALSE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 43) AICPA auditing standards require the auditor to determine whether the financial statement framework to be used by management to prepare the financial statements is appropriate under the circumstances. Answer: TRUE Terms: Communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 44) A CPA firm may decide not to continue doing audits for an existing audit client simply due to what the CPA firm deems to be excessive risk, alone, even if the audit engagement is very profitable to the CPA firm. Answer: TRUE Terms: Continuing clients audit risk and acceptable audit risk Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

45) Auditing standards recommend, but do not require, that auditors obtain an understanding with the client in an engagement letter approved by the audit committee of public companies. Answer: FALSE Terms: Obtaining an understanding with the client and engagement letters Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 46) The engagement letter may include an agreement to provide other services to the audit client such as tax returns and management consulting services allowed under the Code of Professional Conduct and regulatory requirements. Answer: TRUE Terms: Obtaining an understanding with the client and engagement letters Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 47) Specialists may be employed by the client, employed by the audit firm, or affiliated with the client and the audit firm. Answer: FALSE Terms: Evaluating the need for outside specialists Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 48) The auditor's report should not refer to the specialist unless the specialist's report results in a modification of the audit opinion. Answer: TRUE Terms: Evaluating the need for outside specialists Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 49) Discuss the factors an auditor should consider before accepting a company as an audit client. Answer: The auditor should investigate and consider the prospective client's standing in the business community, financial stability, management's integrity, and relations with its bankers, attorneys, and previous CPA firm. The auditor should also determine whether he or she possesses the required competence and independence to do the audit. Terms: Factors to consider before accepting audit client Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking

50) Discuss the primary purpose of an audit engagement letter. Is an engagement letter required? Answer: The purpose of an audit engagement letter is to establish a clear understanding between the auditor and the client regarding the terms of the engagement. An engagement letter is required for both public and private company audits. Terms: Reasons for an audit and audit evidence Difficulty: Easy Objective: LO 8-2 AACSB: Reflective thinking 51) Discuss the essential activities involved in the initial planning of an audit. Answer: There are four essential activities involved in the initial planning of an audit. These are: 1. Client acceptance or continuation. In the case of a new client, the auditor must determine whether the client is one with which they wish to be associated. In the case of a continuing client, an auditor must determine whether continuing the relationship is appropriate and in the firm's best interest. 2. The auditor should identify why the client wants or needs an audit. The auditor should determine the reason for the audit as soon as practical. The remainder of the planning activities may be impacted by the client's reason for requesting the audit. 3. Obtain an understanding with the client about the terms of the engagement. An understanding with the client should be obtained to avoid misunderstandings. Auditors are required to obtain an understanding with their clients. This understanding must be written. 4. Develop an overall audit strategy. The strategy should consider the reasons for the audit, including engagement staffing and any required audit specialists. Setting a strategy helps the auditor determine the resources required for the engagement. Terms: Essential activities involved in initial planning of audit Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 52) Discuss the required communications between predecessor and successor auditors. Answer: Auditing standards require a successor auditor to communicate with the predecessor auditor whenever accepting a client that has been previously audited. The purpose of the communication is to help the successor auditor evaluate whether to accept the engagement. While the burden of initiating the communication rests on the successor auditor, the predecessor auditor must respond to the request for information. However, because of the requirements related to confidentiality, the predecessor must obtain the former client's permission prior to providing information to the successor. Terms: Required communications between predecessor and successor auditors Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

53) Discuss several reasons why an auditor may not wish to continue a relationship with an existing audit client. Answer: There are a number of reasons an auditor may choose not to continue a relationship with an existing client. Examples include: 1. previous conflicts over the appropriate scope of the audit, the type of opinion to issue, unpaid fees, or other matters 2. management integrity may be deemed to be insufficient 3. legal action initiated by either the auditor or client related to prior audit services 4. the presence of excessive risk which could result in financial failure of the client or lawsuits against the audit firm Terms: Reasons auditor may not wish to continue relationship with existing audit client Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking 54) Discuss four of the matters that should be specified in an engagement letter. Answer: Matters that should be specified in the engagement letter include: • the objectives of the engagement • the responsibilities of the auditor and management • identification of the financial reporting framework used by management • reference to the expected form and content of the audit report • the engagement's limitation • an agreement as to any other services to be provided • restrictions to be imposed on the auditor's work • deadlines for completing the audit • assistance to be provided by the client's personnel in obtaining records and documents and schedules to be prepared for the auditor • agreement on fees • auditor cannot guarantee that all acts of fraud will be discovered Terms: Items included in engagement letter Difficulty: Moderate Objective: LO 8-2 AACSB: Reflective thinking

8.3 Learning Objective 8-3 1) In order to obtain an understanding of the client's business, the audit firm will consider A) inherent and control risk of the client. B) audit risk to the CPA firm. C) the client's business risk and the risk of material misstatements in the financial statements. D) the CPA firm's potential ongoing revenue from the audit client. Answer: C Terms: Understanding the client's business and industry Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 2) Most auditors assess the risk of material misstatement as high for related parties and relatedparty transactions because A) of the unique classification of related-party transactions required on the balance sheet. B) of the lack of independence between the parties. C) of the unique classification of related-party transactions required on the income statement. D) it is required by generally accepted accounting principles. Answer: B Terms: Risk of material misstatement assessed high for related party transactions Difficulty: Easy Objective: LO 8-3 AACSB: Reflective thinking 3) A tour of the client's facilities provides the auditor an opportunity to A) meet key personnel. B) observe operations. C) assess physical safeguards over assets. D) all of the above. Answer: D Terms: Understand responsibilities of the auditor and company for the audit Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 4) The auditor determines that Matthews Company occupies the 3rd floor of an office tower for which it pays no rent. The most likely explanation is A) they got lucky the landlord hasn't noticed the lack of payments. B) the landlord has weak system of internal controls over billings. C) a related party transaction in which a major shareholder owns the office tower. D) Matthews Company is engaging in fraudulent activities. Answer: C Terms: Related party transactions Difficulty: Challenging Objective: LO 8-3 AACSB: Analytic thinking 24 Copyright © 2023 Pearson Education, Inc.

5) An official record of meetings of the board of directors and stockholders is included in the corporate A) bylaws. B) charter. C) minutes. D) license. Answer: C Terms: Official record of meetings of board of directors and stockholders Difficulty: Easy Objective: LO 8-3 AACSB: Reflective thinking 6) A related party transaction may be indicated when another company A) subsidizes certain operating expenses of the company. B) purchases its securities at their fair value. C) loans to the company at market rates. D) has had a distributor relationship with the company for 10 years. Answer: A Terms: Related party transactions Difficulty: Moderate Objective: LO 8-3 AACSB: Analytic thinking 7) Which of the following is an accurate statement regarding a public company's code of ethics? A) A code of ethics is required under The Foreign Corrupt Practices Act. B) A code of ethics is required only for mid-level managers and below. C) The SEC requires companies to disclose amendments and waivers to the code of ethics for the CEO, CFO and principal accounting officer. D) The PCAOB requires companies to review their code of ethics every five years. Answer: C Terms: Code of ethics Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 8) An auditor should examine minutes of the board of directors' meetings A) through the date of the financial statements. B) through the date of the audit report. C) only at the beginning of the audit. D) on a test basis. Answer: B Terms: Minutes of the board of directors' meetings Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 25 Copyright © 2023 Pearson Education, Inc.

9) Which of the following would most likely not be classified as a related-party transaction? A) an advance of one week's salary to an employee B) sales of merchandise between affiliated companies C) loans or credit sales to the principal owner of the client company D) exchanges of equipment between two companies owned by the same person Answer: A Terms: Related party transactions Difficulty: Challenging Objective: LO 8-3 AACSB: Reflective thinking 10) Which of the following best describes the corporate minutes of an entity? A) official record of the meetings of the board of directors and the stockholders B) unofficial record of the meeting of the board of directors C) official record of management meeting with investors and creditors of the company D) unofficial record of the board of directors' meetings Answer: A Terms: Corporate minutes Difficulty: Easy Objective: LO 8-3 AACSB: Reflective thinking 11) Related party A) transactions must be disclosed in the footnotes even if the amounts are immaterial. B) disclosures include the nature of the related party relationship and a description of the transaction. C) transactions are considered arm's-length transactions. D) disclosures are required only for public companies. Answer: B Terms: Related party transactions Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 12) Auditors should understand client objectives related to A) reliability of financial reporting. B) effectiveness and efficiency of operations. C) compliance with laws and regulations. D) all of the above. Answer: D Terms: Client objectives and strategies Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking

13) When analyzing a client's performance measurement system, A) ratio analysis and benchmarking against key competitors are utilized. B) only income statement numbers are used. C) inherent risk of financial statement misstatements may be decreased if the performance measurement system encourages aggressive accounting. D) the auditor is likely to decrease the extent of testing if the client has set unreasonable objectives. Answer: A Terms: Performance measurement system Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 14) Auditors should obtain copies of the client's code of ethics and minutes of the meetings of the board of directors to aid in their understanding of the company's management and governance structure. Answer: TRUE Terms: Code of ethics and board of directors' meeting minutes; Understanding of company management and governance structure Difficulty: Easy Objective: LO 8-3 AACSB: Reflective thinking 15) Many risks are common to all clients in certain industries. Answer: TRUE Terms: Common risks Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 16) Transactions with related parties must be disclosed in the financial statements if they are deemed to be material. Answer: TRUE Terms: Related parties Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 17) All known related parties must be identified and included in the auditor's permanent files related to the client. Answer: TRUE Terms: Related parties Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking

18) Because of the lack of independence between related parties, the Sarbanes-Oxley Act prohibits all related party transactions. Answer: FALSE Terms: Related parties Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 19) Management's philosophy and operating style influence the risk of material misstatements in the financial statements. Answer: TRUE Terms: Management integrity Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 20) The auditor should read the corporate minutes to obtain authorizations and other information that is relevant to performing the audit. Answer: TRUE Terms: Corporate minutes Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 21) Material transactions between the client and the client's related parties must be disclosed in the auditor's report. Answer: FALSE Terms: Material related party transactions Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 22) A tour of the client's facilities can help the auditor assess physical safeguards over assets and interpret accounting data related to assets such as factory equipment. Answer: TRUE Terms: Business risk and factors that impact auditor's assessment Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 23) Operations are approaches followed by the entity to achieve organizational objectives. Answer: FALSE Terms: Client objectives and strategies Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

24) Given the extensive use of third-party vendors for a variety of information technologyrelated services, management must obtain greater knowledge regarding these suppliers, not the auditor, when performing their risk assessment procedures. Answer: FALSE Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 25) Auditors cannot learn about potential related parties for an audit client by reviewing Securities and Exchange Commission (SEC) filings. Answer: FALSE Terms: Related party transactions Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 26) A public company must disclose if the company has not adopted a code of ethics that applies to senior management, but not the reason why it has not done so. Answer: FALSE Terms: Code of ethics Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 27) Define the term "related party" and discuss why an auditor should identify the client's related parties early in the audit. Answer: A related party is an affiliated company, principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other. Transactions with related parties are important to auditors because accounting standards require that they be disclosed in the financial statements. Auditors need to be aware of who the client's related parties are early in the audit to enable the auditor to identify related-party transactions, especially those that have not been disclosed. Terms: Related parties Difficulty: Easy Objective: LO 8-3 AACSB: Reflective thinking

28) What documents do auditors routinely obtain to aid in their understanding of a client's governance system? Briefly discuss each of these documents. Answer: Auditors commonly obtain the company's organizational structure, code of ethics, and the minutes of meetings of the board of directors and shareholders. To gain an understanding of the client's governance system, the auditor should understand how the board and the audit committee exercise oversight, including consideration of the company's code of ethics and evaluation of the corporate minutes. Companies frequently communicate the entity's values and ethical standards through policy statements and codes of conduct. The corporate minutes are the official record of the meetings of the board of directors and stockholders. They include summaries of the most important topics discussed and decisions made at the board meetings. Terms: Documents for client's governance system Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 29) What are three factors that have increased the importance of obtaining an understanding of a client's business and industry? How can an auditor obtain this understanding? Answer: Factors that have increased the importance of obtaining an understanding of a client's business and industry include: • Recent significant declines in economic conditions around the world are likely to significantly increase a client's business risks. Auditors need to understand the nature of the client's business to understand the impact of major economic downturns on the client's financial statements and ability to continue as a going concern. • Information technology connects client companies with major customers and suppliers. As a result, auditors need greater knowledge about major customers and suppliers and the related risks. That connectivity also exposes the client to potential cyber risks that the auditor should consider. • Companies have expanded operations globally, often through joint ventures and strategic alliances. • Information technology affects internal client processes, improving the quality and timeliness of accounting information. • The increased importance of human capital and other intangible assets has increased accounting complexity and the importance of management judgments and estimates. • Many clients have invested in complex financial instruments which may have declined in value, require complex accounting treatments, and often involve unknown counterparties who may create unexpected financial risks for the client. Auditors consider these factors using a strategic approach to understand the client's business. The auditor can obtain a good understanding of the client's business and industry through various means. Terms: Factors that increase the importance of obtaining an understanding of a client's business and industry Difficulty: Challenging Objective: LO 8-3 AACSB: Reflective thinking

30) There are three primary reasons for obtaining a thorough understanding of the client's industry and external environment. What are these reasons? Answer: The three reasons are: • Risks associated with specific industries may affect the auditor's assessment of client business risk and acceptable audit risk. • Many risks are typically common to all clients in certain industries. Familiarity with those risks aids the auditor in determining their relevance to the client when assessing client business risk and risk of material misstatement. • Many industries have unique accounting requirements that the auditor must understand to evaluate whether the client's financial statements are in accordance with accounting standards. Terms: Primary reasons for obtaining understanding client's industry and external environment Difficulty: Moderate Objective: LO 8-3 AACSB: Reflective thinking 8.4 Learning Objective 8-4 1) Which of the following is a correct statement regarding analytical procedures? A) A major strength in using industry ratios for auditing is the difference between the nature of the client's financial information and that of the firms making up the industry totals. B) Common-size financial statements display all items as a percentage change from a base year. C) In identifying areas of specific risk, the auditor is likely to focus on the liquidity activity ratios. D) In order to look for a misstatement in the allowance for bad debts, the auditor should divide gross sales by sales returns and allowances. Answer: C Terms: Preliminary analytical procedures Difficulty: Moderate Objective: LO 8-4 AACSB: Reflective thinking 2) Which of the following would not be classified as an analytical procedure? A) benchmarking the company's profitability ratios against others in the industry B) preparing common size financial statements C) calculating income statement account balances as a percent of sales when the level of sales has changed from the prior year D) reconciling fixed asset dispositions with the fixed asset ledger Answer: D Terms: Analytical procedures Difficulty: Moderate Objective: LO 8-4 AACSB: Reflective thinking

3) When performing planning analytical procedures for a client the auditor detected that the gross profit percentage had declined by 50% from the previous year to the year currently under audit. The auditor should A) investigate the possibility the client may have made an error in their cost of goods sold computation. B) assist management in developing greater cost efficiencies in their product line. C) prepare a going concern opinion for the client. D) advise the client to have extensive disclosure to alleviate investor concerns. Answer: A Terms: Analytical procedures in planning phase Difficulty: Challenging Objective: LO 8-4 AACSB: Reflective thinking 4) Which is a liquidity activity ratio? A) profit margin B) inventory turnover C) return on assets D) times interest earned Answer: B Terms: Liquidity ratio Difficulty: Moderate Objective: LO 8-4 AACSB: Reflective thinking 5) Which of the following is not an example of the use of data visualization to perform risk assessment? A) Selecting a sample of accounts receivable to send positive confirmation to. B) Examining trends in general ledger account balances from year to year. C) Selecting general ledger accounts for further detailed analysis. D) Reviewing inventory balance trends by product line or geographic location. Answer: A Terms: Analytical procedures in planning phase Difficulty: Moderate Objective: LO 8-4 AACSB: Reflective thinking; Analytic thinking 6) When using financial ratios, the most important comparisons are to those of previous years for the company and to industry averages or similar companies for the same year. Answer: TRUE Terms: Common financial ratios Difficulty: Easy Objective: LO 8-4 AACSB: Reflective thinking

7) Auditors perform preliminary analytical procedures to better understand the client's business and to assess client business risk. Answer: TRUE Terms: Analytical procedures Difficulty: Easy Objective: LO 8-4 AACSB: Reflective thinking 8) In order to be meaningful, a company's ratios should be compared to their prior year's ratios, not industry benchmarks. Answer: FALSE Terms: Analytical procedures Difficulty: Easy Objective: LO 8-4 AACSB: Reflective thinking 9) Preliminary analytical procedures can help the auditor assess client business risk. Answer: TRUE Terms: Preliminary analytical procedures Difficulty: Easy Objective: LO 8-4 AACSB: Reflective thinking 10) Preliminary analytical procedures for an audit client focusing on liquidity activity ratios find that the client's accounts receivable turnover ratio is significantly better than in previous years. The ratio is also significantly better compared to similar firms in the same industry. The results of this ratio indicate, preliminarily, that the accounts receivable area has been identified as having increased risk to the auditor. Answer: FALSE Terms: Preliminary analytical procedures Difficulty: Easy Objective: LO 8-4 AACSB: Reflective thinking

8.5 Learning Objective 8-5 1) Auditing standards define ________ as the magnitude of misstatements, including omissions, that individually, or when aggregated with other misstatements, could reasonably be expected to influence the judgment made by a reasonable user of the financial statements. A) fraud B) inherent risk C) materiality D) significant Answer: C Terms: Materiality Difficulty: Easy Objective: LO 8-5 AACSB: Reflective thinking 2) Which of the following is part of planning? A) Set materiality for the financial statements as a whole. B) Estimate total misstatement in the segment. C) Estimate the combined misstatement. D) Compare the combined estimated with preliminary judgment. Answer: A Terms: Materiality during the planning phase Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking 3) When dealing with materiality, A) if the client refuses to correct a material misstatement, the auditor is required to adjust the financial statements. B) management is responsible for determining whether financial statements are materially misstated. C) materiality must be determined as a percentage of sales. D) the auditor must bring any material misstatements to the client's attention. Answer: D Terms: Materiality Difficulty: Easy Objective: LO 8-5 AACSB: Reflective thinking

4) ________ materiality is materiality for segments of the audit. A) Segment B) Individual C) Financial statement D) Performance Answer: D Terms: Performance materiality Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking 5) Materiality does not depend on the decisions of users who rely on the statements to make the decisions. Answer: FALSE Terms: Materiality Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking 6) The first step in applying materiality is to determine performance materiality. Answer: FALSE Terms: Steps in applying materiality Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking 7) Income before taxes is often used by the auditor as a benchmark for materiality. Once income before taxes is established as a benchmark for materiality for a particular audit client, the auditor still must decide whether any misstatements could affect other benchmarks such a current assets or current liabilities, for example. Answer: TRUE Terms: Benchmarks for evaluating materiality Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking 8) Materiality is an absolute, rather than a relative, concept in auditing. Answer: FALSE Terms: Factors affecting preliminary judgement about materiality Difficulty: Moderate Objective: LO 8-5 AACSB: Reflective thinking

8.6 Learning Objective 8-6 1) Audit standards require the auditor to consider materiality early in the audit. Which statement(s) regarding preliminary materiality is (are) true? I. Preliminary materiality may change during the engagement. II. Preliminary materiality is the maximum amount by which the auditor believes the financials could be misstated and still not affect the decisions of reasonable users. A) I only B) II only C) both I and II D) neither I nor II Answer: C Terms: Preliminary materiality assessment Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 2) Why do auditors establish a preliminary judgment about materiality? A) to determine the appropriate level of staff to assign to the audit B) so the client can know what records to make available to the auditor C) to help plan the appropriate evidence to accumulate D) to finalize the control risk assessment Answer: C Terms: Purpose to establish preliminary judgment about materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 3) If an auditor establishes a relatively high level for materiality, then the auditor will A) accumulate more evidence than if a lower level had been set. B) accumulate less evidence than if a lower level had been set. C) accumulate approximately the same evidence as would be the case were materiality lower. D) accumulate an undetermined amount of evidence. Answer: B Terms: High level for materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking

4) Which of the following is a reason that the auditors may change the preliminary judgment about materiality? A) The auditors decide that the preliminary judgment was too large. B) The auditors decide that the preliminary judgment was too small. C) Client circumstance may have changed due to qualitative events. D) All of the above. Answer: D Terms: Preliminary judgments about materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 5) Which of the following is the primary basis used to decide materiality for a profit-oriented entity? A) net sales B) net assets C) net income before tax D) all of the above Answer: C Terms: Primary basis to decide materiality for a for-profit entity Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 6) Auditing standards ________ that the basis used to determine the preliminary judgment about materiality be documented in the audit files. A) permit B) do not allow C) require D) strongly encourage Answer: C Terms: Auditing standards; Preliminary judgment about materiality documented Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 7) Amounts involving fraud are usually considered ________ important than unintentional errors of equal dollar amounts. A) less B) no less C) no more D) more Answer: D Terms: Amounts involving fraud Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 37 Copyright © 2023 Pearson Education, Inc.

8) Qualitative factors can affect an auditor's assessment of materiality. Which of the following statements is true? I. Misstatements that are otherwise immaterial may be material if they affect earnings trends. II. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. A) I only B) II only C) both I and II D) neither I nor II Answer: C Terms: Qualitative factors can affect auditor's assessment of materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 9) Which of the following statements is not correct? A) Materiality is a relative rather than an absolute concept. B) The most important base used as the criterion for deciding materiality is total assets. C) Qualitative factors as well as quantitative factors affect materiality. D) Given equal dollar amounts, frauds are usually considered more important than errors. Answer: B Terms: Materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking

10) Certain types of misstatements are likely to be more important than other types to users, even if the dollar amounts are the same. Which of the following demonstrates this? A) Amounts involving frauds are Misstatements that are otherwise considered more important than immaterial may be material if they errors of equal amount. affect a trend in earnings. Yes Yes B) Amounts involving frauds are considered more important than errors of equal amount. No

Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. No

C) Amounts involving frauds are considered more important than errors of equal amount. Yes

Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. No

D) Amounts involving frauds are considered more important than errors of equal amount. No

Misstatements that are otherwise immaterial may be material if they affect a trend in earnings. Yes

Answer: A Terms: Certain types of misstatements are likely more important than other types Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 11) When setting a preliminary judgment about materiality, A) more evidence is required for a low dollar amount than for a high dollar amount. B) less evidence is required for a low dollar amount than for a high dollar amount. C) the same amount of evidence is required for either low or high dollar amounts. D) there is no relationship between materiality and the dollar amount of evidence needed. Answer: A Terms: Setting preliminary judgment about materiality Difficulty: Challenging Objective: LO 8-6 AACSB: Reflective thinking

12) Lewis Corporation has a few large accounts receivable that total one million dollars, whereas Clark Corporation has many small accounts receivable that total one million dollars. Misstatement in any one account is more significant for Lewis corporation because of the concept of A) materiality. B) audit risk. C) reasonable assurance. D) comparative analysis. Answer: A Terms: Misstatements Difficulty: Challenging Objective: LO 8-6 AACSB: Reflective thinking 13) When determining materiality, A) the preliminary judgment about materiality can be increased, but not decreased during the audit. B) auditing standards provide specific materiality guidelines to practitioners. C) only one benchmark can be used. D) the application of guidelines requires considerable professional judgment. Answer: D Terms: Materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 14) Determining materiality requires professional judgment. Answer: TRUE Terms: Materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 15) Once the auditor has made a preliminary judgment about materiality, the auditor may change that judgement during the audit. Answer: TRUE Terms: Preliminary judgement about materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking

16) The auditor's preliminary judgment about materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of reasonable users. Answer: TRUE Terms: Preliminary judgments about materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 17) Preliminary judgments about materiality are often changed during the course of the engagement. Answer: TRUE Terms: Preliminary judgments about materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 18) Net assets are the most often used base for deciding materiality. Answer: FALSE Terms: Base for deciding materiality Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 19) The lower the dollar amount of the preliminary judgment, the more audit evidence is required. Answer: TRUE Terms: Amount of preliminary judgment and audit evidence required Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 20) Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment. Answer: FALSE Terms: Qualitative factors affecting preliminary materiality judgment; Fraud Difficulty: Easy Objective: LO 8-6 AACSB: Reflective thinking 21) CPA firms can establish policy guidelines to help their auditors determine materiality. Answer: TRUE Terms: Difficulty in applying concept of materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 41 Copyright © 2023 Pearson Education, Inc.

22) Statements on Auditing Standards provide detailed, objective guidance on how auditors are to establish a preliminary materiality level, thus eliminating the need for subjective auditor judgment in this task. Answer: FALSE Terms: Statements on Auditing Standards; Objective guidance on establishing preliminary materiality level Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 23) If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease. Answer: TRUE Terms: Preliminary judgment of materiality and audit evidence Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 24) Net income before taxes is the normal base used to determine materiality for a not-for-profit organization. Answer: FALSE Terms: Base used to determine materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 25) Audit standards require the auditor to consider the combined amount of misstatement early in the audit. This is known as preliminary materiality judgment. List and discuss the three main factors that affect an auditor's preliminary judgment about materiality. Answer: The three main factors that affect an auditor's judgment about materiality are: • Materiality is a relative rather than an absolute concept. A misstatement of a given size might be material for a small company, whereas the same dollar misstatement could be immaterial for a larger one. • Benchmarks are needed for evaluating materiality. Because materiality is relative, it is necessary to have benchmarks for establishing whether misstatements are material. Net income before taxes is normally the most commonly used benchmark, but other possible benchmarks include current assets, total assets, current liabilities, and owners' equity. • Qualitative factors also affect materiality. Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same, such as misstatements involving frauds. Terms: Factors that affect auditor's preliminary judgment Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking

26) Due to qualitative factors, certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. Identify two qualitative factors that might significantly affect an auditor's materiality judgment, and give an example of each. Answer: Qualitative factors that affect an auditor's materiality judgment include: • Amounts involving fraud. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar amounts because fraud reflects on the honesty and reliability of the management or other personnel involved. For example, an intentional misstatement of inventory would be more important to users than a clerical error in inventory of the same amount. • Misstatements affecting contractual obligations. Misstatements that are otherwise minor may be material if there are possible consequences arising from contractual obligations. For example, if a misstatement causes a required minimum working capital balance to exceed the minimum, when the correct balance is less than the minimum, this misstatement likely would be important to users. • Amounts affecting a trend in earnings. Amounts that are otherwise immaterial may be material if they affect a trend in earnings. An example is if reported income has increased three percent annually for the past five years but income for the current year has declined one percent, that change may be material. Similarly, a misstatement that would cause a loss to be reported as a profit may be of concern. Terms: Qualitative factors that affect auditor's materiality judgment Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 27) The five steps in applying materiality are listed below in random order. 1. Estimate the combined misstatement. 2. Estimate the total misstatement in the segment. 3. Set materiality for the financial statements as a whole. 4. Determine performance materiality. 5. Compare combined estimate with preliminary judgment about materiality. The first three steps in correct sequence would be A) 1, 2, 5. B) 3, 4, 2. C) 2, 1, 5. D) 3, 2, 4. Answer: B Terms: Five steps in applying materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking

28) Performance materiality is commonly set at 50-75 percent of overall materiality. Answer: TRUE Terms: Determining performance materiality Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 29) The term "tolerable misstatement," used by the Public Company Accounting Oversight Board auditing standards, has the same meaning as "performance materiality," described by AICPA and International Auditing and Assurance Standards Board standards. Answer: TRUE Terms: Performance materiality vs tolerable misstatement Difficulty: Moderate Objective: LO 8-6 AACSB: Reflective thinking 8.7 Learning Objective 8-7 1) The amount(s) set by the auditor at less than the materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole is referred to as A) the materiality range. B) the error range. C) tolerable materiality. D) performance materiality. Answer: D Terms: Allocate preliminary judgment about materiality to account balances Difficulty: Easy Objective: LO 8-7 AACSB: Reflective thinking 2) Auditors generally allocate the preliminary judgment about materiality to the A) balance sheet only. B) income statement only. C) income statement and balance sheet. D) statement of cash flows. Answer: A Terms: Preliminary materiality allocation Difficulty: Easy Objective: LO 8-7 AACSB: Reflective thinking

3) Which of the following is an incorrect statement regarding the allocation of the preliminary judgment about materiality to balance sheet accounts? A) Auditors expect certain accounts to have more misstatements than others. B) The allocation has virtually no effect on audit costs because the auditor must collect sufficient appropriate audit evidence. C) Auditors expect to identify overstatements as well as understatements in the accounts. D) Relative audit costs affect the allocation. Answer: B Terms: Allocation of preliminary judgment about materiality Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 4) Which of the following statements is true concerning the allocation of preliminary materiality? A) It is necessary to allocate preliminary materiality to financial statements as a whole rather than by segments. B) Preliminary materiality should be allocated to income statement accounts only. C) Preliminary materiality is required by the SEC. D) The PCAOB term used when preliminary materiality is allocated to segments is tolerable misstatement. Answer: D Terms: Allocation of preliminary materiality Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 5) Which of the following statements is false? A) Either an overstatement of an asset account or an understatement of a liability account would have the same effect on the income statement. B) A misclassification in the balance sheet will have no effect on operating income. C) Either an overstatement of an asset account or an overstatement of a liability account would have the same effect on the income statement. D) Either an understatement of an asset account or an overstatement of a liability account would have the same effect on the income statement. Answer: C Terms: Effects of misstatements Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking

6) Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts? A) Certain accounts contain Only overstatements Audit costs can more misstatements need be considered. affect allocation. than others. Yes No Yes B) Certain accounts contain more misstatements than others. Yes C) Certain accounts contain more misstatements than others. Yes

Only overstatements need be considered.

Audit costs can affect allocation.

Yes

Only overstatements need be considered.

Audit costs can affect allocation.

Yes

Only overstatements need be considered.

Audit costs can affect allocation.

Yes

D) Certain accounts contain more misstatements than others. No

Answer: A Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 7) When allocating performance materiality, A) it is easy to predict in advance which accounts are most likely to be misstated. B) only overstatements need to be considered. C) professional judgment is critical. D) the sum of all the performance materiality levels cannot exceed the preliminary judgment about materiality. Answer: C Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking

8) When allocating materiality, most practitioners choose to allocate to A) the income statement accounts because they are more important. B) the balance sheet accounts because most audits focus on the balance sheet. C) both balance sheet and income statement accounts because there could be errors on either. D) all of the financial statements because it is required by GAAS. Answer: B Terms: Allocating materiality Difficulty: Challenging Objective: LO 8-7 AACSB: Reflective thinking 9) Which of the following is a correct statement regarding performance materiality? A) Determining performance materiality is necessary because auditors accumulate evidence by segments. B) The level of performance materiality does not affect the amount of evidence needed. C) Performance materiality cannot vary for different classes of transactions. D) Performance materiality is required for public companies, but not for private companies. Answer: A Terms: Performance materiality Difficulty: Challenging Objective: LO 8-7 AACSB: Reflective thinking 10) Most practitioners allocate the preliminary judgment about materiality to both the balance sheet and income statement accounts. Answer: FALSE Terms: Allocate preliminary judgment about materiality to balance sheet accounts Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 11) The primary purpose of allocating the preliminary judgment about materiality to financial statement accounts is to help the auditor decide the appropriate evidence to accumulate. Answer: TRUE Terms: Primary purpose of allocating the preliminary judgment about materiality Difficulty: Easy Objective: LO 8-7 AACSB: Reflective thinking 12) Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts. Answer: TRUE Terms: Allocating materiality; Consideration of overstatements and understatements Difficulty: Easy Objective: LO 8-7 AACSB: Reflective thinking 47 Copyright © 2023 Pearson Education, Inc.

13) If an auditor assigns a tolerable misstatement of $1,000 to accounts payable, he or she would need to obtain more audit evidence for that account than if $100,000 had been assigned. Answer: TRUE Terms: Tolerable misstatements and audit evidence Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 14) To maximize audit efficiency, the auditor should allocate less tolerable misstatement to accounts that can be verified by using low-cost audit procedures, such as analytical procedures, than to accounts that are more costly to audit. Answer: TRUE Terms: Maximize audit efficiency, allocate less tolerable misstatements Difficulty: Challenging Objective: LO 8-7 AACSB: Reflective thinking 15) Explain why it is necessary to allocate the preliminary judgment about materiality to individual accounts (segments) in the financial statements. Also explain why allocating to balance sheet accounts is more common than allocating to income statement accounts. Answer: Allocating the preliminary judgment about materiality to individual accounts (segments) is necessary because evidence is accumulated for accounts (segments) rather than for the financial statements as a whole. Allocating to accounts (segments) establishes a tolerable misstatement amount for each account, which helps the auditor decide the appropriate audit evidence to accumulate for each account. Most practitioners allocate materiality to balance sheet accounts rather than income statement accounts because most income statement misstatements have an equal effect on the balance sheet due to the nature of double-entry accounting. Because there are fewer balance sheet accounts than income statement accounts in most audits, and because most audit procedures focus on balance sheet accounts, materiality should be allocated only to balance sheet accounts. Terms: Allocation of the preliminary judgment about materiality Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking

16) Auditors allocate the preliminary judgment about materiality to financial statement segments rather than by financial statements as a whole. What is the term for the auditor's allocation of preliminary misstatement to account balances? What are three difficulties auditors face when allocating materiality to balance sheet accounts? Answer: Performance materiality is the term for the auditor's allocation of the preliminary judgment of materiality to any given account balance. The three difficulties auditors face when allocating the preliminary materiality to account balances are: 1. Auditors expect certain accounts to have more misstatement than others. 2. Both overstatements and understatements must be considered. 3. Audit costs can affect the allocation. Terms: Allocation of preliminary misstatement to account balances and difficulties that auditors face allocating preliminary materiality judgment to account balances Difficulty: Moderate Objective: LO 8-7 AACSB: Reflective thinking 8.8 Learning Objective 8-8 1) Auditors are ________ to document the known and likely misstatements in the financial statements under audit. A) permitted B) required C) not allowed D) strongly encouraged Answer: B Terms: Documenting known and likely misstatements Difficulty: Easy Objective: LO 8-8 AACSB: Reflective thinking 2) ________ misstatements are those where the auditor can determine the amount of the misstatement in the account. A) Potential B) Likely C) Known D) Projected Answer: C Terms: Misstatements where auditor can determine the amount Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking

3) Likely misstatements can result from A) Computation of the Differences between Projections of sampling error for the management's and an misstatements based on cash account auditor's judgment about an auditor's tests of a account balances sample from a population No Yes Yes B) Computation of the sampling error for the cash account Yes

Differences between Projections of management's and an misstatements based on auditor's judgment about an auditor's tests of a account balances sample from a population Yes No

C) Computation of the sampling error for the cash account No

Differences between Projections of management's and an misstatements based on auditor's judgment about an auditor's tests of a account balances sample from a population No Yes

D) Computation of the sampling error for the cash account Yes

Differences between Projections of management's and an misstatements based on auditor's judgment about an auditor's tests of a account balances sample from a population No No

Answer: A Terms: Likely misstatements result from Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 4) When evaluating the audit findings, the auditor should be satisfied that the A) amount of known misstatement is documented in the management representation letter. B) estimate of the total known and likely misstatements is less than a material amount. C) estimate of the total likely misstatement includes sample error. D) amount of known misstatement is acknowledged and recorded by the client. Answer: B Terms: Evaluating audit findings and materiality Difficulty: Challenging Objective: LO 8-8 AACSB: Reflective thinking

5) The preliminary judgment on materiality is compared to the total estimated misstatement amount to determine if an account balance is materially misstated. Answer: TRUE Terms: Preliminary judgment on materiality; Estimated total misstatements Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 6) Total estimated misstatements include known misstatements and projected misstatements plus a sampling error. Answer: TRUE Terms: Total estimated misstatements and sampling error Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 7) If the total misstatement of an account is known, a sampling error still needs to be determined. Answer: FALSE Terms: Total estimated misstatements and sampling error Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 8) Sampling risk results if the sample accurately represents the population. Answer: FALSE Terms: Sampling risk Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 9) If the auditor approaches the audit of the accounts in a sequential manner, the findings of the audit of accounts audited earlier can be used to revise the performance materiality established for accounts audited later. Answer: TRUE Terms: Total estimated misstatements and sampling error Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 10) To calculate the estimate of the likely misstatement of a total population, the auditor makes a direct projection of the known misstatement from the sample to the population, and subtracts an estimated allowance for sampling risk. Answer: FALSE Terms: Calculating the estimate of likely misstatement Difficulty: Moderate Objective: LO 8-8 AACSB: Reflective thinking 51 Copyright © 2023 Pearson Education, Inc.

11) List the five steps in applying materiality in an audit. Answer: Step 1. Set materiality for the financial statements as a whole. Step 2. Determine performance materiality. Step 3. Estimate total misstatement in segment. Step 4. Estimate the combined misstatement. Step 5. Compare combined estimate with preliminary or revised judgment about materiality. Terms: Five steps in applying materiality Difficulty: Challenging Objective: LO 8-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 9 Assessing the Risk of Material Misstatement 9.1 Learning Objective 9-1 1) Which of the following would not increase the risks of material misstatement at the overall financial statement level? A) effective oversight by the board of directors B) deficiencies in management's integrity C) inadequate accounting systems D) all of the above Answer: A Terms: Risk of material misstatement at the overall financial statement level Difficulty: Easy Objective: LO 9-1 AACSB: Reflective thinking 2) The auditor's responsibility section in an audit report states that "…the standards require that we plan and perform the audit to obtain ________ assurance about whether the financial statements are free of material misstatement." What type of assurance is given? A) immediate B) limited C) reasonable D) absolute Answer: C Terms: Type of assurance provided Difficulty: Easy Objective: LO 9-1 AACSB: Reflective thinking 3) ________ risk represents the auditor's assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of the client's system of internal controls. A) Material B) Account balance C) Control D) Inherent Answer: D Terms: Inherent risk Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking

4) Risk of material misstatement at the assertion level A) is only relevant to account balances. B) determines the nature, timing, and extent of further auditing procedures. C) refers to risks that are pervasive to the financial statements as a whole. D) consists of business risk and inherent risk. Answer: B Terms: Risk of material misstatement at the assertion level Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 5) Assessing the risk of material misstatement is closely related to each of the following except A) the auditor's overall audit responsibilities. B) the auditor's materiality and audit planning. C) this risk not a critical consideration in most financial statement audits. D) the auditor's review of the key transaction cycles and associated audit objectives. Answer: C Terms: Assessing the risk of material misstatement Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 6) The risk of material misstatement at the assertion level consists of which two risk components? A) inherent risk and control risk B) inherent risk and audit risk C) audit risk and control risk D) audit risk and detection risk Answer: A Terms: Risk of material misstatement at the assertion level Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking; Analytic thinking 7) The risk of material misstatement exists only at the overall financial statement level. Answer: FALSE Terms: Risk of material misstatements Difficulty: Easy Objective: LO 9-1 AACSB: Reflective thinking

8) Significant changes in the industry may increase the risk of material misstatement at the assertion level. Answer: FALSE Terms: Risk of material misstatements Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 9) Inherent risk and control risk exist independent of the audit of the financial statements. Answer: TRUE Terms: Control risk and inherent risk Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 10) Audit reports issued under the PCAOB and the AICPA standards contain two important phrases that are directly related to materiality and to risk: obtain absolute assurance and free of material misstatement. Answer: FALSE Terms: Materiality and risk Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 11) Audit reports contain the phrase obtain reasonable assurance, which is intended to inform users that auditors do not guarantee or ensure the fair presentation of the financial statements which the audit reports cover. Answer: TRUE Terms: The phrase reasonable assurance Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 12) Some risk exists that the financial statements are not fairly stated, even when the auditor's opinion is unmodified. Answer: TRUE Terms: The phrase reasonable assurance Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking

13) The phrase free of material misstatement informs users that the auditor's responsibility is not limited to only material financial information. Answer: FALSE Terms: The phrase free of material misstatement Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 14) For well-planned audits, it is practical for auditors to provide assurances on immaterial amounts included in the financial statements. Answer: FALSE Terms: The phrase free of material misstatement Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 15) As management is responsible for the financial statements, failure to assess the risk of material misstatement is not detrimental to the auditor. Answer: FALSE Terms: Assessing the risk of material misstatement Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking 16) Name some examples where the auditor accepts some level of uncertainty in performing the audit function. Answer: • The inherent uncertainty about the appropriateness of evidence obtained. • The uncertainty about the effectiveness of a client's system of internal controls. • The uncertainty about whether the financial statements are fairly stated when the audit is completed. • Assessing risks is a matter of professional judgment rather than a precise measurement. Terms: Risk assessment uncertainty Difficulty: Moderate Objective: LO 9-1 AACSB: Reflective thinking

9.2 Learning Objective 9-2 1) Risk assessment procedures include inquiries of management and others by the auditor. As part of these procedures, the auditor should talk to A) internal auditors. B) board of directors. C) individuals involved with regulatory compliance. D) all of the above. Answer: D Terms: Risk assessment procedures; inquiries Difficulty: Moderate Objective: LO 9-2 AACSB: Reflective thinking 2) Risk assessment procedures include A) a required discussion among the staff members of the audit and the client regarding material misstatements in the financial statement. B) determination of the type of audit opinion to issue. C) observation of the entity's operations. D) assessing acceptable audit risk. Answer: C Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 9-2 AACSB: Reflective thinking 3) Which of the following is not a role of risk assessment procedures? A) Provide sufficient appropriate audit evidence to form an opinion on the financial statements. B) Provide input for understanding the entity and its environment and system of internal control. C) Help the auditor to identify and assess the risk of material misstatement. D) Develop audit strategy and audit plan in response to assessed risks. Answer: A Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 9-2 AACSB: Reflective thinking; Analytic thinking 4) The performance of risk assessment procedures is designed to help the auditor obtain an understanding of the entity. Answer: TRUE Terms: Risk assessment procedures Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking

5) Auditing standards require the engagement partner to be included in discussions about the susceptibility of the client's financial statements to material misstatements. Answer: TRUE Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 9-2 AACSB: Reflective thinking 6) Auditors are not allowed to make inquiries of employees who are not considered management, such as marketing or sales personnel. Answer: FALSE Terms: Risk assessment procedures; inquiries Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking 7) Auditing standards emphasize the benefits and importance of obtaining information or different perspectives through inquiries of others within the entity and employees with differing levels of authority within the organization. Answer: TRUE Terms: Inquiries of management and others within the entity Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking 8) PCAOB auditing standards require the auditor to make inquiries of the audit committee about the risks of material misstatement. Answer: TRUE Terms: Inquiries of management and others within the entity Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking 9) The PCAOB, but not the AICPA, auditing standards require inquiry of internal audit personnel by the auditor when that function exists within the audit client. Answer: FALSE Terms: Inquiries of management and others within the entity Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking

10) Discussions, including exchanges of ideas or brainstorming among the engagement team members about business risks should include the financial statements, but not necessarily the related disclosures. Answer: FALSE Terms: Discussions among engagement team members Difficulty: Easy Objective: LO 9-2 AACSB: Reflective thinking 11) Risk assessment procedures are performed to identify and assess the risk of material misstatement. List three risk assessment procedures. Answer: • Inquiries of management and others within the entity • Analytical procedures • Observation and inspection • Discussion among engagement team members • Other risk assessment procedures, including discussions with predecessor auditor, evidence obtained during other procedures performed for the client Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 9-2 AACSB: Reflective thinking 12) Audit data analytics may be used in performing analytical procedures as part of the auditor's risk assessment process. Describe how audit data analytics (ADA) can help specifically in this process. Answer: ADA can help the auditor in the identification of risks of material misstatements in the financial statements; the assessment of those potential risks; or both identification and assessment of those risks. This includes helping the auditor identify one or more notable items in a population that potentially impact management's relevant assertions made to the auditor during the audit. Terms: Risk assessment procedures Difficulty: Challenging Objective: LO 9-2 AACSB: Reflective thinking

9.3 Learning Objective 9-3 1) When considering the risk of misstatement due to fraud, A) the risk of not detecting a material misstatement due to fraud is lower than the risk of not detecting a misstatement due to error. B) the risk is only made at the financial statement level. C) auditing standards require the auditor to presume that risk of fraud exists in expense transactions. D) auditing standards outline procedures the auditor should perform to obtain information from management about their consideration of fraud. Answer: D Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking 2) Auditing standards require the auditor to presume that the risk of fraud exists in which of the following? A) revenue recognition B) payroll accruals C) liability accruals D) disclosures Answer: A Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking 3) Individuals engaged in conducting a fraud will generally not misrepresent information to the auditor. Answer: FALSE Terms: Fraud risk Difficulty: Easy Objective: LO 9-3 AACSB: Reflective thinking 4) The auditor's risk assessment for fraud should be ongoing throughout the audit. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking

5) The application of professional skepticism consists of two primary components: a questioning mind and a critical assessment of the audit evidence obtained during the audit. Answer: TRUE Terms: Fraud risk Difficulty: Easy Objective: LO 9-3 AACSB: Reflective thinking 6) The auditor's consideration of the risk of material misstatement due to fraud is made primarily at the financial statement level, not at the assertion level. Answer: FALSE Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking 7) Revenue transactions and account balances subject to significant risk are not required to be documented in the working papers if the auditor determines significant risk does not apply in a particular audit engagement. Answer: FALSE Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking 8) Identifying material misstatements due to fraud is not difficult for the auditor to determine if the audit is performed in accordance with generally accepted auditing standards. Answer: FALSE Terms: Fraud risk Difficulty: Moderate Objective: LO 9-3 AACSB: Reflective thinking; Analytic thinking

9.4 Learning Objective 9-4 1) A ________ risk represents an identified and assessed risk of material misstatement that, in the auditor's professional judgment, requires special audit consideration. A) material B) substantial C) financial statement D) significant Answer: D Terms: Significant risk Difficulty: Easy Objective: LO 9-4 AACSB: Reflective thinking 2) Which of the following will generally be considered a significant risk? A) a sale to a customer B) the determination of the amount of bad debt expense C) the purchase of inventory D) obtaining a loan from the bank Answer: B Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking 3) When auditors identify a potential risk of material misstatement due to fraud, auditing standards A) require the auditor to consider that risk a significant risk. B) do not necessarily require the auditor to consider that risk a significant risk. C) do not necessarily require the auditor to respond to those risks. D) require the auditor to immediately withdraw from the audit. Answer: A Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking 4) Significant risks often relate to routine transactions. Answer: FALSE Terms: Significant risk Difficulty: Easy Objective: LO 9-4 AACSB: Reflective thinking

5) The auditor must perform substantive tests related to assertions deemed to have significant risks. Answer: TRUE Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking 6) Financial statement matters like estimates for the allowance for doubtful accounts and allowances for slow-moving inventories, are deemed significant matters which should be addressed by auditor in their assessment of the risk of material misstatement. Answer: TRUE Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking 7) Nonroutine transactions are unusual in nature but not infrequent in occurrence. Answer: FALSE Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking 8) Nonroutine transactions may not necessarily increase the risk of material misstatement. Answer: TRUE Terms: Significant risk Difficulty: Moderate Objective: LO 9-4 AACSB: Reflective thinking

9.5 Learning Objective 9-5 1) Which of the following risks are used in the audit risk model? A) Planned Detection Control Risk Inherent Risk Risk Yes Yes Yes B) Control Risk Yes

Inherent Risk Yes

Planned Detection Risk No

Control Risk No

Inherent Risk No

Planned Detection Risk Yes

Inherent Risk No

Planned Detection Risk No

D) Control Risk No

Answer: A Terms: Audit risk model components Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 2) Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would A) increase materiality levels. B) decrease detection risk. C) decrease substantive testing. D) increase inherent risk. Answer: B Terms: Control risk and planned audit risk model Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking

3) When dealing with audit risk, A) auditors cannot accept any level of risk in performing the audit function. B) most risks that auditors encounter are relatively easy to measure. C) the audit risk model is only used for classes of transactions. D) the audit risk model helps the auditor to decide how much and what types of evidence to accumulate. Answer: D Terms: Audit risk model Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 4) The measurement of the auditor's assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of related system of internal controls, is defined as A) audit risk. B) inherent risk. C) sampling risk. D) detection risk. Answer: B Terms: Inherent risk Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 5) The risk that audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality levels is A) audit risk. B) control risk. C) inherent risk. D) planned detection risk. Answer: D Terms: Risk audit evidence will fail to detect misstatements Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 6) If the auditor decides to reduce acceptable audit risk, planned detection risk A) increases. B) decreases. C) stays the same. D) cannot be determined. Answer: B Terms: Audit risk and detection risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

7) Inherent risk is ________ related to planned detection risk and ________ related to the amount of audit evidence. A) directly; inversely B) directly; directly C) inversely; inversely D) inversely; directly Answer: D Terms: Relationship of inherent risk, detection risk, and amount of audit evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 8) Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance instead of A) detection risk. B) audit report risk. C) acceptable audit risk. D) inherent risk. Answer: C Terms: Audit assurance, overall assurance and level of assurance Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 9) If planned detection risk is reduced, the amount of evidence the auditor accumulates will A) increase. B) decrease. C) remain unchanged. D) be indeterminate. Answer: A Terms: Assess control risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

10) Planned detection risk I. determines the amount of substantive evidence the auditor plans to accumulate. II. is dependent on inherent risk and business risk. A) I only B) II only C) both I and II D) neither I nor II Answer: A Terms: Planned detection risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 11) Inherent risk is often high for an account such as A) inventory. B) land. C) capital stock. D) notes payable. Answer: A Terms: Inherent risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 12) Inherent risk and control risk A) are inversely related to each other. B) are inversely related to detection risk. C) are directly related to detection risk. D) are directly related to audit risk. Answer: B Terms: Inherent risk and control risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 13) To what extent do auditors typically rely on system of internal controls of their public company clients? A) extensively B) only very little C) infrequently D) never Answer: A Terms: Extent auditors rely on system of internal controls of public company client Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 15 Copyright © 2023 Pearson Education, Inc.

14) Auditors typically rely on system of internal controls of their private company clients A) only as needed to complete the audit and satisfy Sarbanes-Oxley requirements. B) only if the controls are determined to be effective. C) only if the client asks an auditor to test controls. D) only if the controls are sufficient to increase control risk to an acceptable level. Answer: B Terms: Extent auditors rely on system of internal controls of private company client Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 15) Which is a true statement about audit risk? A) Audit risk measures the risk that a material misstatement could occur and not be detected by internal control. B) When auditors decide on a higher acceptable audit risk, they want to be more certain that the financial statements are not materially misstated. C) Audit assurance is the complement of acceptable audit risk. D) There is an inverse relationship between acceptable audit risk and planned detection risk. Answer: C Terms: Acceptable audit risk Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking 16) The risk of material misstatement refers to A) control risk and acceptable audit risk. B) inherent risk. C) the combination of inherent risk and control risk. D) inherent risk and audit risk. Answer: C Terms: Risk of material misstatements Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking 17) When assessing risk, it is important to remember that A) for acceptable audit risk, the SEC decides the risk the CPA firm should take for public clients. B) inherent risk can be changed by the auditor. C) detection risk can only be determined after audit risk, inherent risk, and control risk are determined. D) control risk is determined by company management since they are responsible for internal control. Answer: C Terms: Difference between material misstatement and detection risk Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

18) Which of the following is a correct relationship? A) Acceptable audit risk and planned detection risk have an inverse relationship. B) Control risk and planned detection risk have a direct relationship. C) Planned detection risk and inherent risk have an inverse relationship. D) All of the above are correct relationships. Answer: C Terms: Relationship of acceptable audit risk, inherent risk, control risk, and planned detection risk. Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking 19) In a financial statement audit, inherent risk is evaluated to help an auditor assess which of the following? A) the internal audit department's objectivity in reporting a material misstatement of a financial statement assertion it detects to the audit committee B) the risk that the internal control system will not detect a material misstatement of a financial statement assertion C) the risk that the audit procedures implemented will not detect a material misstatement of a financial statement assertion D) the susceptibility of a financial statement assertion to a material misstatement, assuming there are no related controls Answer: D Terms: Inherent risk assessment Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking 20) Which of the following statements is not true? A) Inherent risk is inversely related to the amount of audit evidence whereas detection risk is directly related to the amount of audit evidence required. B) Inherent risk is directly related to evidence whereas detection risk is inversely related to the amount of audit evidence required. C) Inherent risk is the susceptibility of the financial statements to material error, assuming no system of internal controls. D) Inherent risk and control risk are assessed by the auditor and function independently of the financial statement audit. Answer: A Terms: Inherent risk Difficulty: Challenging Objective: LO 9-5 AACSB: Reflective thinking

21) An auditor who audits a business cycle that has low inherent risk should A) increase the amount of audit evidence gathered. B) assign more experienced staff to that area. C) expand planning procedures. D) do none of the above. Answer: D Terms: Low inherent risk Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 22) The most important element of the audit risk model is control risk. Answer: FALSE Terms: Audit risk model and control risk Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 23) The audit risk model that must be used for planning audit procedures and evaluating audit results is: = AAR. Answer: FALSE Terms: Audit risk model Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 24) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high. Answer: TRUE Terms: Relationship of acceptable audit risk, inherent risk, control risk, and planned detection risk. Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 25) If the audit assurance rate is 95%, then the level of acceptable audit risk is 5%. Answer: TRUE Terms: Audit risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

26) A high detection risk equates to a low amount of audit evidence needed. Answer: FALSE Terms: Detection risk and amount of evidence needed Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 27) For a private company client, auditors are required to test any system of internal controls they believe have not been operating effectively during the period under audit. Answer: FALSE Terms: Auditors required to test system of internal controls for private companies Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 28) There is a direct relationship between acceptable audit risk and planned detection risk. Answer: TRUE Terms: Inherent risk and control risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 29) Acceptable audit risk and the amount of substantive evidence required are inversely related. Answer: TRUE Terms: Acceptable audit risk and substantive evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 30) As control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase. Answer: TRUE Terms: Control risk and substantive evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 31) Inherent risk and control risk are directly related. Answer: FALSE Terms: Inherent risk and control risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

32) Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk. Answer: FALSE Terms: Audit assurance and planned detection risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 33) The auditor assesses risks at the overall financial statement level but not at the audit objective level for the acquisition and payment cycle. Answer: FALSE Terms: Audit risk and evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 34) After assessing internal controls are being effective in the sales and collection cycle, the auditor can assume that internal controls will be effective at each of the client's other transaction cycles. Answer: FALSE Terms: Audit risk and evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 35) A planned detection risk (PDR) of .05 means the auditor plans to accumulate audit evidence until the risk of misstatement exceeding performance materiality is reduced to 5 percent. Answer: TRUE Terms: Planned detection risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking 36) The audit committee should determine the risk the CPA firm is willing to take that the financial statements are misstated after the audit is completed. Answer: FALSE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

37) An example of where the auditor will accept very low risk (low acceptable audit risk) is for an audit client having an initial public offering. Answer: TRUE Terms: Acceptable audit risk Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking 38) Why do auditors use the audit risk model when planning an audit? Answer: The audit risk model is used primarily for planning purposes in deciding how much evidence to accumulate in each cycle. The auditor sets an acceptable level of audit risk, (AAR) assesses inherent risk (IR) and control risk (CR), and then uses the following audit risk model to determine an appropriate level of planned detection risk (PDR): PDR = Terms: Audit risk model Difficulty: Easy Objective: LO 9-5 AACSB: Reflective thinking

39) Match the terms below (a-h) with the definitions provided below (1-8). a. preliminary judgment about materiality b. inherent risk c. planned detection risk d. audit assurance e. acceptable audit risk f. performance materiality level g. control risk h. materiality ________ 1. a measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding the performance materiality amount, should such misstatements exist ________ 2. a measure of the auditor's assessment of the likelihood that misstatements exceeding a performance materiality in a segment will not be prevented or detected by the client's system of internal controls ________ 3. a measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued ________ 4. the materiality allocated to any given account balance ________ 5. the maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users ________ 6. This term is synonymous with acceptable audit risk. ________ 7. the magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed ________ 8. a measure of the auditor's assessment of the likelihood that there are material misstatements before considering the effectiveness of system of internal control Answer: 1. c, 2. g, 3. e, 4. f, 5. a, 6. d, 7.h, 8. b Terms: Business risk; Control risk; Acceptable audit risk; Materiality; Audit assurance; Preliminary judgment about materiality; Tolerable misstatement; Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

40) Using your knowledge of the relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, performance materiality, and planned evidence, state the effect on planned evidence (increase or decrease) of changing each of the following factors, while the other factors remain unchanged. 1. an increase in acceptable audit risk ________ 2. an increase in inherent risk ________ 3. a decrease in control risk ________ 4. an increase in planned detection risk ________ 5. an increase in performance materiality ________ Answer: 1. decrease 2. increase 3. decrease 4. decrease 5. decrease Terms: Relationships among acceptable audit risk, inherent risk, control risk, planned detection risk, and tolerable misstatement with planned evidence Difficulty: Moderate Objective: LO 9-5 AACSB: Analytic thinking

41) Describe the audit risk model and each of its components. Answer: The planning form of the audit risk model is stated as follows: PDR = where: PDR = planned detection risk AAR = acceptable audit risk IR = inherent risk CR = control risk Planned detection risk is a measure of the risk that audit evidence for an account (segment) will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate. Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. It is influenced primarily by the degree to which external users will rely on the statements, the likelihood that a client will have financial difficulties after the audit report is issued, and the auditor's evaluation of management's integrity. Inherent risk is a measure of the auditor's assessment of the likelihood that there are material misstatements in an account due to error or fraud before considering the effectiveness of system of internal control. Control risk is a measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in an account (segment) will be prevented or detected on a timely basis by the client's system of internal controls. Terms: Audit risk model Difficulty: Moderate Objective: LO 9-5 AACSB: Reflective thinking

9.6 Learning Objective 9-6 1) If an auditor believes the chance of financial failure is high and there is a corresponding increase in business risk for the auditor, acceptable audit risk would likely A) be reduced. B) be increased. C) remain the same. D) be calculated using a computerized statistical package. Answer: A Terms: Increase in business risk, acceptable audit risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 2) When management has an adequate level of integrity for the auditor to accept the engagement but cannot be regarded as completely honest in all dealings, auditors normally A) reduce acceptable audit risk and increase inherent risk. B) reduce inherent risk and control risk. C) increase inherent risk and control risk. D) increase acceptable audit risk and reduce inherent risk. Answer: A Terms: Management integrity Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 3) When the auditor is attempting to determine the extent to which external users rely on a client's financial statements, they may consider several factors except for A) client size. B) concentration of ownership. C) nature and amounts of liabilities. D) assessment of detection risk. Answer: D Terms: Extent to which external users rely on client's financial statements Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking

4) ________ is the risk that the auditor or audit firm will suffer harm after the audit is finished, even though the audit report was correct. A) Inherent risk B) Audit risk C) Engagement risk D) Control risk Answer: C Terms: Engagement risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 5) If an auditor believes the client will have financial difficulties after the audit report is issued, and external users will be relying heavily on the financial statements, the auditor will probably set acceptable audit risk as low. Answer: TRUE Terms: Auditor believes client will have financial difficulties after audit report is issued; External users rely heavily on financial statements Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 6) Overall assessment of acceptable audit risk is highly subjective. Answer: TRUE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 7) An acceptable audit risk assessment of low indicates a risky client requiring more extensive evidence, assignment of more experienced personnel, and/or a more extensive review of audit files. Answer: TRUE Terms: Acceptable audit risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 8) In assessing management integrity for potential new audit clients, the auditor should examine the prospective client's standing in the business community, financial stability, and relations with its previous CPA firm, among other procedures. Answer: TRUE Terms: Methods practitioners use to assess acceptable audit risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

9) There are several factors that affect engagement risk and, therefore, acceptable audit risk. Discuss three of these factors. Answer: Engagement risk is affected by: • The degree to which external users will rely on the statements. For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal. • The likelihood that a client will have financial difficulties after the audit report is issued. Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties. • The auditor's evaluation of management's integrity. Business risk is greater and acceptable audit risk will be lower when the client's management has questionable integrity. Terms: Factors that affect business risk and acceptable audit risk Difficulty: Moderate Objective: LO 9-6 AACSB: Reflective thinking 9.7 Learning Objective 9-7 1) Which of the following statements regarding inherent risk is correct? A) Inherent risk is unaffected by the auditor's experience with client's organization. B) Most auditors set a low inherent risk in the first year of an audit and increase it if experience shows that it was incorrect. C) Most auditors set a high inherent risk in the first year of an audit and reduce it in subsequent years as they gain more knowledge about the company. D) Inherent risk is dependent upon the strengths in client's internal control system. Answer: C Terms: Inherent risk Difficulty: Easy Objective: LO 9-7 AACSB: Reflective thinking 2) Auditors begin their assessments of inherent risk during audit planning. Which of the following would not help in assessing inherent risk during the planning phase? A) obtaining client's agreement on the engagement letter B) obtaining knowledge about the client's business and industry C) touring the client's plant and offices D) identifying related parties Answer: A Terms: Assessment of inherent risk during audit planning Difficulty: Easy Objective: LO 9-7 AACSB: Reflective thinking

3) Which of the following is not a primary consideration when assessing inherent risk? A) nature of client's business B) existence of related parties C) effectiveness of system of internal controls D) susceptibility to misappropriation of assets Answer: C Terms: Assessing inherent risk Difficulty: Challenging Objective: LO 9-7 AACSB: Reflective thinking 4) Which of the following is an accurate statement regarding inherent risk? A) The profession has established guidelines for setting inherent risk. B) Auditors are generally conservative in setting inherent risk. C) Factors impacting inherent risk will affect all cycles, balances, and disclosures. D) Inherent risk has no impact on the amount of evidence gathered. Answer: B Terms: Inherent risk Difficulty: Moderate Objective: LO 9-7 AACSB: Reflective thinking 5) Which of the following statements is not true with regards to the auditors assessment of ESGrelated risks? A) Auditors do not presently need to evaluate whether expected energy regulations impair client assets. B) Auditors should consider how their clients are affected by ESG goals and risks. C) Auditors should seek outside sources of information regarding ESG risks. D) Auditors should consider whether ESG-related risks are properly disclosed in the financial statements. Answer: A Terms: Assessing inherent risk Difficulty: Moderate Objective: LO 9-7 AACSB: Reflective thinking 6) The risk of fraud should be assessed for the entire audit as well as by cycle, account, and objective. Answer: TRUE Terms: Fraud Difficulty: Moderate Objective: LO 9-7 AACSB: Reflective thinking

7) The auditing profession has established guidelines for setting inherent risk. Answer: FALSE Terms: Inherent risk Difficulty: Moderate Objective: LO 9-7 AACSB: Reflective thinking 8) Accounts that require considerable judgment have a higher inherent risk. Answer: TRUE Terms: Inherent risk Difficulty: Moderate Objective: LO 9-7 AACSB: Reflective thinking 9) The risk of material misstatement is a combination of two client-controlled factors: inherent risk and control risk. What is inherent risk and why is it important? Give examples of inherent risk factors. Answer: Inherent risk is the auditor's assessment of the likelihood that there are material misstatements in the audit segment before the consideration of system of internal controls. Inherent risk is important because it attempts to predict where misstatements are most and least likely to occur. Factors that the auditor considers when assessing inherent risk include but are not limited to: • The nature of the client's business • Results of previous audits • Initial versus repeat engagements • Related parties • Complex or nonroutine transactions • Judgment required to correctly record account balances and transactions • Makeup of the population • Factors related to fraudulent financial reporting • Factors related to misappropriation of assets Terms: Factors affecting inherent risk Difficulty: Easy Objective: LO 9-7 AACSB: Reflective thinking

9.8 Learning Objective 9-8 1) Which of the following is true regarding audit risk for segments? A) Control risk must be assessed at the same level for all accounts. B) Factors affecting inherent risk do not differ from account to account. C) Acceptable audit risk is ordinarily assessed by the auditor during the substantive test of balances phase and is held constant for each major cycle and account. D) In some cases, a lower acceptable audit risk may be more appropriate for one account than for others. Answer: D Terms: Audit risk for segments Difficulty: Moderate Objective: LO 9-8 AACSB: Reflective thinking 2) Auditors respond to risk primarily by I. changing the extent of testing. II. changing the types of audit procedures. A) I only B) II only C) both I and II D) neither I nor II Answer: C Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 9-8 AACSB: Reflective thinking 3) When using the audit risk model, A) auditors find it relatively easy to measure the components of the model. B) many auditors use broad and subjective measurement terms. C) auditors find it easy to measure the amount of evidence implied by a given planned detection risk. D) auditors are only concerned with understating accounts. Answer: B Terms: Audit risk model Difficulty: Moderate Objective: LO 9-8 AACSB: Reflective thinking

4) Assume the auditor confirms accounts payable and, based on the misstatements found, concludes the original control risk assessment as low was inappropriate. The auditor A) should revise their estimate of the control risk upward. B) should revise their estimate of the inherent risk upward. C) should revise their estimate of the acceptable audit risk downward. D) should revise their estimate of the inherent risk downward. Answer: A Terms: Audit risk model Difficulty: Challenging Objective: LO 9-8 AACSB: Reflective thinking; Analytic thinking 5) In applying the audit risk model, auditors are concerned about overstatements, not understatements. Answer: FALSE Terms: Audit risk model Difficulty: Easy Objective: LO 9-8 AACSB: Reflective thinking 6) One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model. Answer: TRUE Terms: Audit risk Difficulty: Easy Objective: LO 9-8 AACSB: Reflective thinking 7) Since the audit risk model is a planning model, it assists the auditor in evaluating results. Answer: FALSE Terms: Audit risk model Difficulty: Easy Objective: LO 9-8 AACSB: Reflective thinking

8) In practice, auditors rarely assign numerical probabilities to inherent risk, control risk, or acceptable audit risk. It is more common to assess these risks as high, medium, or low. For each of the four situations below, fill in the blanks for planned detection risk and the amount of evidence you would plan to gather ("planned evidence") using the terms high, medium, or low.

Acceptable audit risk Inherent risk Control risk Planned detection risk Planned evidence

SITUATION SITUATION SITUATION SITUATION 1 2 3 4 Low Low High High High Low Low Low High Low Medium Low ________ ________ ________ ________ ________ ________ ________ ________

Answer: 1. low, high 2. medium, medium 3. medium, medium 4. high, low Terms: Planned detection risk and planned evidence in relation to acceptable audit risk, inherent risk, and control risk Difficulty: Moderate Objective: LO 9-8 AACSB: Analytic thinking

9) Dracule Industries is a privately owned business that sells medical product and devices to hospitals, clinics and the public. Certain changes have occurred in Dracule Industries during the year undergoing the audit. Harker needs to evaluate the effect these changes have on audit risk. Audit risk at the financial statement level is influenced by the risk of material misstatement; which include factors related to management, the industry and the entity or a combination thereof. For each of the following changes that have occurred during the year under audit, identify the appropriate audit effect from the list of responses. Each response can be used once, more than once, or not at all. Client changes: 1. An internal audit department has been established. 2. A new inventory control system has been installed that reduces the access of unauthorized parties. 3. Inexperienced accounting personnel were hired in the accounting department. 4. Excess cash was used to purchase complex derivatives. 5. Controls over the sales credit approval process have laxed. Possible effect on the audit: 6. New government regulations now apply a. increases the acceptable level of detection to Dracule Industries. risk 7. Management has become overly b. decreases the acceptable level of aggressive in reaching target goals. detection risk 8. An expert was hired to help determine c. change has no effect on the acceptable the value of the ore content in ending level of detection risk materials inventory. Answer: 1. a 2. a 3. b 4. b 5. b 6. b 7. b 8. a Terms: Audit risk Difficulty: Moderate Objective: LO 9-8 AACSB: Analytic thinking

9.9 Learning Objective 9-9 1) When taken together, the concepts of risk and materiality in auditing A) measure the uncertainty of amounts of a given magnitude. B) measure uncertainty only. C) measure magnitude only. D) measure inherent risk. Answer: A Terms: Materiality and risk Difficulty: Moderate Objective: LO 9-9 AACSB: Reflective thinking 2) Which of the following is a correct statement? A) There is no relationship between materiality and risk in auditing. B) Risk is a measure of magnitude or size. C) The combination of performance materiality and the audit risk model factors determines planned audit evidence. D) Performance materiality is part of the audit risk model. Answer: C Terms: Relationship of inherent risk, detection risk, and amount of audit evidence Difficulty: Moderate Objective: LO 9-9 AACSB: Reflective thinking 3) Performance materiality impacts inherent risk and control risk. Answer: FALSE Terms: Performance materiality Difficulty: Moderate Objective: LO 9-9 AACSB: Reflective thinking 4) Performance materiality does not affect any of the four risks but together they determine planned audit evidence. Answer: TRUE Terms: Performance materiality Difficulty: Challenging Objective: LO 9-9 AACSB: Reflective thinking 5) The combination of performance materiality and the audit risk model factors does not affect the auditor's planned audit evidence. Answer: FALSE Terms: Performance materiality Difficulty: Challenging Objective: LO 9-9 AACSB: Reflective thinking 34 Copyright © 2023 Pearson Education, Inc.

6) The statement that the auditor plans to accumulate evidence that there is only a 5 percent acceptable audit risk of failing to uncover misstatements exceeding performance materiality of $250,000 is a precise and meaningful statement. Answer: TRUE Terms: Performance materiality Difficulty: Moderate Objective: LO 9-9 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 10 Fraud Auditing 10.1 Learning Objective 10-1 1) Which of the following best defines fraud in a financial statement auditing context? A) Fraud is an unintentional misstatement of the financial statements. B) Fraud is an intentional misstatement of the financial statements. C) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on materiality. D) Fraud is either an intentional or unintentional misstatement of the financial statements, depending on consistency. Answer: B Terms: Definition of fraud in financial statement auditing Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 2) Companies may intentionally understate earnings when income is high to create ________ that may be used in future years to increase earnings. A) income smoothing B) cookie jar reserves C) cash D) sales Answer: B Terms: Intentionally understate earnings; Reserve earnings Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking

3) Which of the following is a category of fraud? A) Fraudulent financial reporting Misappropriation of assets Yes Yes B) Fraudulent financial reporting No

Misappropriation of assets No

Fraudulent financial reporting Yes

Misappropriation of assets No

Fraudulent financial reporting No

Misappropriation of assets Yes

Answer: A Terms: Category of fraud Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 4) Most cases of fraudulent reporting involve A) inadequate disclosures. B) an intentional misstatement of amounts. C) an overstatement of liabilities. D) an overstatement of expenses. Answer: B Terms: Fraudulent financial reporting Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 5) ________ is fraud that involves theft of an entity's assets. A) Fraudulent financial reporting B) A "cookie jar" reserve C) Misappropriation of assets D) Income smoothing Answer: C Terms: Fraud that involves theft of entity's assets Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking

6) Which of the following is a form of earnings management in which revenues and expenses are shifted between periods to reduce fluctuations in earnings? A) fraudulent financial reporting B) expense smoothing C) income smoothing D) Each of the above is correct. Answer: C Terms: Form of earnings management Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 7) Misappropriation of assets is normally perpetrated by A) members of the board of directors. B) employees at lower levels of the organization. C) management of the company. D) the internal auditors. Answer: B Terms: Misappropriation of assets normally; perpetrators Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 8) Fraudulent financial reporting A) always involves inadequate disclosures. B) can be intentional or unintentional. C) can involve understating net income in order to reduce income taxes. D) all of the above. Answer: C Terms: Fraudulent financial reporting Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 9) According to the Association of Certified Fraud Examiners (ACFE), the average company loses ________ percent of its revenues to fraud. A) one B) five C) ten D) fifteen Answer: B Terms: Revenues lost to fraud Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking

10) Which of the following is an accurate statement regarding the misappropriation of assets? A) In most cases, the amounts involved are material to the financial statements. B) Misappropriation of assets can easily increase in size over time and can lead to significant reputational harm. C) Management should not be concerned about minor misappropriations. D) Asset misappropriation schemes are less common than fraudulent financial statement schemes. Answer: B Terms: Misappropriation of assets Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking 11) Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. Answer: TRUE Terms: Fraudulent financial reporting Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 12) The two main categories of fraud are fraudulent financial reporting and misappropriation of assets. Answer: TRUE Terms: Categories of fraud; Fraudulent financial reporting and misappropriation of assets Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 13) "Cookie jar reserves" are often created by companies whenever their earnings are low to create reserves for future periods when earnings need to be "boosted" upward. Answer: FALSE Terms: Cookie jar reserves Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 14) Misappropriation of assets is normally perpetrated at the lowest levels of the organization hierarchy. Answer: TRUE Terms: Misappropriation of assets Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking

15) Fraudulent financial reporting usually involves manipulation of amounts rather than disclosures. Answer: TRUE Terms: Fraudulent financial reporting Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking 16) According to the Association of Certified Fraud Examiners, losses from misappropriation schemes are higher than losses from financial statement frauds. Answer: FALSE Terms: Fraud and main categories Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 17) One technique to smooth income is to increase the value of inventory and other assets of an acquired company at the time of the acquisition, resulting in lower earnings when the assets are later sold. Answer: FALSE Terms: Fraudulent financial reporting Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking 18) To counter higher than expected earnings, companies may deliberately overstate bad debt expense and reserves for obsolete inventory. Answer: TRUE Terms: Fraudulent financial reporting Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking 19) Fraudulent financial reporting may also involve inadequate disclosures in the financial statements. Answer: TRUE Terms: Fraudulent financial reporting Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking

20) Define fraud and distinguish between the two main categories of fraud. Answer: In the context of financial statement auditing, fraud is defined as an intentional misstatement of the financial statements. The two main categories of fraud are fraudulent financial reporting and misappropriation of assets. Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users of the financial statements. Misappropriation of assets involves theft of an entity's assets. Terms: Fraud and main categories Difficulty: Easy Objective: LO 10-1 AACSB: Reflective thinking 21) List and briefly describe cases and examples of fraudulent financial reporting. Answer: • Overstating income — either by overstating assets or income, or understating or omitting expenses or liabilities. • Understating income — especially by privately held companies in an attempt to reduce income taxes. • Creating reserve or earnings or cookie jar reserves — to help improve reporting earnings in future periods. • Earnings management — deliberate actions such as fraudulent journal entries taken by management to meet analyst earnings expectations. Terms: Fraudulent financial reporting Difficulty: Moderate Objective: LO 10-1 AACSB: Reflective thinking

10.2 Learning Objective 10-2 1) Which of the following are elements of the fraud triangle? A) Attitudes/rationalization Risk Factors Opportunities Yes No Yes B) Attitudes/rationalization No

Risk Factors Yes

Opportunities Yes

C) Attitudes/rationalization Yes

Risk Factors No

Opportunities No

D) Attitudes/rationalization No

Risk Factors Yes

Opportunities No

Answer: A Terms: Fraud triangle Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking 2) Although the financial statements of all companies are potentially subject to manipulation, the risk is greater for companies that A) are heavily regulated. B) have low amounts of debt. C) have to make significant judgments for accounting estimates. D) operate in stable economic environments. Answer: C Terms: Financial statement manipulation risk is elevated Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking

3) Which of the following is not a factor that relates to opportunities to commit fraudulent financial reporting? A) lack of controls related to the calculation and approval of accounting estimates B) ineffective oversight of financial reporting by the board of directors C) management's set of ethical values D) high turnover of accounting, internal audit, and information technology staff Answer: C Terms: Factor relates to opportunities to commit fraudulent financial reporting Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 4) Fraud is more prevalent in smaller businesses and not-for-profit organizations because it is more difficult for them to maintain A) adequate separation of duties. B) adequate compensation. C) adequate financial reporting standards. D) adequate supervisory boards. Answer: A Terms: Fraud more prevalent in smaller business and not-for-profit organizations Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 5) Which of the following is a factor that relates to incentives or pressures to commit fraudulent financial reporting? A) significant accounting estimates involving subjective judgments B) excessive pressure for management to meet debt repayment requirements C) management's practice of making overly aggressive forecasts D) high turnover of accounting, internal audit, and information technology staff Answer: B Terms: Factor that relates to incentives or pressures to commit fraudulent financial reporting Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 6) Which of the following is a factor that relates to attitudes or rationalization to misappropriate assets? A) significant accounting estimates involving subjective judgments B) excessive pressure for management to meet debt repayment requirements C) a sense of superiority by executives D) high turnover of accounting, internal audit, and information technology staff Answer: C Terms: Factor that relates to incentives to misappropriate assets Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

7) Which of the following is not a factor that relates to opportunities to misappropriate assets? A) inadequate system of internal controls over assets B) presence of large amounts of cash on hand C) inappropriate segregation of duties or independent checks on performance D) adverse relationships between management and employees Answer: D Terms: Factor that relates to opportunities to misappropriate assets Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 8) Which of the following is a factor that relates to incentives/pressures to misappropriate assets? A) weak system of internal controls B) significant personal financial obligations C) management's practice of making overly aggressive forecasts D) anger and fear Answer: B Terms: Factor that relates to incentives to misappropriate assets Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 9) According to a ACFE survey, most fraud perpetrators A) are over the age of 60. B) have worked for the company over 10 years. C) have worked for the company 1-5 years. D) are female. Answer: C Terms: Characteristics of fraud perpetrators Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 10) In the fraud triangle, fraudulent financial reporting and misappropriation of assets A) share little in common. B) share most of the same risk factors. C) share the same three conditions of the fraud triangle. D) share most of the same conditions. of the fraud triangle. Answer: C Terms: Fraud triangle Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking

11) Which of the following would the auditor be most concerned about regarding a heightened risk of intentional misstatement? A) Senior management emphasizes that it is very important to beat analyst estimates of earnings every reporting period. B) Senior management emphasizes that budgeted amounts for expenses are to be achieved for each reporting period or explained in the variance analysis report. C) Senior management emphasizes that job rotation is a worthwhile corporate objective. D) Senior management emphasizes that job evaluations are based on performance. Answer: A Terms: Heightened risk of intentional misstatement Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking 12) Which of the following is a risk factor related to opportunities and financial statement fraud? A) ineffective communication of company values B) promotions inconsistent with expectations C) significant related-party transactions D) adverse relationships between management and employees Answer: C Terms: Factor relates to opportunities to commit fraudulent financial reporting Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking 13) Relating to opportunities, why do most people commit fraud? A) They need to fund an extravagant lifestyle. B) They feel a sense of superiority. C) There are weak systems of internal controls. D) They need to meet pre-specified business targets. Answer: C Terms: Fraud risk conditions and opportunity Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 14) According to a KPMG survey, which of the following is not often cited as an incentive to engage in fraudulent financial reporting? A) personal financial incentives B) the desire to fund an extravagant lifestyle C) the need to meet pre-specified business performance targets D) an improvement in the company's financial prospects Answer: D Terms: Risk factors for fraudulent financial reporting Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 10 Copyright © 2023 Pearson Education, Inc.

15) Which of the following is not a risk factor that the auditor should take into account when considering the possibility of fraudulent financial reporting at an audit client? A) Significant accounting estimates are not difficult for the auditor to verify and justify. B) Board members' personal net worth is threatened if the entity's financial performance does not meet market expectations. C) Increasing business complexity occurs as a result of numerous recent acquisitions. D) Information technology personnel are found to be not keeping up with the latest trends in system of internal controls and data security. Answer: A Terms: Risk factors for fraudulent financial reporting Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 16) Which of the following is not a risk factor that the auditor should take into account when considering the possibility of misappropriation of assets at an audit client? A) The presence of inventory items which are large in size and low in value B) Employees with access to cash who have adverse relationships with management C) The audit client announces required layoffs six months from now D) An approved vendor list to detect unauthorized or fictitious vendors is not properly controlled Answer: A Terms: Risk factors for misappropriation of assets Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 17) Which of the following statements is not true regarding Bernie Madoff's Ponzi scheme? A) Fortunately, charities and private foundations were not approached by Madoff. B) In Ponzi schemes, investors are enticed by above-market returns. C) Madoff's Ponzi scheme was investigated by the SEC several times. D) In Ponzi schemes, they usual collapse due to depending upon new investors. Answer: A Terms: Risk factors for conditions of fraud Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 18) Incentives and opportunities are two conditions that are generally present when financial statement fraud occurs. Answer: TRUE Terms: Conditions present when material misstatements due to fraud occur Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking

19) Fraud is more prevalent in large businesses than small businesses and not-for-profit organizations. Answer: FALSE Terms: Fraud prevalence in organizations Difficulty: Easy Objective: LO 10-2 AACSB: Reflective thinking 20) Turnover in accounting personnel can create a rationalization for misstatement. Answer: FALSE Terms: Fraud triangle risk conditions Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 21) A lack of controls over payments to vendors can cause revenue fraud. Answer: FALSE Terms: Opportunities conditions included in fraud triangle Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 22) Ineffective oversight by the board of directors over financial reporting is an example of an incentives/pressures risk factor. Answer: FALSE Terms: Fraud risk factor describing incentives/pressures Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 23) A common incentive for companies to manipulate financial statements is a decline in the company's financial prospects. Answer: TRUE Terms: Fraud risk factor describing incentives/pressures Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 24) The pressure to do "whatever it takes" to meet goals is one of the main reasons why financial statement fraud occurs. Answer: TRUE Terms: Risk factors related to incentives, opportunities, and attitudes Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking

25) In the fraud triangle, fraudulent financial reporting and misappropriation of assets share the same conditions and risk factors. Answer: FALSE Terms: Fraud triangle risk conditions Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking 26) List and briefly describe the three conditions for fraud. Answer: • Incentives/pressures – Management or other employees have incentives or pressures to commit fraud. • Opportunities – Circumstances provide opportunities for management or employees to commit fraud. • Attitudes/Rationalization – An attitude, character, or set of ethical values exists that allows management or employees to intentionally commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act. Terms: Conditions for fraud Difficulty: Moderate Objective: LO 10-2 AACSB: Reflective thinking

27) List and briefly describe examples of risk factors for each condition of fraud for fraudulent financial reporting. Answer: Incentives/Pressures: 1. Financial stability or profitability is threatened by economic, industry, or entity operating conditions. 2. Excessive pressure for management to meet debt repayment or other debt covenant requirements. 3. Management or the board of directors' personal net worth is materially threatened by the entity's financial performance. Opportunities: 1. Significant accounting estimates involve subjective judgments or uncertainties that are difficult to verify. 2. Ineffective board of director or audit committee oversight over financial reporting. 3. High turnover or ineffective accounting, internal audit, or information technology staff. 4. Deficient system of internal controls. 5. Significant related party transactions. Attitudes/Rationalization: 1. Inappropriate or ineffective communication and support of the entity's values. 2. Known history of violations of securities laws and other laws and regulations. 3. Management's practice of making overly aggressive or unrealistic forecasts to analysts, creditors, and other third parties. Terms: Risk factors for conditions of fraud Difficulty: Challenging Objective: LO 10-2 AACSB: Reflective thinking

10.3 Learning Objective 10-3 1) Which of the following is a true statement regarding professional skepticism? A) Auditors reject most potential clients perceived as lacking honesty and integrity. B) If the auditor has past experience with a client, they can assume the client is honest. C) Material frauds occur in most of the audits of financial statements. D) Professional skepticism is required only during the planning phase. Answer: A Terms: Professional skepticism when auditing a client Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 2) Upon discovering information that indicates a material misstatement due to fraud may have occurred, auditors should A) acquire additional evidence as needed. B) thoroughly probe the issues. C) consult with other team members. D) all of the above. Answer: D Terms: Criteria by which an auditor evaluates information Difficulty: Easy Objective: LO 10-3 AACSB: Reflective thinking

3) As part of the brainstorming sessions, auditors are directed to emphasize A) How management could perpetrate The audit team's response to and conceal fraudulent financial potential fraud risks reporting Yes Yes B) How management could perpetrate and conceal fraudulent financial reporting No C) How management could perpetrate and conceal fraudulent financial reporting Yes D) How management could perpetrate and conceal fraudulent financial reporting No

The audit team's response to potential fraud risks No

The audit team's response to potential fraud risks Yes

Answer: A Terms: Auditors directed to emphasize in brainstorming sessions Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 4) Which of the following questions is the auditor not required to ask company management when assessing fraud risk? A) Does management have knowledge of any fraud or suspected fraud within the company? B) What is the nature of the fraud risks identified by management? C) Is management using all assets effectively? D) What system of internal controls have been implemented to address the fraud risks? Answer: C Terms: Sources of information to assess fraud risks; inquiries of management Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

5) When assessing the risk for fraud, the auditor must be cognizant of the fact that A) the existence of fraud risk factors means fraud exists. B) analytical procedures must be performed on revenue accounts. C) horizontal analysis is not useful in helping to determine unusual financial statement relationships. D) the auditor cannot make inquiries about fraud to company personnel who have no financial statement responsibilities. Answer: B Terms: Assessment of fraud risk Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 6) Which of the following is not a likely source of information to assess fraud risks? A) communications among audit team members B) inquiries of management C) analytical procedures D) consideration of fraud risks discovered during recent audits of other clients Answer: D Terms: Source of information to assess fraud risks Difficulty: Challenging Objective: LO 10-3 AACSB: Reflective thinking 7) When assessing fraud risk, A) fraud risk is assessed only at the overall financial statement level. B) the auditor's assessment of fraud risk should be ongoing throughout the audit. C) if the auditor concludes that there is a risk of material misstatement due to fraud, auditing standards require that the risks be treated as pervasive. D) auditing standards require that the auditor presume there is a risk of fraud in the inventory account. Answer: B Terms: Assessment against a defendant of the full loss suffered by a plaintiff Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 8) In vertical analysis, the account balance is compared to the previous period, and the percentage change for the period is calculated. Answer: FALSE Terms: Analytical procedures Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

9) Information and idea exchange sessions by the audit team are required by current auditing standards. Answer: TRUE Terms: Information and idea exchange by audit team sessions required by current audit standards Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 10) Upon discovering information that indicates a material misstatement due to fraud, the auditor must assume that the misstatement is an isolated incident. Answer: FALSE Terms: Assessment of fraud risk Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 11) The presence of fraud risk factors increases the likelihood of fraud and may suggest that fraud is being perpetrated. Answer: TRUE Terms: Presence of fraud risk factors Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 12) When the auditor receives inconsistent responses from management and others within the organization, the auditor should obtain additional audit evidence to resolve the inconsistency. Answer: TRUE Terms: Presence of fraud risk factors Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 13) Auditing standards require that the auditor presume that there is a risk of fraud in revenue recognition. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

14) For significant risks, including fraud risks, the auditor should obtain an understanding of the system of internal controls related to the risks. Answer: TRUE Terms: Significant risk Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 15) Material frauds are frequent compared to the number of financial statement audits conducted annually in the U.S. Answer: FALSE Terms: Professional skepticism Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 16) Most auditors will encounter a material fraud during their auditing careers. Answer: FALSE Terms: Professional skepticism Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 17) If the auditor discovers information indicating a material misstatement due to fraud may have occurred, the auditor should immediately withdraw from the audit engagement. Answer: FALSE Terms: Critical evaluation of audit evidence Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 18) If the auditor discovers that a current year sale should be recorded in the following year, the auditor should determine if this situation was intentional by the client or fraud committed by the client. Answer: TRUE Terms: Critical evaluation of audit evidence Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

19) The Securities and Exchange Commissions will set up the Office of the Whistleblower sometime in the near future in an effort to combat fraud and offer monetary rewards for being a whistleblower. Answer: FALSE Terms: Securities and Exchange Commission Office of the Whistleblower Difficulty: Easy Objective: LO 10-3 AACSB: Reflective thinking 20) Auditing standards state that the auditor should focus inquiries regarding fraud with the board of directors and management of their audit clients, and not spend time making inquiries of personnel outside of the normal financial reporting lines of responsibility. Answer: FALSE Terms: Inquiries of management and other personnel Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 21) When the auditor concludes there is a risk of material misstatement due to fraud, auditing standards do not require to automatically treat those risks as significant risks. Answer: FALSE Terms: Identified risks of material misstatements due to fraud Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking 22) Discuss the need for maintaining professional skepticism during an audit. Answer: Auditing standards require that the audit be planned and performed with an attitude of professional skepticism in all aspects of the engagement, recognizing the possibility that a material misstatement could exist regardless of the auditor's prior experience with the integrity and honesty of client management and those charged with governance. In practice, maintaining this attitude can be difficult because, despite some recent high-profile financial statement frauds, material frauds are infrequent compared to the number of audits of financial statements conducted annually. Terms: Professional skepticism Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

23) Briefly discuss the brainstorming session required by current auditing standards. Be sure to include a list of ideas that should be addressed in the session. Answer: Auditing standards require the audit team to conduct discussions to share insights from more experienced audit team members and to "brainstorm" ideas that address several ideas. The ideas that should be discussed are: • How and where the entity's financial statements might be susceptible to material misstatements due to fraud. This includes known external and internal factors affecting the entity that might (1) create an incentive or pressure for management to commit fraud, (2) provide the opportunity for fraud to be perpetrated, including the risk of management override of system of internal controls, and (3) indicate a culture or environment that enables management to rationalize fraudulent acts. • How management could perpetrate and conceal fraudulent financial reporting. • How assets of the entity could be misappropriated. • How the auditor might respond to the susceptibility of material misstatements due to fraud. Terms: Brainstorming session required by auditing standards Difficulty: Moderate Objective: LO 10-3 AACSB: Reflective thinking

24) Describe the five sources of information gathered to assess fraud risks. Answer: The five sources of information to assess fraud risk are: • Communications among audit team members. The following ideas should be "brainstormed" (1) How and where the entity's financial statements might be susceptible to material misstatements due to fraud, including known external and internal factors that might (a) create an incentive or pressure for management to commit fraud, (b) provide the opportunity for fraud to be perpetrated, and (c) indicate a culture or environment that enables management to rationalize fraudulent acts. (2) How management could perpetrate and conceal fraudulent financial reporting. (3) How anyone might misappropriate assets of the entity. (4) How the auditor might respond to the susceptibility of material misstatements due to fraud. • Inquiries of management. These inquiries should address whether management has knowledge of any fraud or suspected fraud within the company. Auditors should also inquire about management's process of assessing fraud risks, the nature of fraud risks identified by management, any system of internal controls implemented to address those risks, and any information about fraud risks and related controls that management has reported to the audit committee or others charged with governance. • Risk factors. The auditor must evaluate whether fraud risk factors indicate incentives or pressures to perpetrate fraud, opportunities to carry out fraud, or attitudes or rationalizations used to justify a fraudulent action. • Analytical procedures. Auditors must perform analytical procedures during the planning and completion phases of the audit to help identify unusual transaction or events that might indicate the presence of material misstatements in the financial statements. Analytical procedures include ratio analysis, horizontal analysis, and vertical analysis. • Other procedures. Auditors should consider all information they have obtained in any phase or part of the audit as they assess the risk of fraud. Information about management's integrity and honesty, inquiries and analytical procedures, and information considered in assessing inherent and control risks, may lead to auditor concerns about the likelihood of misstatements due to fraud. Terms: Sources of information to assess fraud risks; inquiries of management Difficulty: Challenging Objective: LO 10-3 AACSB: Reflective thinking

10.4 Learning Objective 10-4 1) Which of the following is the best reason for management to emphasize fraud prevention and deterrence? A) It is often more effective and economical for companies to focus on fraud prevention and deterrence rather than on fraud detection. B) Collusion is impossible to detect. C) The AICPA requires management to implement a fraud prevention program. D) All of the above are equally valid reasons. Answer: A Terms: Reason for management to emphasize fraud prevention and deterrence Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 2) Which of the following parties is responsible for implementing system of internal controls to minimize the likelihood of fraud? A) external auditors B) audit committee members C) management D) Committee of Sponsoring Organizations Answer: C Terms: Party responsible for implementing system of internal controls to minimize likelihood of fraud Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 3) Research indicates that the most effective way to prevent and deter fraud is to A) implement programs and controls that are based on core values embraced by the company. B) hire highly ethical employees. C) communicate expectations to all employees on an annual basis. D) terminate employees who are suspected of committing fraud. Answer: A Terms: Most effective way to prevent and deter fraud Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking

4) Fraud awareness training should be A) broad and all-encompassing. B) extensive and include details for all functional areas. C) specifically related to the employee's job responsibility. D) focused on employees understanding the importance of ethics. Answer: C Terms: Fraud awareness training Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 5) Which party has the primary responsibility to oversee an organization's financial reporting and system of internal control process? A) the board of directors B) the audit committee C) management of the company D) the financial statement auditors Answer: B Terms: Party with primary responsibility to oversee organization's financial reporting and system of internal control processes Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 6) Management is responsible for A) Identifying and measuring fraud risks Taking steps to mitigate identified risks Yes Yes B) Identifying and measuring fraud risks Taking steps to mitigate identified risks No No C) Identifying and measuring fraud risks Taking steps to mitigate identified risks Yes No D) Identifying and measuring fraud risks Taking steps to mitigate identified risks No Yes Answer: A Terms: Management responsibilities for fraud risks Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 24 Copyright © 2023 Pearson Education, Inc.

7) Which of the following is not one of the elements to prevent, deter, and detect fraud according to the AICPA? A) performing analytical procedures B) culture of honesty and high ethics C) management's responsibility to evaluate risks of fraud D) audit committee oversight Answer: A Terms: Corporate governance oversight to reduce fraud risks Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 8) Who is responsible for setting the "tone at the top"? A) management B) PCAOB C) audit committee D) SEC Answer: A Terms: Responsibility for setting tone at the top Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 9) An effective code of conduct should contain the company's policies regarding A) conflicts of interests. B) kickbacks. C) gifts and entertainment. D) all of the above. Answer: D Terms: Elements of code of conduct Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 10) Which of the following is not true with regards to PCAOB auditing standards? A) It is not important if the internal auditors report to either management or the audit committee. B) The auditors evaluation of the audit committee should consider the committees responsibilities. C) Ineffective oversight by the audit committee may be an indicator of a material system of internal control weakness. D) The auditor should consider the audit committees independence from management. Answer: A Terms: Audit committee oversight Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking; Analytic thinking 25 Copyright © 2023 Pearson Education, Inc.

11) Management and the board of directors are responsible for setting the "tone at the top." Answer: TRUE Terms: Responsibility for setting tone at the top Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 12) If employees have positive feelings about their employers, they are less likely to commit fraud. Answer: TRUE Terms: Positive work environment Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 13) Management must recognize that almost any employee is capable of committing a dishonest act under the right circumstances. Answer: TRUE Terms: Mitigating fraud risks Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking 14) Audit committee oversight also serves as a deterrent to fraud by senior management. Answer: TRUE Terms: Audit committee and fraud Difficulty: Challenging Objective: LO 10-4 AACSB: Reflective thinking 15) Collusion and false documentation make detection of fraud by management a challenge. Answer: TRUE Terms: Management responsibility for corporate governance and limitations Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 16) The Committee of the Sponsoring Organization (COSO) of the Treadway Commission recently issued a Fraud Risk Management Guide which is not consistent with the COSO Internal Control - Integrated Framework. Answer: FALSE Terms: COSO Fraud Risk Management Guide issued recently Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

17) Management, not the board of directors, is responsible for setting the "tone at the top" for ethical behavior in the company. Answer: FALSE Terms: Setting tone at the top Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 18) Public Company Accounting Oversight Board auditing standards require the auditor of a public company to evaluate the effectiveness of the board of directors and the audit committee. Answer: TRUE Terms: Audit committee oversight Difficulty: Easy Objective: LO 10-4 AACSB: Reflective thinking 19) The "tone at the top" provides a foundation upon which a more detailed code of conduct can be developed to provide specific guidance for the organization and its employees. Components of a code of conduct may include sections on 1) general employee conduct, 2) relationships with clients and suppliers, and 3) conflicts of interest. Give a narrative description of what might be included in each of the above components of a code of conduct. Answer: (may vary) General employee conduct—Employees should conduct themselves in a businesslike manner and prohibit unprofessional activities such as drinking, gambling, fighting, and swearing, while on the job. Relationships with client and suppliers—Employees should avoid investing in or acquiring a financial interest in any business organization that has a contractual relationship with the organizations. Conflicts of Interest—Employees are expected to perform their duties conscientiously, honestly, and in accordance with the best interests of the organization and to not use their positions or knowledge gained for private or personal advantage. Terms: Elements of code of conduct Difficulty: Challenging Objective: LO 10-4 AACSB: Reflective thinking

20) Senior management is responsible for promoting a culture of honesty and ethics. Describe what that implies for the organization. Answer: Note: responses with examples may vary Management cannot act one way and expect others in the company to behave differently. Through its actions and communications, management can show that dishonest or unethical behavior is not tolerated, even if the results benefit the company. For example, statements by management about the absolute need to meet operating and financial targets create undue pressures that may lead employees to commit fraud to achieve them. In contrast, statements indicating management's desire to aggressively pursue the entity's goals and targets while at the same time requiring honest and ethical actions to achieve those goals, clearly indicates to employees that integrity is a requirement. Whichever course management pursues, its actions establish the "tone at the top." Terms: Management responsibility for promoting a culture of honesty and ethics Difficulty: Challenging Objective: LO 10-4 AACSB: Reflective thinking 21) Explain at least three of the roles which the Human Resource function can play in reducing the fraud risk within a company. Answer: Effective screening policies — help reduce the likelihood of hiring and promoting individuals holding position of trust which have low levels of honesty Background checks — perform background checks on individuals being considered for positions of trust, promotions to positions of trust, or for employment Code of conduct policy enforcement — assist management in enforcing the company's code of conduct policy, including updating it and distributing the policy and getting written acknowledgement from every employee Training — starting with beginning of employment, explain the company's expectations with regards to ethical conduct; how to communicate actual or suspected fraud; tailor fraud awareness training to each employee's job responsibilities Discipline — enforcement of code of conduct violations, regardless of the level of the employee violating the code of conduct; investigation of all violations; and appropriate and consistent responses Terms: Human resource role in reducing fraud risk Difficulty: Moderate Objective: LO 10-4 AACSB: Reflective thinking

10.5 Learning Objective 10-5 1) As part of designing and performing procedures to address management override of controls, auditors must perform which of the following procedures? A) Examine journal entries for Review accounting estimates for evidence of possible misstatements biases due to fraud Yes Yes B) Examine journal entries for evidence of possible misstatements due to fraud No

Review accounting estimates for biases No

C) Examine journal entries for evidence of possible misstatements due to fraud Yes

Review accounting estimates for biases No

D) Examine journal entries for evidence of possible misstatements due to fraud No

Review accounting estimates for biases Yes

Answer: A Terms: Designing and performing procedures to address override controls Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 2) Auditors may identify conditions during fieldwork that change or support a judgment about the initial assessment of fraud risks. Which of the following is not a condition which should alert an auditor that the initial assessment should be changed? A) The subsidiary ledger agrees with the general ledger. B) discrepancies in the accounting records C) unusual relationships between the auditor and management D) missing or conflicting evidence Answer: A Terms: Alert auditor to change initial assessment of fraud risks Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

3) When the auditor identifies risk at the assertion level, A) the auditor may need to obtain audit evidence that is more reliable and relevant. B) the auditor may choose to conduct substantive testing during interim periods rather than at the end of the period. C) the auditor may decrease the sample size. D) both A and B Answer: A Terms: Fraud risk Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 4) Because fraud perpetrators are often knowledgeable about audit procedures, auditors should incorporate unpredictability into the audit strategy. Answer: TRUE Terms: Auditors to incorporate unpredictability into audit plan Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 5) The auditors should pay careful attention to accounting principles that involve subjective measurements or complex transactions. Answer: TRUE Terms: Responding to the risk of fraud Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 6) If the risk of misstatement due to fraud is increased, the auditor is required to assign a fraud specialist to the audit team. Answer: FALSE Terms: Responding to the risk of fraud Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 7) It is possible that management may have programs designed to deter, prevent, and to detect fraud. The auditor should therefore consider whether such antifraud programs mitigate the risk of material misstatement due to fraud. Answer: TRUE Terms: Responding to the risk of fraud Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking

8) The risk of management override of controls exists in just about every audit. Therefore, auditors must perform certain features in every audit, including examining journal entries and other adjustments, for evidence of possible misstatements due to fraud. Answer: TRUE Terms: Responding to the risk of management override of controls Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 9) The risk of management override of controls exists in just about every audit. Therefore, auditors must perform certain features in every audit, including examining management's estimates, judgments, and assumptions that may indicate a potential for bias. Answer: TRUE Terms: Responding to the risk of management override of controls Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking 10) Auditors are required to perform certain procedures in every audit to address the risk of management override of system of internal controls. What are these procedures? Answer: Auditing procedures require the following to be performed to address the risk of management override of controls: • Examine journal entries and other adjustments for evidence of possible misstatements due to fraud. • Review accounting estimates for bias. • Evaluate the business rationale for significant unusual transactions. Terms: Audit procedures required to address the risk of management override of system of internal controls Difficulty: Moderate Objective: LO 10-5 AACSB: Reflective thinking

10.6 Learning Objective 10-6 1) Auditing standards specifically require auditors to identify ________ as a fraud risk in most audits. A) overstated assets B) understated liabilities C) revenue recognition D) overstated expenses Answer: C Terms: Specific fraud risk areas Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 2) Company management is often under pressure to increase revenue and/or net income. One approach is to use a "bill and hold" arrangement. "Bill and hold" is an example of which of the following? A) significant accounting estimates B) fictitious revenue recorded C) premature revenue recognized D) alteration of cutoff documents Answer: C Terms: Bill and hold arrangement to increase revenue and/or net income Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 3) A company is concerned with the theft of cash after the sale has been recorded. One way in which fraudsters conceal the theft is by a process called "lapping." Which of the following best describes lapping? A) reduce the customer's account by recording a sales return B) write off the customer's account C) apply the payment from another customer to the customer's account D) reduce the customer's account by recording a sales allowance Answer: C Terms: Lapping; Theft of cash Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking

4) Analytical procedures can be very effective in detecting inventory fraud. Which of the following analytical procedures would not be useful in detecting fraud? A) gross margin percentage B) inventory turnover C) cost of sales percentage D) accounts receivable turnover Answer: D Terms: Analytical procedures to detect inventory fraud Difficulty: Challenging Objective: LO 10-6 AACSB: Reflective thinking 5) When dealing with revenue frauds, A) the most egregious form of revenue fraud involves premature revenue recognition. B) premature revenue recognition involves recognizing the revenue after the accounting standards requirements have been met. C) premature revenue recognition is the same as cutoff errors. D) side agreements can modify the terms of the sales transaction and should be analyzed carefully. Answer: D Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 6) Two of the most useful warning signals that can indicate that revenue fraud is occurring are A) analytical procedures and documentary discrepancies. B) analytical procedures and misappropriation of assets. C) documentary discrepancies and vague responses to inquiries. D) missing audit evidence and vague responses to inquiries. Answer: A Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 7) Fictitious revenues A) increase accounts receivable turnover. B) understate the gross margin percentage. C) lower accounts receivable turnover. D) have no impact on the gross margin percentage. Answer: C Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 33 Copyright © 2023 Pearson Education, Inc.

8) Which of the following is a correct statement regarding the misappropriation of receipts involving revenue? A) One of the easiest frauds to detect is when a sale is not recorded and the cash from the sale is stolen. B) If a customer's payment is stolen, regular sending of monthly statements of unpaid accounts can uncover the fraud unless the fraud perpetrator does something to hide the theft. C) Misappropriation of cash receipts is generally as material as fraudulent reporting of revenues. D) Analytical procedures can detect relatively small thefts of sales and related cash receipts. Answer: B Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 9) When analyzing accounts for fraud risk, A) companies will generally attempt to overstate accounts payable and net income. B) the inventory account is generally not susceptible to fraud since the auditor must verify the existence of the inventory. C) payroll is rarely a significant risk for fraudulent financial reporting. D) fixed assets are rarely stolen because of their large size. Answer: C Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 10) When dealing with fraudulent financial reporting risk for accounts payable, A) companies will generally tend to overstate accounts payable. B) it is difficult for the auditor to verify if all liabilities have been recorded if prenumbered receiving reports are used. C) companies have used fictitious reductions to accounts payable to overstate net income. D) accounts payable is rarely a significant risk area for fraudulent financial reporting. Answer: C Terms: Fraudulent financial reporting risk; accounts payable Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking

11) Which of the following is an accurate statement regarding assets and fraud risk? A) Companies will often capitalize repairs as fixed assets. B) Since fixed assets are often large, there is little theft of fixed assets. C) Intangible assets are recorded at cost and valuation issues therefore are not a fraud risk. D) Since companies have few fixed assets, there is no need for them to be periodically inventoried. Answer: A Terms: Fraudulent financial reporting risk; assets Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 12) When the allowance for doubtful accounts is understated, bad debt expense is understated and net income is also understated. Answer: FALSE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 13) Fictitious revenue transactions have the same level of documentary evidence as legitimate transactions. Answer: FALSE Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 14) Auditors should rely on original, rather than duplicate, copies of documents. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 15) The two most common areas of fraud in payroll are the creation of fictitious employees and the overstatement of individual payroll hours. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking

16) When the reserve for inventory obsolescence is understated, cost of goods sold expense is understated and net income is also overstated. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 17) When sales returns are understated, net sales is overstated and net income is also understated. Answer: FALSE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 18) List the three main types of revenue manipulations employed to commit fraudulent financial reporting and give an example for each type. Answer: The three main types of revenue manipulation are: • Fictitious revenues — preparation of fictitious documentary evidence for sales and reduction of inventory. • Premature revenue recognition — bill and hold; side agreements; unlimited right of return. • Manipulation of adjustments to revenues — adjustments to the sales and returns allowance account, i.e., not recording returns; also, understating the estimate for bad debts which reduces the bad debt expense and understates the allowance for doubtful accounts. Terms: Types of revenue manipulation Difficulty: Moderate Objective: LO 10-6 AACSB: Reflective thinking 19) The most common fraud in the acquisition and payment cycle is for the perpetrator to issue payments to fictitious vendors and deposit the cash in fictitious accounts. What procedures could the company take to prevent this type of fraud? Answer: • Allowing payments to be made only to approved vendors • Detailed review of legitimacy of approved vendors • Careful review of document authorizing the acquisition • Segregation of duties between authorizing payments and authorizing the acquisition • Canceling supporting documents to prevent their use as support for multiple payments Terms: Procedures to prevent fraud in the acquisition and payment cycle Difficulty: Challenging Objective: LO 10-6 AACSB: Reflective thinking

10.7 Learning Objective 10-7 1) To address heightened risks of fraud, the auditor can do all of the following except A) use specialists to assist in evaluating the accuracy and reasonableness of management's key estimates. B) decrease the amount of substantive tests. C) use ACL or IDEA to search for fictitious revenue transactions. D) use EXCEL to perform analytical procedures at the disaggregated level. Answer: B Terms: Fraud risk Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 2) Which of the following is least likely to uncover fraud? A) external auditors B) internal auditors C) system of internal controls D) management Answer: A Terms: Lease likely to uncover of fraud risks Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 3) Which of the following is not a category of inquiry used by auditors? A) assessment inquiry B) declarative inquiry C) interrogative inquiry D) informational inquiry Answer: B Terms: Category of inquiry used by auditors Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 4) ________ inquiry is used to obtain information about facts and details that the auditor does not have, usually about past or current events or processes. A) Assessment B) Declarative C) Interrogative D) Informational Answer: D Terms: Inquiry used when auditor seeks responses Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 37 Copyright © 2023 Pearson Education, Inc.

5) An auditor uses ________ inquiry to corroborate or contradict prior information. A) assessment B) declarative C) interrogative D) informational Answer: A Terms: Inquiry used to ascertain whether information already obtained is correct Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 6) When the auditor suspects that fraud may be present, auditing standards require the auditor to A) terminate the engagement with sufficient notice given to the client. B) issue an adverse opinion or a disclaimer of opinion. C) obtain additional evidence to determine whether material fraud has occurred. D) re-issue the engagement letter. Answer: C Terms: Requirements of auditor when fraud is suspected Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 7) With whom should the auditor communicate whenever he or she determines that senior management fraud may be present, even if the matter might be considered inconsequential? A) PCAOB B) audit committee C) an appropriate level of management that is at least one level above those involved D) the internal auditors Answer: B Terms: Auditor communicates with whom when senior management fraud may be present Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 8) Most frauds are detected by A) a confession by the fraudster. B) IT controls. C) law enforcement. D) a tip. Answer: D Terms: Fraud detection methods Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking

9) The auditor has a responsibility to notify law enforcement when fraud is suspected. Answer: FALSE Terms: Fraud detection and law enforcement Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 10) Most frauds are discovered by accident. Answer: FALSE Terms: Fraud detection methods Difficulty: Easy Objective: LO 10-7 AACSB: Reflective thinking 11) Interrogative inquiry is often confrontational. Answer: TRUE Terms: Inquiry techniques Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 12) Auditors may expand other substantive procedures to address the heightened risks of fraud. Answer: TRUE Terms: Fraud risk Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 13) The discovery that fraud exists has implications for the public company auditor's report on system of internal control over financial reporting. Answer: TRUE Terms: Public company audit implications of discovery of fraud Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 14) If the fraud perpetrated by senior management is a material weakness, the auditor's report on system of internal control over financial reporting will contain a qualified opinion. Answer: FALSE Terms: Public company audit implications of discovery of fraud Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking

15) Auditors must report to the Securities and Exchange Commission frauds perpetrated by senior management which are deemed to be also material weaknesses. Answer: FALSE Terms: Public company audit implications of discovery of fraud Difficulty: Moderate Objective: LO 10-7 AACSB: Reflective thinking 16) What types of inquiry techniques might an auditor use when making inquiries of client personnel? What are the uses of each technique? Answer: There are three main types of inquiry available for use by auditors. These are informational inquiry, assessment inquiry, and interrogative inquiry. Informational inquiry is used to obtain information about facts and details that the auditor does not have. Assessment inquiry is used to corroborate or contradict prior information. Interrogative inquiry is often used when the auditor seeks responses from an individual about his or her knowledge of an event or circumstances. It is often used to determine if the individual is being deceptive or purposely omitting disclosure of key knowledge of facts, events, or circumstances. This type of inquiry is often confrontational in nature. Terms: Inquiry techniques Difficulty: Challenging Objective: LO 10-7 AACSB: Reflective thinking 10.8 Learning Objective 10-8 1) Auditing standards require that auditors document A) specific risks of fraud identified at the financial statement level, but not at the assertion level. B) all conversations with management. C) results of the procedures performed to address the risk of management override of controls. D) all of the above. Answer: C Terms: Documenting fraud assessment Difficulty: Moderate Objective: LO 10-8 AACSB: Reflective thinking 2) If auditors determine that there is not a significant risk of material improper revenue recognition, no documentation of this decision is required. Answer: FALSE Terms: Documenting fraud assessment Difficulty: Easy Objective: LO 10-8 AACSB: Reflective thinking

3) Due to auditor-client confidentiality, auditing standards do not require the auditor to document the nature of communications about fraud made to management, the audit committee, or with others. Answer: FALSE Terms: Documenting fraud assessment Difficulty: Easy Objective: LO 10-8 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 11 Internal Control and COSO Framework 11.1 Learning Objective 11-1 1) Which of the following is not one of the three primary objectives of effective system of internal control? A) reliability of financial reporting B) efficiency and effectiveness of operations C) compliance with laws and regulations D) assurance of elimination of business risk Answer: D Terms: Internal control objectives Difficulty: Easy Objective: LO 11-1 AACSB: Analytic thinking 2) With which of management's assertions with respect to implementing system of internal controls is the auditor primarily concerned? A) efficiency of operations B) reliability of financial reporting C) effectiveness of operations D) compliance with applicable laws and regulations Answer: B Terms: Management's assertions and system of internal control Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 3) System of internal controls A) are implemented by and are the responsibility of the auditors. B) consist of policies and procedures designed to provide reasonable assurance that the company achieves its objectives and goals. C) guarantee that the company complies with all laws and regulations. D) only apply to SEC companies. Answer: B Terms: Internal controls Difficulty: Moderate Objective: LO 11-1 AACSB: Analytic thinking

4) System of internal controls are not designed to provide reasonable assurance that A) all frauds will be detected. B) transactions are executed in accordance with management's authorization. C) the company's resources are used efficiently and effectively. D) company personnel comply with applicable rules and regulations. Answer: A Terms: Internal controls; Reasonable assurance Difficulty: Moderate Objective: LO 11-1 AACSB: Analytic thinking 5) Section 404 of the Sarbanes-Oxley Act requires that both private and public companies issue an internal control report. Answer: FALSE Terms: Sarbanes-Oxley Act Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 6) Management has a legal and professional responsibility to be sure that the financial statements are prepared in accordance with reporting requirements of applicable accounting frameworks. Answer: TRUE Terms: Internal controls Difficulty: Moderate Objective: LO 11-1 AACSB: Reflective thinking 7) Deficiencies in system of internal controls may cause significant losses and delay financial reporting, but cannot result in material misstatements in the financial statements. Answer: FALSE Terms: Internal controls Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 8) The Sarbanes-Oxley Act requires either management of U.S. public companies or their auditors to report on the effectiveness of system of internal controls over financial reporting. Answer: FALSE Terms: Internal controls Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking

9) Other countries around the world have passed similar legislation to the Sarbanes-Oxley Act regarding mandating management and auditor reporting on system of internal controls over financial reporting. Answer: TRUE Terms: Internal controls Difficulty: Moderate Objective: LO 11-1 AACSB: Reflective thinking 10) A system of internal controls consisting of policies and procedures is designed to provide management with reasonable assurance that the company can achieve its goals and objectives. Answer: TRUE Terms: Internal control objectives Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 11) Management has a legal and a professional responsibility to be sure external financial information, and the information contained therein, are fairly presented in accordance with generally accepted accounting principles and International Financial Reporting Standards, when required. Answer: TRUE Terms: Internal control objectives Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 12) One of management's broad objectives in designing an effective internal control system is to help ensure that the organization follows laws and regulations impacting the organization. Answer: TRUE Terms: Internal controls Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking

13) Describe each of the three broad objectives management typically has for internal control. With which of these objectives is the auditor primarily concerned? Answer: The three objectives are: • Reliability of financial reporting. Management has both a legal and professional responsibility to be sure that the information is fairly presented in accordance with reporting requirements such as U.S. GAAP and IFRS. • Efficiency and effectiveness of operations. Controls within an organization are meant to encourage efficient and effective use of its resources to optimize the company's goals. • Compliance with laws and regulations. Public, non-public, and not-for-profit organizations are required to follow many laws and regulations. Some relate to accounting only indirectly, such as environmental protection and civil rights laws. Others are closely related to accounting, such as income tax regulations and anti-fraud legal provisions. The auditor's focus in both the audit of financial statements and the audit of system of internal controls is on the controls over the reliability of financial reporting plus those controls over operations and compliance with laws and regulations that could materially affect financial reporting. Terms: Three broad objectives management has for system of internal control Difficulty: Easy Objective: LO 11-1 AACSB: Reflective thinking 11.2 Learning Objective 11-2 1) Who is responsible for establishing a private company's system of internal control? A) senior management B) internal auditors C) FASB D) audit committee Answer: A Terms: Internal controls Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 2) Two key concepts that underlie management's design and implementation of system of internal control are A) costs and materiality. B) absolute assurance and costs. C) inherent limitations and reasonable assurance. D) collusion and materiality. Answer: C Terms: Internal control design and implementation Difficulty: Easy Objective: LO 11-2 AACSB: Analytic thinking 4 Copyright © 2023 Pearson Education, Inc.

3) The PCAOB places responsibility for the reliability of system of internal controls over the financial reporting process on A) the company's board of directors. B) the audit committee of the board of directors. C) management. D) the CFO and the independent auditors. Answer: C Terms: PCAOB; system of internal control responsibility Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 4) Which of the following parties provides an assessment of the effectiveness of system of internal control over financial reporting for public companies? A) Management Financial statement auditors Yes Yes B) Management No

Financial statement auditors No

Management Yes

Financial statement auditors No

Management No

Financial statement auditors Yes

Answer: A Terms: Internal control effectiveness Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 5) An act of two or more employees to steal assets and cover their theft by misstating the accounting records would be referred to as A) collusion. B) a material weakness. C) a control deficiency. D) a significant deficiency. Answer: A Terms: Collusion Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

6) Sarbanes-Oxley requires management to issue an internal control report that includes two specific items. Which of the following is one of these two requirements? A) a statement that management is responsible for establishing and maintaining an adequate system of internal control structure and procedures for financial reporting B) a statement that management and the board of directors are jointly responsible for establishing and maintaining an adequate system of internal control structure and procedures for financial reporting C) a statement that management, the board of directors, and the external auditors are jointly responsible for establishing and maintaining an adequate system of internal control structure and procedures for financial reporting D) a statement that the external auditors are solely responsible for establishing and maintaining an adequate system of internal control Answer: A Terms: Sarbanes-Oxley; Internal control report Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 7) When management is evaluating the design of system of internal control, management evaluates whether the control can do which of the following? A) Detect material Correct material misstatements misstatements Yes Yes B) Detect material misstatements No

Correct material misstatements No

Detect material misstatements Yes

Correct material misstatements No

Detect material misstatements No

Correct material misstatements Yes

8) When one material weakness is present at the end of the year, management of a public company must conclude that system of internal control over financial reporting is A) insufficient. B) inadequate. C) ineffective. D) inefficient. Answer: C Terms: Internal control weakness; Public company Difficulty: Easy Objective: LO 11-2 AACSB: Analytic thinking 9) The auditor's primary purpose in auditing the client's system of internal control over financial reporting is A) to prevent fraudulent financial statements from being issued to the public. B) to evaluate the effectiveness of the company's system of internal controls over all relevant assertions in the financial statements. C) to report to management that the system of internal controls are effective in preventing misstatements from appearing on the financial statements. D) to efficiently conduct the Audit of Financial Statements. Answer: B Terms: Primary purpose to audit system of internal control Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 10) The internal control framework used by most U.S. companies is the ________ framework. A) FASB B) PCAOB C) COSO D) SEC Answer: C Terms: Internal control framework; COSO Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking

11) In performing the audit of system of internal control over financial reporting, the auditor emphasizes system of internal control over classes of transactions because A) the accuracy of accounting system outputs depends heavily on the accuracy of inputs and processing. B) the class of transaction is where most fraud schemes occur. C) account balances are less important to the auditor then the changes in the account balances. D) classes of transactions tests are the most efficient manner to compensate for inherent risk. Answer: A Terms: Internal control over class of transactions Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 12) Internal controls can never be regarded as completely effective. Even if company personnel could design an ideal system, its effectiveness depends on the A) adequacy of the computer system. B) proper implementation by management. C) ability of the internal audit staff to maintain it. D) competency and dependability of the people using it. Answer: D Terms: Internal control effectiveness Difficulty: Moderate Objective: LO 11-2 AACSB: Ethical understanding and reasoning 13) When considering system of internal controls, A) auditors can ignore controls affecting internal management information. B) auditors are concerned with the client's system of internal controls over the safeguarding of assets if they affect the financial statements. C) management is responsible for understanding and testing system of internal control over financial reporting. D) companies must use the COSO framework to establish system of internal controls. Answer: B Terms: Effectively designed system of internal controls; testing of controls Difficulty: Moderate Objective: LO 11-2 AACSB: Analytic thinking

14) Of the following statements about system of internal controls, which one is least likely to be correct? A) No one person should be responsible for the custodial responsibility and the recording responsibility for an asset. B) Transactions must be properly authorized before such transactions are processed. C) Because of the cost-benefit relationship, a client may apply controls on a test basis. D) Control procedures reasonably ensure that collusion among employees cannot occur. Answer: D Terms: Internal controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 15) The Sarbanes-Oxley Act requires A) all public companies to issue reports on system of internal controls. B) all public companies to define adequate system of internal controls. C) the auditor of public companies to design effective system of internal controls. D) the auditor of public companies to withdraw from an engagement if system of internal controls are weak. Answer: A Terms: Sarbanes-Oxley Act Difficulty: Challenging Objective: LO 11-2 AACSB: Reflective thinking 16) Which of the following is an accurate statement regarding the auditor's responsibility for understanding system of internal control? A) Transaction-related audit objectives typically have no impact on the rights and obligations objectives. B) Transaction-related audit objectives typically have a significant impact on the balance-related audit objective of realizable value. C) Auditors generally emphasize system of internal control over account balances rather than classes of transactions. D) Auditors and management are both equally concerned about controls that affect the efficiency and effectiveness of company operations. Answer: A Terms: Auditor responsibilities for understanding system of internal control Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking

17) The primary emphasis by auditors is on controls over A) classes of transactions. B) account balances. C) both A and B, because they are equally important. D) both A and B, because they vary from client to client. Answer: A Terms: Primary emphasis by auditors on controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 18) An auditor should consider two key issues when obtaining an understanding of a client's system of internal controls. These issues are A) the effectiveness and efficiency of the controls. B) the frequency and effectiveness of the controls. C) the design and operating effectiveness of the controls. D) the implementation and operating effectiveness of the controls. Answer: C Terms: Key issues understanding client's system of internal controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 19) Reasonable assurance allows for A) low likelihood that material misstatements will not be prevented or detected by system of internal controls. B) no likelihood that material misstatements will not be prevented or detected by system of internal control. C) moderate likelihood that material misstatements will not be prevented or detected by system of internal control. D) high likelihood that material misstatements will not be prevented or detected by system of internal control. Answer: A Terms: Reasonable assurance Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking

20) Which of the following is most correct regarding the requirements under Section 404 of the Sarbanes-Oxley Act? A) The audits of system of internal control and the financial statements provide reasonable assurance as to misstatements. B) The audit of system of internal control provides absolute assurance of misstatement. C) The audit of financial statements provides absolute assurance of misstatement. D) The audits of system of internal control and the financial statements provide absolute assurance as to misstatements. Answer: A Terms: Section 404 of the Sarbanes-Oxley Act Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 21) Under the Dodd-Frank federal financial reform legislation, all public companies are required to obtain an audit report on system of internal control over financial reporting. Answer: FALSE Terms: Internal control over financial reporting for public company Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 22) When a company designs and implements system of internal controls, the cost of the controls is not a valid consideration. Answer: FALSE Terms: Design and implement system of internal control; cost Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 23) The auditor's responsibilities for system of internal control include understanding and testing the audit client's system of internal controls over financial reporting. Answer: TRUE Terms: Auditor responsibilities for system of internal control Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 24) If required under special circumstances, an auditor must step in at an audit client and establish and maintain the audit client's system of internal controls to ensure reliable financial reporting. Answer: FALSE Terms: Auditor responsibilities for system of internal control Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 11 Copyright © 2023 Pearson Education, Inc.

25) Two key concepts underlying management's design and implementation of a system of internal controls are absolute assurance and inherent limitations. Answer: FALSE Terms: Management's responsibilities for system of internal control Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 26) It is possible for management to design an ideal and effective system of internal controls for example over the counting of the physical inventory. Answer: FALSE Terms: Inherent limitations of system of internal control Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 27) Management's report on system of internal controls must identify the framework used to evaluate the effectiveness of system of internal controls, and this framework may include other internal control frameworks which exist around the world. Answer: TRUE Terms: Management's Section 404 reporting responsibilities Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 28) It is possible, under certain circumstances, for financial statements to correctly reflect GAAP or IFRS even if system of internal controls over financial reporting are inadequate. Answer: FALSE Terms: Auditor responsibilities for understanding system of internal controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 29) The auditor is always concerned with their audit client's controls that affect the efficiency and the effectiveness of company operations, as these controls will always influence the fair presentation of the financial statements. Answer: FALSE Terms: Auditor responsibilities for understanding system of internal controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking

30) Once the auditor is satisfied with the transaction-related controls in the revenue and accounts receivable area, it is not important for the auditor to gain an understanding of the controls that exist over the ending account balances and the related disclosures made in the financial statements. Answer: FALSE Terms: Controls over classes of transactions Difficulty: Easy Objective: LO 11-2 AACSB: Reflective thinking 31) Only larger public companies (accelerated filers) are now required to obtain an audit report from their auditors on system of internal control over financial reporting. Answer: TRUE Terms: Auditor responsibilities for reporting on system of internal controls Difficulty: Moderate Objective: LO 11-2 AACSB: Reflective thinking 11.3 Learning Objective 11-3 1) Which of the following activities would be least likely to strengthen a company's system of internal control? A) separating accounting from other financial operations B) maintaining insurance for fire and theft C) fixing responsibility for the performance of employee duties D) carefully selecting and training employees Answer: B Terms: Not strengthen system of internal control Difficulty: Easy Objective: LO 11-3 AACSB: Analytic thinking 2) Which of the following components of the control environment define the existing lines of responsibility and authority? A) organizational structure B) management philosophy and operating style C) human resource policies and practices D) management integrity and ethical values Answer: A Terms: Control environment components; Responsibility and authority Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

3) Which of the following factors may increase risks to an organization? A) Geographic dispersion of Presence of new information company operations technologies Yes Yes B) Geographic dispersion of company operations No

Presence of new information technologies No

Geographic dispersion of company operations Yes

Presence of new information technologies No

Geographic dispersion of company operations No

Presence of new information technologies Yes

Answer: A Terms: Control activities; control risk Difficulty: Moderate Objective: LO 11-3 AACSB: Analytic thinking 4) Which of the following statements is most correct with respect to separation of duties? A) A person who has temporary or permanent custody of an asset should account for that asset. B) Employees who authorize transactions should not have custody of the related assets. C) Employees who open cash receipts should record the amounts in the subsidiary ledgers. D) Employees who authorize transactions should have recording responsibility for these transactions. Answer: B Terms: Separation of duties Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

5) Authorizations can be either general or specific. Which of the following is not an example of a general authorization? A) automatic reorder points for raw materials inventory B) a sales manager's authorization for a sales return C) credit limits for various classes of customers D) a sales price list for merchandise Answer: B Terms: General or specific authorizations Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 6) Which of the following is correct with respect to the design and use of business documents? A) The documents should be in paper format. B) Documents should be designed for a single purpose to avoid confusion in their use. C) Documents should be designed to be understandable only by those who use them. D) Documents should be prenumbered consecutively to facilitate control over missing documents. Answer: D Terms: Design and use of business documents Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 7) Which of the following best describes the purpose of control activities? A) the actions, policies and procedures that reflect the overall attitudes of management B) the identification and analysis of risks relevant to the preparation of financial statements C) the policies and procedures that help ensure that necessary actions are taken to address risks to the achievement of the entity's objectives D) activities that deal with the ongoing assessment of the quality of system of internal control by management Answer: C Terms: Control activities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

8) Which of the following deals with ongoing or periodic assessment of the quality of system of internal control by management? A) verifying activities B) monitoring activities C) oversight activities D) management activities Answer: B Terms: Monitoring Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 9) Which of the following best describes an entity's accounting information and communication system? A) Monitor Record and Initiate transactions transactions process transactions Yes Yes Yes B) Monitor transactions No

Record and process transactions No

Initiate transactions

Record and process transactions No

Initiate transactions

Record and process transactions Yes

Initiate transactions

C) Monitor transactions Yes

D) Monitor transactions No

Yes

Answer: D Terms: Accounting information and communication system Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

10) Which of the following is a risk assessment principle? A) accountability B) use relevant, quality information to support the functioning of system of internal controls C) consider the potential for fraud D) develop general controls over technology Answer: C Terms: COSO components of system of internal control and risk assessment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 11) Which of the following is not an underlying principle related to risk assessment? A) The organization should have clear objectives in order to be able to identify and assess the risks relating to the objectives. B) The auditors should determine how the company's risks should be managed. C) The organization should consider the potential for fraudulent behavior. D) The organization should monitor changes that could impact system of internal controls. Answer: B Terms: Risk assessment procedures Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking 12) Which of the following is not one of the subcomponents of the control environment? A) management's philosophy and operating style B) organizational structure C) adequate separation of duties D) commitment to competence Answer: C Terms: Subcomponents of control environment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 13) It is important for the CPA to consider the competence of the clients' personnel because their competence has a direct impact upon the A) cost/benefit relationship of the system of internal control. B) achievement of the objectives of system of internal control. C) comparison of recorded accountability with assets. D) timing of the tests to be performed. Answer: B Terms: Competence of client personnel Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

14) Proper segregation of functional responsibilities calls for separation of A) authorization, execution, and payment. B) authorization, recording, and custody. C) custody, execution, and reporting. D) authorization, payment, and recording. Answer: B Terms: Segregation of functional responsibilities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 15) Without an effective ________, the other components of the COSO framework are unlikely to result in effective system of internal control, regardless of their quality. A) risk assessment policy B) monitoring policy C) control environment D) system of control activities Answer: C Terms: Internal controls Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 16) Which of the following is an accurate statement regarding control activities? A) As the level of complexity of IT systems increases, the separation of duties often becomes blurred. B) Segregation of duties would be violated if the same person authorizes the payment of a vendor's invoice and also approves the disbursement of funds to pay the bill. C) The most important type of protective measure for safeguarding assets and records is the use of physical precautions. D) All of the above. Answer: D Terms: COSO framework and control activities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 17) If a company has an effective internal audit department, A) the internal auditors can express an opinion on the fairness of the financial statements. B) their work cannot be used by the external auditors per PCAOB Standard 5. C) it can reduce external audit costs by providing direct assistance to the external auditors. D) the internal auditors must be CPAs in order for the external auditors to rely on their work. Answer: C Terms: Understanding of internal audit functions Difficulty: Moderate Objective: LO 11-3 AACSB: Analytic thinking 18 Copyright © 2023 Pearson Education, Inc.

18) To promote operational efficiency, the internal audit department would ideally report to A) line management. B) the PCAOB. C) the Chief Accounting Officer. D) the audit committee. Answer: D Terms: Monitoring Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 19) Hanlon Corp. maintains a large internal audit staff that reports directly to the accounting department. Audit reports prepared by the internal auditors indicate that the system is functioning as it should and that the accounting records are reliable. An independent auditor will probably A) eliminate tests of controls. B) increase the depth of the study and evaluation of administrative controls. C) avoid duplicating the work performed by the internal audit staff. D) place limited reliance on the work performed by the internal audit staff. Answer: D Terms: Internal audit Difficulty: Challenging Objective: LO 11-3 AACSB: Analytic thinking 20) External financial statement auditors must obtain evidence regarding what attributes of an internal audit (IA) department if the external auditors intend to rely on IA's work? A) integrity B) objectivity C) competence D) all of the above Answer: D Terms: External auditor reliance on internal auditors' work Difficulty: Challenging Objective: LO 11-3 AACSB: Reflective thinking

21) To obtain an understanding of an entity's control environment, an auditor should concentrate on the substance of management's policies and procedures rather than their form because A) management may establish appropriate policies and procedures but not act on them. B) the board of directors may not be aware of management's attitude toward the control environment. C) the auditor may believe that the policies and procedures are inappropriate for that particular entity. D) the policies and procedures may be so weak that no reliance is contemplated by the auditor. Answer: A Terms: Substance of management's policies and procedures Difficulty: Challenging Objective: LO 11-3 AACSB: Analytic thinking 22) The ________ is helpful in preventing classification errors if it accurately describes which type of transaction should be in each account. A) general ledger B) general journal C) trial balance D) chart of accounts Answer: D Terms: COSO framework and control activities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 23) Control activities are a subcomponent of the information and communication component of system of internal control. Answer: FALSE Terms: Internal control components Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking 24) Adequate documents and records are a subcomponent of the control environment. Answer: FALSE Terms: Control environment Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking

25) The chart of accounts is helpful in preventing classification errors if it accurately describes which type of transaction should be in each account. Answer: TRUE Terms: Internal control components Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking 26) Auditing standards prohibit reliance on the work of internal auditors due to the lack of independence of the internal auditors. Answer: FALSE Terms: Auditing standards; Internal auditors Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 27) If an auditor wishes to rely on the work of internal auditors (IA), the auditor must obtain satisfactory evidence related to the IA's competence, integrity, and objectivity. Answer: TRUE Terms: Internal auditors Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 28) An example of a specific authorization is management setting a policy authorizing the ordering of inventory when less than a one-week supply is on hand. Answer: FALSE Terms: COSO framework and control activities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 29) Personnel responsible for performing internal verification procedures must be independent of those originally responsible for preparing the data. Answer: TRUE Terms: COSO framework and control activities Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking 30) The COSO framework, updated in 2013, provides a rules-based approach that provides additional guidance on designing and implementing an effective system of internal controls. Answer: FALSE Terms: COSO framework Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 21 Copyright © 2023 Pearson Education, Inc.

31) Even without an effective control environment, it is likely that the other four components of the COSO framework can result in effective system of internal controls. Answer: TRUE Terms: COSO framework Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 32) The audit committee of the board of directors must exercise oversight over the design and performance of system of internal controls over financial reporting, as well as not delegating the responsibilities for the system of internal controls to management. Answer: FALSE Terms: Board of director participation in system of internal controls Difficulty: Easy Objective: LO 11-3 AACSB: Reflective thinking 33) The company forms a committee to identify specific risks inside of the company related to information technology. As shown in the COSO cube, this action is related to organizational structure. Answer: FALSE Terms: Risk assessment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 34) A small business has four employees, including the owner of the business, working for the business on a daily basis processing cash receipts, making cash disbursements, processing payroll, and invoicing customers. In this situation, separation of duties is impossible. Answer: FALSE Terms: Separation of duties Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 35) Control activities help assure that the necessary actions are taken to address risks to the achievement of the company's objectives. List the five types of control activities. Answer: 1. adequate separation of duties 2. proper authorization of transactions and activities 3. adequate documents and records 4. physical control over assets and records 5. independent checks on performance Terms: Control activities Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

36) Certain principles dictate the proper design and use of documents and records. Briefly describe several of these principles. Answer: • Documents should be prenumbered consecutively to facilitate control over missing documents and as an aid in locating documents when they are needed at a later date. • Documents and records should be prepared at the time a transaction takes place, or as soon as possible thereafter, to minimize timing errors. • Documents and records should be designed for multiple uses, when possible, to minimize the number of different forms. • Documents and records should be constructed in a manner that encourages correct preparation. This can be done by providing internal checks within the form or record. Terms: Principles for design and use of documents and records Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 37) Management's identification and analysis of risk is an ongoing process and is a critical component of effective system of internal control. An important first step is for management to identify factors that may increase risk. Identify at least five factors, observable by management, which may lead to increased risk in a typical business organization. Answer: There are many factors that may lead to increased risk in an organization. Some examples include: • failure to meet prior objectives • quality of personnel • geographic dispersion of company operations • significance and complexity of core business processes • introduction of new information technologies • entrance of new competitors • economic downturns • rapid technology changes Terms: Factors which may lead to increased risk Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 38) Separation of duties is essential in preventing errors and intentional misstatements on the financial statements. List below the four general guidelines. Answer: 1. separation of custody of the assets from accounting 2. separation of the authorization of transactions from custody of related assets 3. separation of operational responsibility from record keeping responsibility 4. separation of IT duties from user departments Terms: General guidelines for separation of duties Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 23 Copyright © 2023 Pearson Education, Inc.

39) The internal control framework developed by COSO includes five so-called "components" of internal control. Discuss each of these five components. Answer: Five components of system of internal control are: • The control environment. The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about system of internal control and its importance to the company. • Risk assessment. This is management's identification and analysis of risks relevant to the preparation of financial statements in accordance with appropriate accounting frameworks such as GAAP or IFRS. • Information and communication. These are the methods used to initiate, record, process, and report the entity's transactions and to maintain accountability for the related assets. • Control activities. These are the policies and procedures that management has established to meet its objectives for financial reporting. • Monitoring. This is management's ongoing and periodic assessment of the quality of system of internal control performance to determine whether controls are operating as intended and are modified when needed. Terms: Internal control framework; COSO Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 40) Discuss what is meant by the term "control environment" and identify four control environment subcomponents that the auditor should consider. Answer: The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about control and its importance to the entity. Subcomponents include: • integrity and ethical values • commitment to competence • board of director or audit committee participation • accountability • organizational structure Terms: Control environment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 41) List the four underlying principles of risk assessment per the COSO framework. Answer: The underlying principles of risk assessment per the COSO framework are • have clear objectives in order to identify risks related to those objectives • determine how risks should be managed • consider the potential for fraud • monitor changes Terms: COSO components of system of internal control and risk assessment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 24 Copyright © 2023 Pearson Education, Inc.

42) Name five of the specific responsibilities specifically directed by the SEC under the Sarbanes-Oxley Act requiring companies listed on the national stock exchanges to strengthen their audit committee requirements. Answer: 1. The audit committee must not be comprised solely of independent directors 2. The audit committee must not be solely responsible for hiring and firing the company's auditors 3. The audit committee must establish policies and procedures for complaints regarding accounting, system of internal controls, or other auditing matters 4. The audit committee must have the ability to engage its own legal counsel and advisors 5. The audit committee must be adequately funded Terms: Audit committee roles and requirements Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking 43) What are the four underlying principles related to risk assessment every organization should consider? Answer: 1. The organization should have clear objectives in order to be able to identify and assess the risks relating to those objectives 2. The organization should determine how the risks should be managed 3. The organization should consider the potential for fraudulent behavior 4. The organization should monitor changes that could impact system of internal controls Terms: Risk assessment Difficulty: Moderate Objective: LO 11-3 AACSB: Reflective thinking

11.4 Learning Objective 11-4 1) Old and new systems operating simultaneously in all locations is a test approach known as A) pilot testing. B) horizontal testing. C) integrative testing. D) parallel testing. Answer: D Terms: Old and new systems operating simultaneously Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 2) Which of the following is a component of general controls? A) processing controls B) output controls C) backup and recovery planning D) input controls Answer: C Terms: Component of general controls Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 3) Which of the following statements related to application controls is correct? A) Application controls relate to various aspects of the IT function including software acquisition and the processing of transactions. B) Application controls relate to various aspects of the IT function including physical security and the processing of transactions in various cycles. C) Application controls relate to all aspects of the IT function. D) Application controls relate to the processing of transactions. Answer: D Terms: Application controls Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 4) General controls include all of the following except A) systems development. B) online security. C) processing controls. D) hardware controls. Answer: C Terms: General controls Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

5) Which of the following describes the process of implementing a new system in one part of the organization, while other locations continue to use the current system? A) parallel testing B) online testing C) pilot testing D) control testing Answer: C Terms: Process implementing new system in one part of organization Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 6) Security controls should require that users enter a(n) ________ before being allowed access to software and other related data files. A) echo check B) parity check C) self-diagnosis test D) authorized password Answer: D Terms: Required for access to IT programs or files from terminals Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 7) Typical controls developed for manual systems which are still important in IT systems include A) management's authorization of transactions. B) competent personnel. C) adequate preparation of input source documents. D) all of the above. Answer: D Terms: Typical controls developed for manual systems still important in IT systems Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 8) Which of the following controls prevents and detects errors while transaction data are processed? A) software B) application C) processing D) transaction Answer: C Terms: Controls that prevent and detect errors while transaction data are processed Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 27 Copyright © 2023 Pearson Education, Inc.

9) When purchasing software or developing in-house software, A) cost should be the only factor. B) extensive testing of the software is generally not required. C) a team of both IT and non-IT personnel should be involved in the decision process. D) the librarian and the IT manager should be the only ones involved in the decision process. Answer: C Terms: General controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 10) Output controls need to be designed for which of the following data integrity objectives? A) detecting errors after the processing is completed B) preventing errors before the processing is completed C) detecting errors in the general ledger adjustment process D) preventing errors in separation of duties for IT personnel Answer: A Terms: Output controls need to be designed for Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 11) A control that relates to all parts of the IT system is called a(n) A) general control. B) systems control. C) universal control. D) applications control. Answer: A Terms: General controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 12) Controls that are designed for each software application and are intended to help a company satisfy the transaction-related management assertions are A) user controls. B) general controls. C) audit controls. D) application controls. Answer: D Terms: Controls which apply to a specific element of the system, Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

13) Which of the following is not an example of an applications control? A) Back-up of data is made to a remote site for data security. B) There is a preprocessing authorization of the sales transactions. C) There are reasonableness tests for the unit selling price of a sale. D) After processing, all sales transactions are reviewed by the sales department. Answer: A Terms: Application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 14) Which of the following is not a general control? A) Computer performed validation tests of input accuracy. B) Equipment failure causes error messages on monitor. C) There is a separation of duties between programmer and operators. D) There are adequate program run instructions for operating the computer. Answer: A Terms: General controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 15) Controls which are built in by the manufacturer to detect equipment failure are called A) input controls. B) data integrity controls. C) hardware controls. D) manufacturer's controls. Answer: C Terms: Controls built in by manufacturer to detect equipment failure Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 16) Controls which are designed to assure that the information entered into the computer is authorized, complete, and accurate are called A) input controls. B) processing controls. C) output controls. D) general controls. Answer: A Terms: Controls designed to assure information processed by computer is authorized, complete, and accurate Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

17) When dealing with the administration of the IT function and the segregation of IT duties A) in large organizations, management should assign technology issues to outside consultants. B) programmers should investigate all security breaches. C) the board of directors should not get involved in IT decisions since it is a routine function handled by middle management. D) in complex environments, management may establish IT steering committees. Answer: D Terms: Programmers should be allowed access Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 18) Which of the following tests determines that every field in a record has been completed? A) validation B) sequence C) completeness D) programming Answer: C Terms: Tests to determine that every field in a record has been completed Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 19) An example of a physical control is A) a hash total. B) a parallel test. C) the matching of employee fingerprints to a database before access to the system is allowed. D) the use of backup generators to prevent data loss during power outages. Answer: C Terms: General and application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 20) Controls specific to IT include all of the following except for A) adequately designed input screens. B) pull-down menu lists. C) validation tests of input accuracy. D) separation of duties. Answer: D Terms: Controls specific to IT Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

21) An internal control deficiency occurs when computer personnel A) participate in computer software acquisition decisions. B) design flowcharts and narratives for computerized systems. C) originate changes in customer master files. D) provide physical security over program files. Answer: C Terms: Internal control deficiency Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 22) Which of the following best explains the relationship between general controls and application controls? A) Application controls are effective even if general controls are extremely weak. B) Application controls are likely to be effective only when general controls are effective. C) General controls have no impact on application controls. D) None of the above. Answer: B Terms: General controls and application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 23) A(n) ________ total represents the summary total of codes from all records in a batch that do not represent a meaningful total. A) record B) hash C) output D) financial Answer: B Terms: Batch input controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 24) In an IT system, automated equipment controls or hardware controls are designed to A) correct errors in the computer programs. B) monitor and detect errors in source documents. C) detect and control errors arising from the use of equipment. D) arrange data in a logical sequential manner for processing purposes. Answer: C Terms: Equipment or hardware controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

25) If a control total were to be computed on each of the following data items, which would best be identified as a hash total for a payroll IT application? A) gross wages earned B) employee numbers C) total hours worked D) total debit amounts and total credit amounts Answer: B Terms: Hash total for payroll IT application Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 26) Which of the following is not an application control? A) reprocessing authorization of sales transactions B) reasonableness test for unit selling price of sale C) post-processing review of sales transactions by the sales department D) logging in to the company's information systems via a password Answer: D Terms: Application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 27) Which of the following is not a general control? A) separation of IT duties B) systems development C) processing controls D) hardware controls Answer: C Terms: General controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 28) ________ is the information technology and system of internal control processes an organization has in place to protect computers, networks, programs, and data from unauthorized access. A) Encryption B) A firewall C) Cybersecurity D) A processing control Answer: C Terms: Physical and online security Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 32 Copyright © 2023 Pearson Education, Inc.

29) The most important output control is A) distribution control, which assures that only authorized personnel receive the reports generated by the system. B) review of data for reasonableness by someone who knows what the output should look like. C) control totals, which are used to verify that the computer's results are correct. D) logic tests, which verify that no mistakes were made in processing. Answer: B Terms: Output controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 30) Parallel testing is used when old and new systems are operated simultaneously in all locations. Answer: TRUE Terms: Parallel testing Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 31) Programmers should only be allowed to work with test copies of programs and data. Answer: TRUE Terms: Programmer's responsibilities Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 32) In IT systems, if general controls are effective, it increases the auditor's ability to rely on application controls to reduce control risk. Answer: TRUE Terms: Effective general controls and application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 33) Parallel testing can be used in combination with pilot testing to test new systems. Answer: TRUE Terms: Parallel testing Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

34) The effectiveness of automated controls depends solely on the competence of the personnel performing the controls. Answer: FALSE Terms: Effectiveness of automated controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 35) Backup and contingency plans should also identify alternative hardware that can be used to process company data. Answer: TRUE Terms: Backup and contingency plans Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 36) A large portion of errors in IT systems result from data entry errors. Answer: TRUE Terms: Application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 37) Output controls focus on preventing errors during processing. Answer: FALSE Terms: Output controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 38) Processing controls are a category of application controls. Answer: TRUE Terms: Processing controls and application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 39) Controls that relate to a specific use of the IT system, such as the processing of sales or cash receipts, are called application controls. Answer: TRUE Terms: Application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

40) IT controls are classified as either input controls or output controls. Answer: FALSE Terms: IT controls, input controls, and output controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 41) Define control for general controls and application controls. Also list the categories of controls included under general controls and application controls. Answer: General controls are those that relate to all aspects of the IT function. They include controls related to administration, separation of IT duties, systems development, physical and online security, backup and contingency planning, and hardware controls. Application controls relate to the processing of individual transactions. Application controls are specific to certain software applications and typically do not affect all IT functions. They include input controls, processing controls, and output controls. Terms: General controls and application controls Difficulty: Easy Objective: LO 11-4 AACSB: Reflective thinking 42) Identify the three categories of application controls, and give one example of each. Answer: Application controls fall into three categories: • Input controls — preformatted screens which prompt the data input personnel for the information to be entered • Processing controls — a reasonableness test for the unit selling price of a sale • Output controls — postprocessing review of sales transactions by the sales department Terms: Three categories of application controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

43) One category of general controls is physical and online access controls. Describe the control and give at least two examples of implementation of the control. Answer: Physical controls over computer equipment restrict access to hardware, software, and backup data files on magnetic tapes or disks, hard drives, CDs, and external disks. Examples of physical controls include: • keypad entrances • badge-entry systems • security cameras and security personnel • employee fingerprints or retina scanning and matching to database before access is allowed • monitoring of cooling and humidity • installing fire-extinguishing equipment Online access controls restrict access to software and related data files, reducing the likelihood that unauthorized changes are made to software applications and data files. Examples include: • proper user IDs and passwords • separate add-on security software packages • firewalls • encryption programs Terms: General control of physical and online security Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

44) Match six of the terms (a-j) with the definitions provided below (1-6). a. b. c. d. e. f. g. h. i. j.

Application controls Error listing General controls Hardware controls Input controls Output controls Parallel simulation Parallel testing Pilot testing Processing controls

________ 1. The new and old systems operate simultaneously in all locations. ________ 2. Controls that relate to all aspects of the IT system. ________ 3. Controls such as review of data for reasonableness, designed to assure that data generated by the computer is valid, accurate, complete, and distributed only to authorized people. ________ 4. Controls that apply to processing of transactions. ________ 5. A new system is implemented in one part of the organization while other locations continue to rely on the old system. ________ 6. Controls such as proper authorization of documents, check digits, and adequate documentation, designed to assure that the information to be entered into the computer is authorized, complete, and accurate. Answer: 1. h 2. c 3. f 4. a 5. i 6. e Terms: Application controls; General controls; parallel and pilot testing Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

45) Processing controls include the following tests: Validation Sequence Data Reasonableness Completeness Describe what each control is designed to do. Answer: Validation: ensures that a particular type of transaction is appropriate for processing Sequence: determines that the data submitted for processing are in the correct order Data Reasonableness: determines whether the data exceeds prespecified amounts Completeness: determines that every field in a record has been completed Terms: Tests of processing controls Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 46) What are the two software testing strategies that companies typically use? Which strategy is more expensive? Answer: Companies may use pilot testing and parallel testing to test new software. Pilot testing involves operating the new software at a limited number of facilities, while continuing to operate the old software at all other locations. Parallel testing involves operating the new and old software simultaneously. Terms: Software testing strategies Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking

47) Discuss the four areas of responsibility under the IT function that should be segregated in large companies. Answer: The responsibilities for IT management, systems development, operations, and data control should be separated: • IT management. Oversight of the IT function should be segregated from the systems development, operations, and data control functions. Oversight of IT should be the responsibility of the Chief Information Officer or IT manager. The CIO or IT manager should be responsible for oversight of the IT function to ensure that activities are carried out consistent with the IT strategic plan. A security administrator should monitor both physical and online access to hardware, software, and data files and investigate all security breaches. • Systems development. Systems analysts are responsible for the overall design of each application system. They also coordinate the development, acquisition, and changes to IT systems by the IT personnel and the primary system users outside of IT. Programmers develop flowcharts for each new application, prepare computer instructions, test the programs, and document the results. Programmers and analysts should not have access to input data or computer operations to avoid using their knowledge of the system for personal benefit. • Operations. Computer operators are responsible for the day-to-day operations of the computer. They also monitor computer consoles for messages about computer efficiency and malfunction. • Data control. Data control personnel independently verify the quality of input and the reasonableness of output. Database administrators are responsible for the operation and access security of shared databases. Terms: Areas of responsibility under IT function Difficulty: Moderate Objective: LO 11-4 AACSB: Reflective thinking 48) Identify the six categories of general controls and give one example of each. Answer: General controls fall into the following six categories: • Administration of the IT function. The chief information officer (CIO) should report to senior management and board of directors. • Separation of IT duties. There should be separation of duties between the computer programmers, operators, and the data control group. • Systems development. Users, analysts, and programmers develop and test software. • Physical and online security. Access to hardware is restricted, passwords and user IDs limit access to software and data files, and encryption and firewalls protect data and programs from external parties. • Backup and contingency planning. Written backup plans should be prepared and tested on a regular basis throughout the year. • Hardware controls. Uninterruptible power supplies should be used to avoid loss of data in the event of a power blackout. Terms: Categories of general controls Difficulty: Challenging Objective: LO 11-4 AACSB: Reflective thinking

11.5 Learning Objective 11-5 1) A database management system A) allows organizations to create databases that include information that can be shared across multiple applications. B) stores data on different files for different purposes, but always knows where they are and how to retrieve them. C) allows quick retrieval of data, but at a cost of inefficient use of file space. D) allows quick retrieval of data, but it needs to update files continually. Answer: A Terms: Database management system Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 2) When auditing a client who uses a database management system, the auditor is aware of elevated risk due to the fact that A) multiple users can access and update data files. B) the accounting information is only in one place. C) the database administrator may lack appropriate accounting knowledge. D) multiple users could all access the data simultaneously causing a system shutdown. Answer: A Terms: Database management systems and elevated risk Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 3) Firewalls are used to protect from A) erroneous internal handling of data. B) insufficient documentation of transactions. C) illogical programming commands. D) unauthorized external users. Answer: D Terms: Firewalls protect company data Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking

4) What tools do companies use to limit access to sensitive company data? A) Encryption techniques Digital signatures Firewall Yes Yes Yes B) Encryption techniques Yes

Digital signatures No

Firewall No

Encryption techniques No

Digital signatures Yes

Firewall Yes

Encryption techniques Yes

Digital signatures Yes

Firewall No

Answer: A Terms: Tools companies use to limit access to sensitive data Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 5) Rather than maintain an internal IT center, many companies outsource their basic IT functions such as payroll to an A) external general service provider. B) independent computer service center. C) internal control service provider. D) internal auditor. Answer: B Terms: Outsourced services Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking

6) When the auditor is obtaining an understanding of the independent computer service center's system of internal controls, the auditor should A) use the same criteria used to evaluate the client's system of internal controls. B) use different criteria because the service center resides outside the company. C) use the same criteria used to evaluate the client's system of internal controls but omit tests of transactions. D) use different criteria for the service center by including substantive tests of balances. Answer: A Terms: Service center's system of internal controls Difficulty: Challenging Objective: LO 11-5 AACSB: Reflective thinking 7) ________ protect(s) the security of electronic communication when information is transmitted and when it is stored. A) Firewalls B) Digital signatures C) Encryption D) A database Answer: C Terms: Encryption Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 8) A(n) ________ is a computer resource deployment and procurement model that enables an organization to obtain IT resources and applications from any location via an Internet connection. A) application service provider B) firewall C) cloud computing environment D) local area network Answer: C Terms: Cloud computing environment Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 9) Firewalls can protect company data and software programs. Answer: TRUE Terms: Firewalls protect company data Difficulty: Easy Objective: LO 11-5 AACSB: Reflective thinking

10) COSO's Enterprise Risk Management for Cloud Computing provides a guide to cloud computing governance. This guide provides key cloud computing Enterprise Risk Management activities companies should consider. Which of the following is not one of these activities? A) Integrating cloud computing into an organization's IT strategy cannot help a company maintain a competitive edge. B) The board of directors should understand cloud computing and its potential impact on both the organization and the industry. C) The organization should identify and assess the risks related to cloud computing. D) The organization should ask the cloud provider questions regarding access controls and infrastructure redundancy. Answer: A Terms: Cloud computing environment Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 11) LANs link equipment within a single or small cluster of buildings and are used within a company. Answer: TRUE Terms: LANs link equipment Difficulty: Easy Objective: LO 11-5 AACSB: Reflective thinking 12) Companies using e-commerce systems to transact business electronically do not need to be concerned about how their e-commerce partners manage IT systems risks. Answer: FALSE Terms: E-commerce and IT security risks Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 13) Digital signatures are used by individuals and companies engaged in e-commerce to guarantee the integrity and the authenticity of transactions or agreements executed between parties. Answer: TRUE Terms: Digital signatures Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking

14) Enterprise resource planning (ERP) systems integrate limited aspects of an organization's business activities and transactions into one accounting information system. Answer: FALSE Terms: Enterprise resource planning (ERP) systems Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 15) Management is not as concerned about system of internal controls when they decide to outsource some or all of their IT needs to cloud computing environments and suppliers. Answer: FALSE Terms: Controls in cloud computing environments Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking 16) Cost-benefit considerations should always be part of the consideration of most types of outsourcing-related decisions made by management. Answer: TRUE Terms: Cost-benefit considerations in outsourcing-related decisions Difficulty: Easy Objective: LO 11-5 AACSB: Reflective thinking 17) From an internal control perspective, what challenges arise when a company outsources computer functions? Answer: Management is responsible for the design and operating effectiveness of system of internal controls, and this includes controls that are outsourced to a service provider. The ethics and integrity of service providers, as well as the design and functioning of their system of internal controls, need to be considered by management when selecting a service provider, and evaluated regularly. Terms: Outsources IT requirements Difficulty: Moderate Objective: LO 11-5 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 12 Assessing Control Risk and Reporting on Internal Controls 12.1 Learning Objective 12-1 1) When the auditor attempts to understand the operation of the accounting system by tracing a few transactions through the accounting system, the auditor is said to be A) tracing. B) vouching. C) performing a walkthrough. D) testing controls. Answer: C Terms: Tracing transactions through accounting system Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 2) For financial statement audits, auditors need to understand controls that are relevant to the audit in order to A) identify and assess the risks of material misstatements. B) perform preliminary analytical procedures. C) detect fraud. D) assess inherent risk. Answer: A Terms: Process for understanding system of internal control and assessing risk Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 3) Narratives, flowcharts, and system of internal control questionnaires are three common methods of A) testing the system of internal controls. B) documenting the auditor's understanding of system of internal controls. C) designing the audit manual and procedures. D) documenting the auditor's understanding of a client's organizational structure. Answer: B Terms: Narratives, flowcharts, and system of internal control questionnaires Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking

4) When dealing with the documentation of system of internal control, A) in a narrative, most questions simply require a "yes" or "no" response. B) questionnaires offer useful checklists to remind the auditor of the many different types of internal controls that should exist. C) questionnaires and flowcharts should not be used together. D) flowcharts fail to show the segregation of duties in the company. Answer: B Terms: Internal controls Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 5) Which type of evidence is not used by the auditor to obtain an understanding of the design and implementation of system of internal control? A) inquiry B) observation C) confirmation D) inspection Answer: C Terms: Audit evidence and system of internal control Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 6) Walkthroughs combine observation, inspection, and inquiry to assure that the controls designed by management have been implemented. Answer: TRUE Terms: Walkthroughs; understanding system of internal control Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 7) A narrative should describe the disposition of every document and record in the system. Answer: TRUE Terms: Understanding system of internal controls Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 8) Flowcharts are harder to read and update than narratives. Answer: FALSE Terms: Flowcharts Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking

9) When documenting their understanding of a client's system of internal controls, auditors are required to use narratives. Answer: FALSE Terms: Understanding system of internal controls; narratives Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 10) The level of understanding of a client's system of internal controls required is less than what is required for an audit of only the financial statements. Answer: FALSE Terms: Obtaining and documenting an understanding system of internal control Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 11) For integrated audits of large, publicly traded companies, the level of understanding of system of internal controls and the extent of testing of those controls need to be sufficient for the auditor to issue an opinion on the effectiveness of system of internal controls over financial reporting. Answer: TRUE Terms: Obtaining and documenting an understanding system of internal control Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 12) Management's documentation is not a major source of information for auditors in gaining an understanding of the design of system of internal controls. Answer: FALSE Terms: Obtaining and documenting an understanding system of internal control Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 13) Evaluating the design of a control involves considering whether the control is effective in preventing, detecting, or correcting material misstatements in the financial statements. Answer: TRUE Terms: Obtaining and documenting an understanding system of internal control Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking

14) As Section 404 of the Sarbanes-Oxley Act requires management to assess and to document the design effectiveness of system of internal controls over financial reporting, management may have already prepared narratives and flowcharts which the auditor can the use in documenting their understanding of the design of such system of internal controls. Answer: TRUE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 15) An adequate system flowchart should include the same characteristics required for system narratives. Answer: TRUE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 16) Flowcharts have two advantages over narratives: typically, they are easier to read and easier to update. Answer: TRUE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 17) It is typical to use both a narrative and a flowchart to describe the same system. Answer: FALSE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 18) When using questionnaires, "no" responses typically indicate a potential internal control deficiency requiring follow up by the auditor. Answer: TRUE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking

19) The two disadvantages of using questionnaires are their inability to provide an overview of the system and their inapplicability for some audits, especially smaller ones. Answer: TRUE Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 20) Auditors should not use audit software and other automated tools to reperform internal control processes. Answer: FALSE Terms: Obtaining and documenting an understanding system of internal control Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking; Analytic thinking 21) Name four types of evidence which the auditor uses to obtain an understanding of the design and implementation of controls. Answer: Inspection; inquiries of client personnel; observation of employees performing control processes; and reperformance by tracing one or a few transactions through the accounting system from the start to the finish. Terms: Obtaining and documenting an understanding system of internal control Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 22) Name three types of documents which auditors commonly use to obtain and to document their understanding in the audit working paper of the design of system of internal controls. Answer: Narratives; flowcharts; and system of internal control questionnaires Terms: Obtaining and documenting an understanding system of internal control Difficulty: Easy Objective: LO 12-1 AACSB: Reflective thinking 23) A proper narrative of an accounting system and the related controls should include which four characteristics? Answer: The origin of every document and record in the system; the processing that takes place; the disposition of every document and record in the system; and an indication of the controls relevant to the control risk (including separation of duties; authorizations and approvals; and internal verification performed by the client). Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking

24) Auditors should obtain an understanding of IT general controls. Name four procedures which the auditor should employ to document their understanding of IT general controls. Answer: Interview key IT personnel and key users; examine IT system documentation such as flowcharts; examine user manuals; examine program change request procedures; examine system testing results; review detailed questionnaires completed by IT staff. Terms: Obtaining and documenting understanding of system of internal control design Difficulty: Moderate Objective: LO 12-1 AACSB: Reflective thinking 12.2 Learning Objective 12-2 1) When making a preliminary assessment of control risk, the starting point for most auditors is A) IT assessment controls. B) assessment of entity level controls. C) transaction-related controls. D) fraud controls. Answer: B Terms: Control risk Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 2) You are performing the audit of system of internal control for Clifton Company. Which of the following would represent a material weakness in system of internal control? A) The company's audit committee has experienced an unusual turnover of members. B) The company's CFO was indicted for embezzling from the company. C) Bank reconciliations are done monthly. D) The CEO retired after twenty years of service to the company. Answer: B Terms: Material weaknesses in system of internal control Difficulty: Challenging Objective: LO 12-2 AACSB: Reflective thinking 3) The employee in charge of authorizing credit to the company's customers does not fully understand the concept of credit risk. This lack of knowledge would A) constitute a deficiency in operation of system of internal controls. B) constitute a deficiency in design of system of internal controls. C) constitute a deficiency of management. D) not constitute a deficiency. Answer: A Terms: Design and operation of system of internal control Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

4) When assessing whether the financial statements are auditable, the auditor must consider A) that the integrity of management and the adequacy of accounting records are the two primary factors determining auditability. B) that the integrity of management and the adequacy of risk management are the two primary factors determining auditability. C) that if all of the transaction information is available only in electronic form without a visible audit trail, the company cannot be audited. D) the control risk before determining if the entity is auditable. Answer: A Terms: Auditability of financial statements Difficulty: Moderate Objective: LO 12-2 AACSB: Ethical understanding and reasoning 5) Once auditors determine that entity level controls are designed and placed in the operation, they A) make a preliminary assessment for each transaction-related audit objective for each major type of transaction. B) make a preliminary assessment of control risk. C) obtain an understanding of the design and implementation of system of internal control. D) prepare audit documentation in order to express their opinion on the company's internal control system. Answer: A Terms: Entity level controls Difficulty: Moderate Objective: LO 12-2 AACSB: Analytic thinking 6) Which of the following is the correct definition of "control deficiency"? A) A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis. B) A control deficiency exists if one or more deficiencies exist that adversely affect a company's ability to prepare external financial statements reliably. C) A control deficiency exists if the design or operation of controls results in a more than remote likelihood that controls will not prevent or detect misstatements. D) A control deficiency exists if the design or operation of controls results in a more than probable likelihood that controls will prevent or detect misstatements. Answer: A Terms: Control deficiency Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking

7) Which deficiency exists if a necessary control is missing or not properly implemented? A) control B) significant C) design D) operating Answer: C Terms: Design deficiency Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 8) To determine if significant system of internal control deficiencies are material weaknesses, they must be evaluated on their A) Likelihood Significance Yes Yes B) Likelihood No

Significance No

C) Likelihood Yes

Significance No

D) Likelihood No

Significance Yes

Answer: A Terms: Internal control deficiencies are material weaknesses Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 9) The auditor should identify and include only ________ controls since they will be sufficient to achieve the transaction-related audit objectives and will also provide audit efficiency. A) key B) significant C) material D) compensating Answer: A Terms: Key controls Difficulty: Easy Objective: LO 12-2 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

10) Before making the final assessment of system of internal control at the end of an audit, the auditor must A) Test controls Perform substantive tests Yes Yes B) Test controls No

Perform substantive tests No

Test controls Yes

Perform substantive tests No

Test controls No

Perform substantive tests Yes

Answer: A Terms: Final assessment of system of internal control for an audit Difficulty: Moderate Objective: LO 12-2 AACSB: Analytic thinking 11) When identifying audit objectives and existing controls, A) audit objectives are identified for classes of transactions, account balances, and presentation and disclosure. B) the auditor identifies controls to satisfy each objective. C) it is helpful for the auditor to use the five control activities as reminders of controls. D) all of the above. Answer: D Terms: Audit objectives and existing controls Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 12) A(n) ________ control is a control elsewhere in the system that offsets the absence of a key control. A) significant B) alternate C) design D) compensating Answer: D Terms: Compensating control; key control Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 9 Copyright © 2023 Pearson Education, Inc.

13) A ________ exists if one or more control deficiencies exist that are less severe than a material weakness, but are important enough to merit attention by those responsible for oversight of the company's financial reporting. A) potential misstatement B) significant weakness C) significant deficiency D) fraud symptom Answer: C Terms: Significant deficiencies Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 14) A five-step approach can be used to identify deficiencies, significant deficiencies, and material weaknesses. The first step in this approach is A) identify the absence of key controls. B) consider the possibility of compensating controls. C) determine potential misstatements that could result. D) identify existing controls. Answer: D Terms: Control risk Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 15) When assessing control risk, A) many auditors use actuarial tables to assist in the control risk assessment process. B) each control can be used to satisfy only one audit objective. C) many auditors use a control risk matrix to assist in the control risk assessment process. D) all controls, including key controls, should be considered. Answer: C Terms: Assessed level of control risk Difficulty: Challenging Objective: LO 12-2 AACSB: Reflective thinking

16) When a compensating control exists, the absence of a key control A) is no longer a concern because there is no longer a significant deficiency or material weakness. B) is still a major concern to the auditor. C) could cause a material loss, so it must be tested using substantive procedures. D) is magnified and must be removed from the sampling process and examined in its entirety. Answer: A Terms: Compensating control; key control Difficulty: Challenging Objective: LO 12-2 AACSB: Analytic thinking 17) The assessment of control risk is the measure of the auditor's expectation that system of internal controls will prevent material misstatements from occurring or detect and correct them if they have occurred. Answer: TRUE Terms: Internal control risk assessment Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 18) Key controls are not sufficient to achieve the transaction-related audit objectives. Answer: FALSE Terms: Key controls Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 19) A design deficiency exists if the person performing the control is not qualified. Answer: FALSE Terms: Design deficiency Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 20) A significant system of internal control deficiency is always considered a material weakness. Answer: FALSE Terms: Significant deficiencies and material weaknesses Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking

21) In some cases, management can correct deficiencies and material weaknesses before the auditor does significant testing, which may permit a reduction in control risk. Answer: TRUE Terms: Control risk assessment Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 22) In a small business, the daily involvement of the owner in the business is not sufficient to overcome significant deficiencies or material weaknesses in system of internal controls. Answer: FALSE Terms: Compensating controls Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 23) If the likelihood that a material misstatement would be prevented, detected, or corrected by the controls in place, then the control risk is low in the revenue transaction cycle. Answer: TRUE Terms: Control risk assessment Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 24) In order for the auditor to determine whether a significant system of internal control deficiency is a material weakness, the deficiency should be evaluated along one of the following two dimensions: likelihood or significance. Answer: FALSE Terms: Evaluation of potential material weakness Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 25) If there is more than a reasonable possibility that a material misstatement could result from a significant deficiency found during the audit, then that deficiency is considered a material weakness in system of internal control. Answer: TRUE Terms: Evaluation of significant deficiency in controls Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking

26) You are the audit manager for a new audit client. Your staff auditors are unsure of what constitutes a control deficiency. Discuss the terms control deficiency, design deficiency, and operating deficiency. Answer: A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis in the normal course of performing their assigned functions. A design deficiency exists if a necessary control is missing, is not properly designed, or is not properly implemented. An operation deficiency exists if a well-designed control does not operate as designed or if the person performing the control is insufficiently qualified or authorized. Terms: Control deficiency; Design deficiency; Operating deficiency Difficulty: Moderate Objective: LO 12-2 AACSB: Reflective thinking 27) The text suggested a five-step approach to identify deficiencies, significant deficiencies, and material weaknesses. Describe this approach. Answer: 1. Identify existing controls. Because deficiencies and material weaknesses are the absence of adequate controls, the auditor must first know which controls exist. 2. Identify the absence of key controls. System of internal control questionnaires, flowcharts, and walkthroughs are useful tools to identify where controls are lacking and the likelihood of misstatement is therefore increased. It is also useful to examine the control risk matrix to look for objectives where there are no or only a few controls to prevent or detect misstatements. 3. Consider the possibility of compensating controls. A compensating control is one elsewhere in the system that offsets the absence of a key control. When a compensating control exists, there is no longer a significant deficiency or material weakness. 4. Decide whether there is a significant deficiency or material weakness. The likelihood of misstatements and their materiality are used to evaluate if there are significant deficiencies or material weaknesses. 5. Determine potential misstatements that could result. This step is intended to identify specific misstatements that are likely to result because of the significant deficiency or material weakness. The importance of a significant deficiency or material weakness is directly related to the likelihood and materiality of potential misstatements. Terms: Five-step approach to identify deficiencies Difficulty: Challenging Objective: LO 12-2 AACSB: Reflective thinking; Analytic thinking

12.3 Learning Objective 12-3 1) If the results of tests of controls support the design and operations of controls as expected, the auditor uses ________ assessed control risk as the preliminary assessment. A) a lower B) the same C) a higher D) either a lower or higher Answer: B Terms: Control risk as preliminary assessment Difficulty: Moderate Objective: LO 12-3 AACSB: Analytic thinking 2) An auditor is likely to use four types of procedures to support the operating effectiveness of system of internal controls. Which of the following would generally not be used? A) make inquiries of appropriate client personnel B) examine documents, records, and reports C) reperform client procedures D) inspect design documents Answer: D Terms: Operating effectiveness of system of internal controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 3) Which of the following represents a correct statement regarding system of internal control testing? A) When auditors plan to use evidence about the operating effectiveness of system of internal control contained in prior audits, auditing standards require tests of the controls' effectiveness at least every other year. B) The greater the risk, the less audit evidence the auditor should obtain that controls are operating effectively. C) The auditor uses control risk assessment and results of tests of controls to determine planned detection risk and the related substantive tests for the financial statement audit. D) Testing of system of internal controls can only be performed by the auditor at the end of the fiscal year. Answer: C Terms: Internal control risk assessment Difficulty: Challenging Objective: LO 12-3 AACSB: Analytic thinking

4) An auditor traces the sales prices to the authorized price list in effect at the date of the transaction. Which of the following procedures has the auditor performed? A) inquiry B) observation C) reperformance D) examination Answer: C Terms: Procedures for tests of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 5) Tests of controls A) are the procedures used to test the effectiveness of controls in support of a reduced assessed control risk. B) are used to support the ending balances in the balance sheet and income statement accounts. C) are performed at the end of the audit. D) are designed to detect fraud. Answer: A Terms: Tests of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 6) Which of the following is an accurate statement relating to the extent of control audit procedures? A) If an auditor wants a lower assessed control risk than the preliminary assessed control risk, the number of controls tested increases while the extent of the tests for each control decrease. B) The extent of testing depends on the frequency of the operation of the controls. C) All controls must be tested only at year-end. D) The frequency of testing is the same for both manual and computer controls. Answer: B Terms: Extent of tests of controls procedures Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking

7) When testing manual or automated controls, A) automated controls are always subject to random error or manipulation. B) automated controls cannot be altered by making a change to the software application. C) when there are effective general controls and automated application controls, the auditor will need to select a larger sample size of transactions to verify. D) the extent of testing depends on whether it is a manual or automated control. Answer: D Terms: Extent of tests of controls procedures Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 8) Which of the following is true regarding the relationship between tests of controls and procedures to obtain an understanding? A) In obtaining an understanding of system of internal control, the procedures to obtain an understanding are applied to all controls identified during that phase. B) Tests of controls are applied only when the assessed control risk has not been satisfied by the procedures to obtain an understanding. C) Procedures to obtain an understanding are performed only on one or a few transactions. D) All of the above are correct. Answer: D Terms: Relationship between tests of controls and procedures to obtain an understanding Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 9) When a client uses a service center for processing transactions, A) the auditor can assume that the controls are adequate because it is an independent enterprise. B) auditing standards require the auditor to test the service center's controls if the service center application involves processing significant financial data. C) and the user auditor decides to rely on the service auditor's report, the user auditor must make reference to the report of the service auditor in the opinion on the user organization's financial statements. D) none of the above. Answer: B Terms: Outsourced services Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking

10) An auditor traces the cost of sales entry for a sample of product sales to the inventory unit costs in effect at the date of each transaction. Which of the following procedures has the auditor performed? A) inquiry B) observation C) reperformance D) examination Answer: C Terms: Procedures for tests of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 11) Which of the following statements is not true with regards to audit testing of controls for less than the entire audit period? A) For controls that are applied throughout the accounting period, it is usually impractical to test them at an interim date. B) Management's report on system of internal control deals with the effectiveness of system of internal controls as of the end of the fiscal year. C) PCAOB auditing standards require the auditor to perform tests of controls that are adequate to determine whether controls are operating effectively at year end. D) The timing of the auditors tests of controls depends on the nature of the controls and when the company uses them. Answer: A Terms: Procedures for tests of controls Difficulty: Challenging Objective: LO 12-3 AACSB: Reflective thinking; Analytic thinking 12) Which of the following is not true with regards to audit test of controls over journal entries and other adjustments? A) Auditors are not required to test the operating effectiveness of controls over journal entries and other adjustments based upon their overall control evaluation made during the audit. B) Management is in a unique position to perpetrate financial statement fraud due to their ability to manipulate the accounting records. C) Management override risk is a significant risk due to the unpredictable ways management override can occur. D) Auditors should always be aware of management's ability to override controls that appear to be operating effectively. Answer: A Terms: Procedures for tests of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking; Analytic thinking

13) The procedures to obtain an understanding of system of internal control are only applied when the assessed control risk is high. Answer: FALSE Terms: Internal controls Difficulty: Easy Objective: LO 12-3 AACSB: Analytic thinking 14) Controls that are applied throughout the accounting period must be tested both at an interim date and then again on the balance sheet date. Answer: FALSE Terms: Internal controls Difficulty: Moderate Objective: LO 12-3 AACSB: Analytic thinking 15) When there are a number of controls tested in prior audits that have not been changed, auditing standard require auditors to test some of those controls each year to ensure there is a rotation of controls testing throughout the three-year period. Answer: TRUE Terms: Reliability of evidence Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 16) The AICPA guide to data analytics indicates audit data analysis can be used throughout the audit process, but not including tests of controls. Answer: FALSE Terms: Using audit software and data analytics to perform test of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 17) A company requires the controller's e-approval for all fixed asset purchases in excess of $50,000. Audit software can be used to identify if there are any instances where a fixed asset purchase in excess of $50,000 lacked the controller's e-approval, instead of manual checking. Answer: TRUE Terms: Using audit software and data analytics to perform test of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking

18) An example of substantive testing and also a test of controls is using audit software to identify purchases where the vendor's invoice, the receiving report, and the purchase order did not match prior to payment of the vendor's invoice. Answer: TRUE Terms: Using audit software and data analytics to perform test of controls Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 19) In evaluating the operational effectiveness of system of internal controls, the auditor is likely to use four types of audit procedures. List the procedures below. Answer: • Make inquiries of appropriate client personnel. • Examine documents, records, and reports. • Observe control-related activities. • Reperform client procedures. Terms: Operational effectiveness; system of internal controls; audit procedures Difficulty: Moderate Objective: LO 12-3 AACSB: Reflective thinking 12.4 Learning Objective 12-4 1) Which of the following is a correct statement? A) The auditor uses the control risk assessment and results of tests of controls to determine planned detection risk. B) The auditor links the inherent risk assessments to the balance-related audit objectives. C) The audit risk model is used determine the level of audit risk. D) All of the above are correct statements. Answer: A Terms: Planned detection risk and design substantive tests Difficulty: Moderate Objective: LO 12-4 AACSB: Reflective thinking 2) The auditor assesses control risk for each related audit objective and supports control risk assessments with tests of controls. Answer: TRUE Terms: Planned detection risk and design substantive tests Difficulty: Easy Objective: LO 12-4 AACSB: Reflective thinking

3) In October 2013, the PCAOB issued Staff Audit Practice Alert No. 11, titled "Considerations for Audits of Internal Control over Financial Reporting." In this Staff Audit Practice Alert, the PCAOB highlighted three common deficiencies related to audits of system of internal control. Name these three common deficiencies. Answer: The failure of the auditor to understand a company's flow of transactions; auditor's lack of understanding of management review controls, a detective control designed to identify error or fraud; and the testing of system-generated data or reports. Terms: Planned detection risk and design substantive tests Difficulty: Moderate Objective: LO 12-4 AACSB: Reflective thinking 12.5 Learning Objective 12-5 1) How must significant deficiencies and material weaknesses be communicated to those charged with governance? A) Either oral or written communication is acceptable. B) Oral communication is required. C) Written communication is required. D) Written communication is required for material weaknesses, but oral communication is allowed for significant deficiencies. Answer: C Terms: Significant deficiencies and material weaknesses Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking 2) Auditors often identify less significant system of internal control-related issues, as well as opportunities for the client to make operational improvements in the A) adverse opinion. B) Section 404 report. C) management letter. D) Type 1 report. Answer: C Terms: Management representation letter Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking

3) The auditor will issue an unqualified opinion on system of internal control over financial reporting when A) there are no identified material weaknesses as of the end of the fiscal year. B) there have been no restrictions on the scope of the auditor's work. C) both A and B D) either A or B Answer: C Terms: Types of opinions on system of internal control Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking 4) What type of report is issued when one or more material system of internal control weaknesses exist? A) unqualified opinion B) disclaimer of opinion C) adverse opinion D) qualified opinion Answer: C Terms: Types of opinions on system of internal control Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking 5) Which of the following is true regarding the auditor's opinion on the effectiveness of system of internal control? A) The auditor is attesting to the effectiveness of system of internal controls as of the end of the fiscal year. B) If the client remedies a material weakness before the end of the fiscal year, the auditor must still issue a qualified opinion or a disclaimer of opinion. C) A scope limitation requires the auditor to issues an adverse opinion. D) Section 404 requires that the auditor design the audit to detect all deficiencies in system of internal control. Answer: A Terms: Types of opinions on system of internal control Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking

6) When determining what type of report to issue on system of internal control under Section 404, A) an adverse opinion on system of internal control must be given if any weaknesses in a key system of internal control is discovered. B) a scope limitation requires the auditor to disclaim an opinion on system of internal controls. C) if the auditor gives a qualified opinion on the financial statements, they must give a qualified opinion on system of internal controls. D) a scope limitation requires the auditor to express a qualified opinion or a disclaimer of opinion on system of internal controls. Answer: D Terms: Internal control audit requirements of auditor Difficulty: Easy Objective: LO 12-5 AACSB: Reflective thinking 7) The scope of the auditor's report on system of internal control is limited to obtaining reasonable assurance that significant weaknesses in system of internal control are identified. Answer: FALSE Terms: Section 404 of the Sarbanes-Oxley Act Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking 8) To issue an unqualified opinion on system of internal control over financial reporting, there must be no identified material weaknesses and no restrictions on the scope of the audit. Answer: TRUE Terms: Unqualified opinion on system of internal control Difficulty: Moderate Objective: LO 12-5 AACSB: Reflective thinking

9) Assume an auditor identified a material misstatement in the financial statements that was not initially identified by the company's system of internal controls. Describe the auditors likely responses in this situation. Answer: 1. The auditor should consider whether the misstatement indicates the existence of a material weakness. 2. The auditor can issue an unqualified opinion on the financial statements if the client adjusts the statements to correct the misstatement prior to their issuance. 3. Management is likely to change its report on system of internal control to assert that the controls are not operating effectively. 4. The auditor must issue an adverse opinion on system of internal control over financial reporting if the deficiency is considered a material weakness. 5. In addition, the auditor should communicate in writing to the audit committee that the material weakness was not disclosed or identified as a material weakness in management's assessment, if that is the case. Terms: Internal control audit requirements of auditor Difficulty: Challenging Objective: LO 12-5 AACSB: Reflective thinking 12.6 Learning Objective 12-6 1) It is generally possible for small companies to have all of the following except for A) adequate documents and records. B) physical controls over assets. C) competent, trustworthy personnel. D) internal auditors. Answer: D Terms: Control; smaller company Difficulty: Easy Objective: LO 12-6 AACSB: Reflective thinking 2) The auditor designs and performs a combination of tests of controls and substantive procedures to obtain reasonable assurance that the financial statements are fairly stated when control risk A) is assessed above the maximum. B) is assessed below the maximum. C) cannot be assessed. D) none of the above Answer: B Terms: Control risk assessment Difficulty: Easy Objective: LO 12-6 AACSB: Reflective thinking

3) In the audit of a private company, the auditor will test system of internal controls when control risk is initially assessed at A) Low Moderate High Yes No Yes B) Low No

Moderate No

High Yes

C) Low Yes

Moderate Yes

High No

D) Low No

Moderate Yes

High No

Answer: C Terms: Control risk Difficulty: Moderate Objective: LO 12-6 AACSB: Reflective thinking 4) Which of the following may represent the biggest challenge smaller public companies and nonpublic companies face in implementing effective system of internal control? A) a lack of competent, trustworthy personnel B) no clear lines of authority C) no adequate separation of duties D) a lack of adequate documents and records Answer: C Terms: Internal control, biggest challenge Difficulty: Challenging Objective: LO 12-6 AACSB: Reflective thinking 5) Which of the following is most correct for audits of non-public companies? A) An audit of system of internal control is required. B) An audit of system of internal control is not required. C) An audit of the design of system of internal controls is required. D) An audit of the operational effectiveness of system of internal controls is required. Answer: B Terms: Audits of non-public companies Difficulty: Moderate Objective: LO 12-6 AACSB: Reflective thinking 24 Copyright © 2023 Pearson Education, Inc.

6) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably set a high assessment of control risk. Answer: TRUE Terms: Control activities; control risk Difficulty: Easy Objective: LO 12-6 AACSB: Analytic thinking 7) The auditor obtains a sufficient understanding of system of internal control to assess the risk of material misstatement at the overall financial statement level and at the relevant assertion level. Answer: TRUE Terms: Understanding system of internal controls Difficulty: Easy Objective: LO 12-6 AACSB: Reflective thinking 8) The procedures used to gain an understanding of system of internal control do not vary from client to client. Answer: FALSE Terms: Understanding system of internal controls Difficulty: Easy Objective: LO 12-6 AACSB: Reflective thinking 9) In an audit of a nonpublic company, the less control risk there is, the smaller the amount of planned substantive evidence that is required. Answer: TRUE Terms: Nonpublic company; control risk; substantive evidence Difficulty: Moderate Objective: LO 12-6 AACSB: Analytic thinking 10) The assessment of control risk does not impact the testing of controls. Answer: FALSE Terms: Control risk Difficulty: Easy Objective: LO 12-6 AACSB: Reflective thinking

11) A company's size should have no impact on the nature of system of internal control and the controls that are implemented. Answer: FALSE Terms: Internal controls for smaller companies Difficulty: Moderate Objective: LO 12-6 AACSB: Reflective thinking 12) Control risk is generally set at minimum for most private companies. Answer: FALSE Terms: Internal controls for smaller companies Difficulty: Moderate Objective: LO 12-6 AACSB: Reflective thinking 12.7 Learning Objective 12-7 1) The auditor's objective in determining whether the client's computer program correctly processes valid and invalid transactions is accomplished through the A) test data approach. B) generalized audit software approach. C) microcomputer-aided auditing approach. D) generally accepted auditing standards. Answer: A Terms: Test data approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 2) When using the test data approach, A) auditors process test data supplied by the client. B) auditors often obtain assistance from an IT audit specialist. C) the tests must be performed at the end of the year. D) the test data must remain in the client's records. Answer: B Terms: Test data approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking

3) Which of the following is not seen as an advantage to using generalized audit software (GAS)? A) Auditors can learn the software in a short period of time. B) It can be applied to a variety of clients after detailed customization. C) It can be applied to a variety of clients with minimal adjustments to the software. D) It greatly accelerates audit testing over manual procedures. Answer: B Terms: Generalized audit software Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 4) When using the test data approach, A) test data should include data that the client's system should accept or reject. B) application programs tested by the auditor's test data must be different from those used by the client throughout the year. C) select data may remain in the client system after testing. D) None of the above statements is correct. Answer: A Terms: Test data approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 5) Auditing by testing automated system of internal controls and account balances electronically is known as A) auditing through the computer. B) auditing around the computer. C) embedded audit module approach. D) parallel simulation testing. Answer: A Terms: IT auditing environment Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 6) Which of the following computer-assisted auditing techniques inserts an audit module in the client's application system to identify specific types of transactions? A) parallel simulation testing B) test data approach C) embedded audit module D) generalized audit software testing Answer: C Terms: Computer-assisted auditing techniques allow fictitious and real transactions Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 27 Copyright © 2023 Pearson Education, Inc.

7) Which of the following best describes the test data approach? A) Auditors process their own test data using the client's IT system and application program. B) Auditors process their own test data using their own computers that simulate the client's computer system. C) Auditors use auditor-controlled software to do the same operations that the client's software does, using the same data files. D) Auditors use client-controlled software to do the same operations that the client's software does, using auditor-created data files. Answer: A Terms: Test data approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 8) The embedded audit module approach requires the auditor to insert an audit module in the client's application system to identify specific types of transactions. Answer: TRUE Terms: Embedded audit module approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 9) The objective of the test data approach is to determine whether the client's computer programs can correctly process valid and invalid transactions. Answer: TRUE Terms: Test data approach Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 10) Parallel simulation is used primarily to test system of internal controls over the client's IT systems, whereas the test data approach is used primarily for substantive testing. Answer: FALSE Terms: Parallel simulation Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 11) Generalized audit software is used to test automated controls. Answer: TRUE Terms: Generalized audit software Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking

12) Describe three computer auditing techniques available to the auditor. Answer: Computer auditing techniques available to the auditor are: • Test data approach. Using this approach, the auditors process their own test data using the client's computer system and application program to determine whether the automated controls correctly process the test data. • Parallel simulation. The auditors use auditor-controlled software to do the same operations that the client's software does, using the same data files. The purpose is to determine the effectiveness of automated controls and to obtain evidence about electronic account balances. • Embedded audit module. Using this approach, the auditor inserts an audit module into the client's application system to identify specific types of transactions. Terms: Computer auditing techniques Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 13) Discuss the advantages and benefits of using generalized audit software. Answer: Advantages and benefits of using generalized audit software include: • It is relatively easy to train the audit staff in its use, even if they have little formal IT training. • The software can be applied to a wide variety of clients with minimal customization. • It has the ability to do audit tests much faster, and in more detail, than using traditional manual procedures. Terms: Advantages of using generalized audit software Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking 14) Auditors often use Generalized Audit Software during their testing of a client's system of internal controls. For the following uses of the software provide a description and an example. Verify extensions and footings Print confirmation requests Compare data on separate files Answer: Verify extensions and footings: Verify accuracy of the client's computations by calculating information independently; foot any subsidiary ledger. Print confirmation requests: Print data for sample items selected for confirmation testing; print customer name, address, and account balance information from master files. Compare data on separate files: Determine that information contained in two or more data files agrees; compare changes in accounts receivable balances between two dates using sales and cash receipts in transaction files. Terms: Generalized Audit Software and testing of system of internal controls Difficulty: Moderate Objective: LO 12-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 13 Overall Audit Strategy and Audit Program 13.1 Learning Objective 13-1 1) Shown below (1 through 5) are the five types of tests which auditors use to determine whether financial statements are fairly stated. Which three are substantive tests? 1. risk assessment procedures 2. tests of controls 3. substantive tests of transactions 4. substantive analytical procedures 5. tests of details of balances A) 1, 2, and 3 B) 3, 4, and 5 C) 2, 3, and 5 D) 2, 3, and 4 Answer: B Terms: Three types of substantive tests which auditors use Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 2) Collectively, procedures performed to obtain an understanding of the entity and its environment, including system of internal controls, represent the auditor's A) audit strategy. B) tests of controls. C) risk assessment procedures. D) tests of transactions. Answer: C Terms: Procedures performed to obtain understanding of entity and environment, including system of internal controls Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 3) Which of the following would not be considered further audit procedures? A) tests of controls B) analytical procedures C) tests of details of balances D) risk assessment procedures Answer: D Terms: Not considered a further audit procedure Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking

4) Which of the following procedures would most likely be performed in response to the auditor's assessment of the risk of monetary misstatements in the financial statements? A) ratio analysis B) tests of controls C) tests of details of balances D) risk assessment procedures Answer: C Terms: Procedure performed in response to auditor's assessment of risk of monetary misstatement Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 5) Which of the following further audit procedures are used to determine whether all six transaction-related audit objectives have been achieved for each class of transactions? A) tests of controls B) risk assessment procedures C) substantive tests of transactions D) preliminary analytical procedures Answer: C Terms: Further audit procedures to determine whether all six transaction-related audit objectives have been achieved Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 6) You are auditing Rodgers and Company. After performing substantive analytical procedures, you conclude that, for the accounts tested, the client's balance appears reasonable. This may indicate that A) detailed test of balances can be eliminated for those accounts. B) certain tests of details of balances may be eliminated for those accounts. C) control tests may be eliminated for those accounts. D) control tests may be reduced for those accounts. Answer: B Terms: After performing substantive analytic procedures Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking

7) The purpose of tests of controls is to provide reasonable assurance that the A) accounting treatment of transactions and balances is valid and proper. B) system of internal control procedures are functioning as intended. C) entity has complied with GAAP disclosure requirements. D) entity has complied with requirements of quality control. Answer: B Terms: Purpose of tests of controls Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 8) In the context of an audit of financial statements, substantive tests are audit procedures that A) may be eliminated under certain conditions. B) are designed to discover significant subsequent events. C) are designed to test for dollar misstatements. D) will increase proportionately with the auditor's reliance on system of internal control. Answer: C Terms: Substantive tests Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 9) Which of the following is true? A) Tests of details of balances focus on the ending general ledger balances for both balance sheet and income statement accounts. B) Tests of details of balances focus on the transactions during the period for both balance sheet and income statement accounts. C) Tests of details of balances focus on the auditor's understanding of system of internal controls. D) Tests of details of balances focus on comparisons of recorded amounts to expectations developed by the auditor. Answer: A Terms: Tests of details of balances focus on Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 10) A system walkthrough is primarily used to help the auditor A) test the ending account balances. B) test the details of transactions. C) determine whether system of internal controls have been properly implemented. D) determine whether the audit engagement should be accepted. Answer: C Terms: System walkthrough Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 3 Copyright © 2023 Pearson Education, Inc.

11) Risk assessment procedures are performed by auditors during an audit in order to A) determine the risk of material misstatement in the financial statements. B) determine the amount of testing of system of internal control. C) determine the extent of testing of details of balances. D) determine the extent of testing of transactions. Answer: A Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 12) Tests of controls are directed toward the control's A) efficiency. B) effectiveness. C) cost and effectiveness. D) cost benefit ratio. Answer: B Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 13) A procedure designed to test for monetary misstatements directly affecting the correctness of financial statement balances is a A) test of controls. B) substantive test. C) test of attributes. D) monetary unit sampling test. Answer: B Terms: Procedures designed to test for monetary misstatements Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 14) Analytical procedures A) focus on the ending balances for income statement accounts. B) are only performed during the planning stage of the audit. C) are required to be performed when auditing an account balance. D) provide substantive evidence. Answer: D Terms: Analytical procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

15) The primary emphasis in most tests of details of balances is on the A) balance sheet accounts. B) revenue accounts. C) cash flow statement accounts. D) expense accounts. Answer: A Terms: Primary emphasis in most tests of details of balances Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 16) Which of the following statements is not true? A) Analytical procedures emphasize the overall reasonableness of transactions and balances. B) Tests of controls are concerned with evaluating whether controls are sufficiently effective to justify reducing control risk and thereby reducing analytical review procedures. C) Substantive tests of transactions emphasize the verification of transactions recorded in the journals and then posted in the general ledger. D) Tests of details of balances emphasize the ending balances in the general ledger. Answer: B Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 17) Many auditors perform extensive analytical procedures because A) they are required by GAAS. B) they pinpoint errors in accounts. C) they indicate areas of potential risk and misstatement. D) they are required for tests of controls. Answer: C Terms: Auditors perform extensive analytical procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

18) The auditor has determined that a key control in the audit of the sales and collection cycle is that recorded sales are supported by authorized shipping documents and approved customer orders. What typical test of controls should be used in this situation? A) Examine a sample of duplicate sales invoices to determine that each one is supported by an authorized shipping document and approved customer order. B) Observe whether shipping documents are forwarded daily to billing and observe when they are billed. C) Examine a sample of sales invoices and agree prices to the authorized computer price list. D) Use audit software to trace postings from the batch of sales transactions to the subsidiary and general ledgers. Answer: A Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 19) Which of the following is ordinarily designed to detect material dollar errors on the financial statements? A) tests of controls B) analytical review procedures C) computer controls D) tests of details of balances Answer: D Terms: Designed to detect material dollar errors on the financial statements Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 20) Risk assessment procedures are performed by the auditor to assess the risk of material misstatement in the financial statements. Below are four types of further audit procedures the auditor should perform that provide the basis for the auditor's opinion. Which of these are compliance procedures? 1. Tests of controls 2. Tests of details of balances 3. Substantive tests of transactions 4. Substantive analytical procedures A) 1, 2, and 3 B) 2, 3, and 4 C) 1 only D) 1 and 2 Answer: C Terms: Risk assessment procedures which are compliance procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

21) Tests of controls, either manual or automated, may include the following types of evidence and procedures. Which of these procedures is not the same as those procedures used to obtain an understanding of system of internal controls? A) Make inquiries of appropriate client personnel. B) Examine documents, records, and reports. C) Observe control-related activities. D) Substantive analytical procedures. Answer: D Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 22) For automated controls, the auditor's procedures to determine whether the automated control has been implemented cannot also serve as the test of that control. Answer: FALSE Terms: Tests of controls audit tests Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 23) Procedures to obtain an understanding of system of internal control generally provide sufficient appropriate evidence that a control is operating effectively. Answer: FALSE Terms: Internal controls Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 24) Substantive tests are procedures designed to test for dollar misstatements that directly affect the correctness of financial statement balances. Answer: TRUE Terms: Substantive tests Difficulty: Easy Objective: LO 13-1 AACSB: Reflective thinking 25) Risk assessment procedures are performed to assess the risk of material misstatement in the financial statements. Answer: TRUE Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

26) Tests of controls should be performed after substantive tests of transactions. Answer: FALSE Terms: Tests of controls and substantive tests of transactions Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 27) Tests of details of balances emphasize the overall reasonableness of transactions and the general ledger balances. Answer: FALSE Terms: Tests of details of balances Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 28) Auditors must perform tests of controls separately from substantive tests of transactions. Answer: FALSE Terms: Tests of controls and substantive tests of transactions Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 29) One factor that determines the amount of additional evidence required for tests of controls is the planned reduction in control risk. Answer: TRUE Terms: Control risk Difficulty: Challenging Objective: LO 13-1 AACSB: Reflective thinking 30) Tests of controls are performed to support a reduced assessment of detection risk. Answer: FALSE Terms: Procedures to obtain an understanding of system of internal control Difficulty: Challenging Objective: LO 13-1 AACSB: Reflective thinking 31) Auditors use substantive analytical procedures and tests of details of balances to satisfy planned control risk. Answer: FALSE Terms: Procedures to obtain an understanding of system of internal control Difficulty: Challenging Objective: LO 13-1 AACSB: Reflective thinking

32) Substantive tests of transactions affect control risk but do not affect planned detection risk. Answer: FALSE Terms: Procedures to obtain an understanding of system of internal control Difficulty: Challenging Objective: LO 13-1 AACSB: Reflective thinking 33) Collectively, procedures performed to obtain an understanding of the entity and its environment, including system of internal controls, represent the auditor's risk assessment procedures. Answer: TRUE Terms: Risk assessment procedures Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 34) For automated controls, the auditor's procedures to determine whether the automated control has been implemented may also serve as the test of that control. Answer: TRUE Terms: Tests of automated controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 35) The amount of additional evidence required for tests of controls depends on two things: the extent of evidence obtained in gaining an understanding of system of internal controls, and the planned reduction in detection risk. Answer: FALSE Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 36) Assume the beginning balance in cash was audited in the prior year and is considered to be correct. In the current year, the auditor verifies that sales and cash receipts transactions are correctly recorded in the accounting records and posted to the general ledger. Before the auditor can reach a conclusion about the ending balance in the cash account in the current year, cash disbursement transactions will have to be audited. Answer: TRUE Terms: Tests of controls Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

37) Substantive tests are procedures designed to test for dollar misstatements that directly affect the correctness of financial statements balances and disclosures. Substantive tests are often called monetary misstatements. Answer: TRUE Terms: Substantive tests of transactions Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 38) It is inefficient to perform tests of controls separately from substantive tests of transactions. Answer: FALSE Terms: Substantive tests of transactions and tests of controls performed simultaneously Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 39) List each of the five types of audit tests. Answer: • risk assessment procedures • tests of controls • substantive tests of transactions • substantive analytical procedures • tests of details of balances Terms: Types of audit tests Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 40) Describe the five types of audit tests. Identify which of the five types are substantive tests, and which are used to reduce assessed control risk. Answer: The five types of audit tests used to determine whether financial statements are fairly stated are: risk assessment procedures, tests of controls, substantive tests of transactions, substantive analytical procedures, and tests of details of balances. Substantive tests of transactions, substantive analytical procedures, and tests of details of balances are substantive tests, whereas procedures to obtain an understanding of system of internal control and tests of controls are used to reduce assessed control risk. Auditors use substantive analytical procedures and tests of details of balances to satisfy planned detection risk. Substantive tests of transactions affect both control risk and planned detection risk, because they test the effectiveness of system of internal controls and the dollar amounts of the transactions. Terms: Types of audit tests Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

41) Discuss the purposes of (1) substantive tests of transactions, (2) tests of controls, and (3) tests of details of balances. Give an example of each. Answer: The purpose of substantive tests of transactions is to determine whether all six transaction-related audit objectives have been satisfied for each class of transactions. For example, as part of the auditor's test of the accuracy objective for sales, the auditor would compare the amount recorded in the sales journal for a sample of sales transactions with the total on the corresponding sales invoices. The purpose of tests of controls is to determine the effectiveness of both the design and operations of specific system of internal controls. For example, the auditor might observe for a month whether statements are mailed to all customers. The purpose of tests of details of balances is to determine the monetary correctness of the accounts to which they relate. The confirmation of accounts receivable is an example. Terms: Substantive tests of transactions, tests of controls and tests of details of balances Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking 42) There are three stages of the audit in which analytical procedures are performed. Identify each of these three stages and, for each stage, discuss the purpose of performing analytical procedures in that stage. Also indicate in which stage(s) analytical procedures are required by current professional auditing standards. Answer: Analytical procedures are performed in the audit planning stage to help the auditor decide the other evidence needed to satisfy sufficient competent evidence requirements. Analytical procedures can also be performed as substantive tests in the testing phase of the audit. Analytical procedures are performed in the audit completion phase as a final test of reasonableness. Auditing standards require that analytical procedures be performed in the planning and completion phases of every audit. Terms: Analytical procedures in stages of audit Difficulty: Moderate Objective: LO 13-1 AACSB: Reflective thinking

13.2 Learning Objective 13-2 1) In order to promote audit efficiency, the auditor considers cost in selecting audit tests to perform. Which of the following audit tests would be the most costly? A) substantive analytical procedures B) risk assessment procedures C) tests of controls D) tests of details of balances Answer: D Terms: Most costly audit test Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 2) An exception or deficiency found in a test of controls A) indicates a financial statement misstatement. B) indicates the likelihood of a misstatement. C) indicates that the financial statements are fairly stated. D) indicates that an adverse opinion is warranted on the audit of system of internal control. Answer: B Terms: Exception or deficiency in test of controls Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 3) If no material differences are found using analytical procedures, and the auditor concludes that misstatements are not likely to have occurred, A) other substantive tests may be reduced. B) it will be necessary to increase the tests of balances. C) it will not be necessary to perform tests of balances. D) it will be necessary to increase the tests of transactions. Answer: A Terms: If no material differences are found using analytical procedures Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 4) Which of the following audit tests is usually the least costly to perform? A) substantive analytical procedures B) tests of controls C) tests of balances D) substantive tests of transactions Answer: A Terms: Least costly audit test Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 12 Copyright © 2023 Pearson Education, Inc.

5) An increased extent of tests of controls is most likely to occur when A) it is a first-year audit. B) the auditor is doing a "fraud audit." C) controls are effective and the preliminary control risk assessment is low. D) controls are ineffective and the preliminary control risk assessment is high. Answer: C Terms: Increased extent of tests of controls most likely to occur Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 6) When an auditor believes that analytical procedures indicate a reasonable possibility of misstatement, the auditor usually would A) Perform additional tests of controls Decide to modify tests of details of balances Yes Yes B) Perform additional tests of controls Decide to modify tests of details of balances No No C) Perform additional tests of controls Decide to modify tests of details of balances Yes No D) Perform additional tests of controls Decide to modify tests of details of balances No Yes Answer: D Terms: Analytical procedures indicate reasonable possibility of misstatement Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 7) If tests of controls support the control risk assessment, then ________ in the audit risk model is increased. A) planned detection risk B) planned inherent risk C) planned fraud risk D) planned assurance risk Answer: A Terms: Control risk assessment and planned detection risk Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

8) The auditor would design which of the following audit tests to detect possible monetary errors in the financial statements? A) control tests B) substantive analytical procedures C) risk assessment procedures D) tests of operating effectiveness of controls over revenue and cash Answer: B Terms: Audit tests to detect possible monetary errors in the financial statements Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 9) The reliance the auditor places on substantive tests in relation to the reliance placed on system of internal control varies in a relationship that is ordinarily A) parallel. B) inverse. C) direct. D) equal. Answer: B Terms: Reliance auditor places on substantive tests and system of internal controls Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 10) A deficiency uncovered in the audit of system of internal control is explained by which of the following in relation to a financial statement misstatement? A) the amount of the misstatement B) the likelihood of the misstatement C) the amount, likelihood, and classification of the misstatement D) the amount and the classification of the misstatement Answer: B Terms: Deficiency uncovered in audit of system of internal control Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 11) Several factors influence the auditor's choice of the types of tests to select, including A) the availability of the types of evidence. B) the relative costs of each type of test. C) the effectiveness of the system of internal controls. D) all of the above. Answer: D Terms: Selecting types of tests to perform Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 14 Copyright © 2023 Pearson Education, Inc.

12) When auditors must decide which type of test to select for obtaining sufficient appropriate evidence, the cost of obtaining the evidence is an important consideration. Rank the following types of tests in order of increasing cost: 1. Tests of controls 2. Substantive tests of transactions 3. Test of details of balances 4. Risk assessment procedures 5. Substantive analytical procedures A) 1, 2, 3, 4, and 5 B) 2, 4, 3, 5, and 1 C) 5, 4, 1, 2, and 3 D) 5, 4, 3, 2, and 1 Answer: C Terms: Relative costs of obtaining audit evidence Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 13) Tests of controls are generally costlier to perform than analytical procedures. Answer: TRUE Terms: Cost of tests of controls vs. analytical procedures Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 14) Which of the following types of evidence is not available when performing substantive tests of transactions? A) inspection B) confirmation C) inquiries of the client D) reperformance Answer: B Terms: Types of evidence not available when using substantive tests of transactions Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking

15) Which of the following types of evidence is not available when performing tests of controls? A) confirmation B) inspection C) inquiries of the client D) reperformance Answer: A Terms: Types of evidence not available when using substantive tests of transactions Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 16) Which of the following types of evidence is not available when performing tests of details of balances? A) analytical procedures B) inquiries of the client C) recalculation D) inspection Answer: A Terms: Types of evidence not available when using substantive tests of transactions Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 17) Only tests of details of balances involve physical examination and confirmation. Answer: TRUE Terms: Substantive tests of details of balances cost Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 18) Analytical procedures are the least costly type of audit test. Answer: TRUE Terms: Analytical procedures cost Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 19) In a computerized environment, the auditor can often perform substantive tests of transactions quickly for a large sample of transactions. Answer: TRUE Terms: Costs of obtaining audit evidence Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking

20) The cost of each type of evidence does not vary in different situations. Answer: FALSE Terms: Costs of obtaining audit evidence Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 21) Because of the high cost of tests of details of balances, auditors do not perform this type of testing unless fraud is suspected. Answer: FALSE Terms: Tests of details of balances Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 22) The auditor's understanding of system of internal control performed as part of risk assessment procedures provides the basis for the auditor's initial assessment of control risk. Answer: TRUE Terms: Variation in audit evidence in cycles Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 23) Analytical procedures are the most expensive type of audit test to perform because of the expertise and training required to properly use them. Answer: FALSE Terms: Analytical procedures cost Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 24) The results of tests of controls and substantive tests of transactions affect the design of tests of details of balances. Answer: TRUE Terms: Results of tests of controls affect design of tests of details of balances Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 25) If system of internal controls are tested and are considered effective, the auditor generally will increase both substantive tests of transactions and tests of details of balances. Answer: FALSE Terms: Auditor's preliminary assessment of control risk Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 17 Copyright © 2023 Pearson Education, Inc.

26) Tests of controls provide evidence about the likelihood for misstatements in a client's financial statements. Answer: TRUE Terms: Tests of controls; Misstatements in client's financial statements Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 27) An exception in a test of control provides only an indication of the likelihood of monetary misstatements in the financial statements because tests of controls do not reveal whether monetary misstatements have actually occurred. Answer: TRUE Terms: Exception in test of control; Indication of likelihood of monetary misstatements Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 28) If the auditor's test of controls supports the control risk assessment, planned detection risk in the audit risk model is decreased, and planned substantive tests should therefore be reduced. Answer: FALSE Terms: Trade-off between tests of controls and substantive tests Difficulty: Moderate Objective: LO 13-2 AACSB: Reflective thinking 29) Like tests of controls, analytical procedures only indicate the likelihood of misstatements affecting the dollar value of the financial statements. Answer: TRUE Terms: Relationship between substantive analytical procedures and other substantive tests Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking 30) For accounts with small balances and minimal potential for material misstatements, auditors often limit their tests to substantive analytical procedures if they conclude the accounts are reasonably stated. Answer: TRUE Terms: Relationship between substantive analytical procedures and other substantive tests Difficulty: Easy Objective: LO 13-2 AACSB: Reflective thinking

31) There are eight types of audit evidence: physical examination, confirmation, inspection, observation, inquiries of the client, reperformance, analytical procedures, and recalculation. For each of the following types of audit tests, indicate the type(s) of evidence that can be obtained through the test: (1) tests of controls, (2) substantive tests of transactions, (3) analytical procedures, and (4) tests of details of balances. Answer: 1. Tests of controls. Inspection, observation, inquiries of the client, reperformance 2. Substantive tests of transactions. Inspection, inquiries of the client, reperformance, recalculation 3. Substantive analytical procedures. Inquiries of the client, analytical procedures 4. Tests of details of balances. Physical examination, confirmation, inspection, inquiries of the client, reperformance, recalculation Terms: Relationship of audit tests and types of audit evidence Difficulty: Challenging Objective: LO 13-2 AACSB: Reflective thinking 13.3 Learning Objective 13-3 1) Which of the following is generally not included in the "evidence mix"? A) tests of controls B) substantive tests of transactions C) risk assessment procedures D) tests of details of balances Answer: C Terms: Evidence mix Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking 2) The ________ is the combination of the types of tests to obtain sufficient appropriate evidence for a cycle. There are likely to be variations in the mix from cycle to cycle depending on the circumstances of the audit. A) testing mix B) evidence mix C) audit process mix D) procedures mix Answer: B Terms: Evidence mix Difficulty: Easy Objective: LO 13-3 AACSB: Reflective thinking

3) Which of the following would most likely not be included in the evidence mix for an integrated audit of a public company's financial statements and system of internal control over financial reporting? A) sophisticated system of internal controls B) extensive substantive analytical procedures C) extensive tests of details of balances D) low inherent risk Answer: C Terms: Evidence mix Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking 4) If the auditor finds extensive control test deviations and significant misstatements while performing substantive tests of transactions and substantive analytical procedures, A) the cost of the audit should decrease. B) the auditor will conclude that system of internal controls are effective. C) extensive tests of details of balances will need to be performed. D) all of the above. Answer: C Terms: Evidence mix Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking 5) The evidence mix includes risk assessment procedures. Answer: FALSE Terms: Evidence mix and risk assessment procedures Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking 6) The choice of which types of tests to use and how extensively they need to be performed must be the same for all audits. Answer: FALSE Terms: Evidence mix and risk assessment procedures Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking

7) A medium-sized, nonpublic company has few effective controls and significant inherent risks. The auditor in this situation should emphasize tests of details and balances and substantive tests of transactions; no substantive analytical procedures should be performed in this situation by the auditor. Answer: FALSE Terms: Evidence mix and risk assessment procedures Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking 8) A medium-sized company has some controls and a few inherent risks. The auditor in this situation should do a medium amount of testing for all types of tests including substantive analytical procedures. Answer: FALSE Terms: Evidence mix and risk assessment procedures Difficulty: Moderate Objective: LO 13-3 AACSB: Reflective thinking; Analytic thinking 13.4 Learning Objective 13-4 1) The document that details the specific audit procedures for each type of test is the A) audit strategy. B) audit program. C) audit procedure. D) audit risk model. Answer: B Terms: Audit program Difficulty: Easy Objective: LO 13-4 AACSB: Reflective thinking 2) Auditors follow a four-step approach to reduce assessed control risk. Which of the following is not one of the four? A) Apply transaction-related audit objectives to a class of transactions. B) Identify accounts that have high inherent risk. C) Identify key controls that reduce control risk. D) For potential misstatements, design appropriate substantive tests of transactions. Answer: B Terms: Approach to reduce assessed control risk Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking

3) When designing the audit program and the particular audit tests, the auditor should keep in mind that A) the audit program is broken down into two parts—the risk assessment procedures and the tests of details of balances. B) the tests of controls will not vary depending on assessed control risk. C) analytical procedures performed during substantive testing are generally more focused and more extensive than those done as part of planning. D) auditing standards require that the tests contained in the audit program must be approved by the PCAOB. Answer: C Terms: Important consideration in developing the audit program Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 4) The auditor obtained an aged list of receivables and traced the accounts to the master file, footed the schedule, and traced the amounts to the general ledger. Which balance-related audit objective was met? A) existence B) cutoff C) detail tie-in D) all of the above Answer: C Terms: Balance-related audit objectives Difficulty: Easy Objective: LO 13-4 AACSB: Ethical understanding and reasoning 5) One of the most challenging parts of auditing is properly applying the factors that affect tests of details of balances. Answer: TRUE Terms: Tests of details of balances Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 6) Auditing standards require a written audit program. Answer: TRUE Terms: Auditing standards; Audit program Difficulty: Easy Objective: LO 13-4 AACSB: Reflective thinking

7) When designing an audit program for tests of details of balances, the auditor should make assumptions about inherent risk and control risk, and predictions concerning the outcome of tests of controls, substantive tests of transactions, and analytical procedures. Answer: TRUE Terms: Designing audit program; Inherent risk and control risk; Tests of controls, substantive tests of transactions, and analytical procedures Difficulty: Easy Objective: LO 13-4 AACSB: Reflective thinking 8) Once set during the planning phase, the audit program cannot be revised. Answer: FALSE Terms: Audit program Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 9) Inherent risk can be extended to individual balance-related audit objectives. Answer: TRUE Terms: Inherent risk Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 10) When controls are effective and control risk is assessed as low, auditors put heavy emphasis on tests of balances. Answer: FALSE Terms: Control risk assessment Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 11) If control risk is assessed at maximum, only substantive tests of transactions will be used by the auditor, assuming the audit is of a smaller public company, a nonpublic company, or other type of entity. Answer: TRUE Terms: Control risk assessment Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking

12) Analytical procedures performed during substantive testing, such as those for the audit of inventories, are typically more focused and more extensive than those done as part of the audit planning. Answer: TRUE Terms: Control risk assessment Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 13) An example of an auditor using disaggregated data to increase the precision of the auditor's expectations using substantive analytical procedures in the audit of inventories would be to calculate gross margin by product line, rather than calculating the total gross margin for total sales in the planning stage of the audit. Answer: TRUE Terms: Control risk assessment Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking 14) When designing tests of controls and substantive tests, an auditor is gathering evidence to satisfy the transaction-related audit objectives. What are the four steps the auditor would normally follow to reduce assessed control risk? Answer: 1. Apply the transaction-related audit objectives to the class of transactions being tested. 2. Identify key controls that should reduce control risk for each transaction-related audit objective. 3. Develop appropriate tests of controls for all system of internal controls that are used to reduce the preliminary assessment of control risk below maximum (key controls). 4. For potential types of misstatements related to each transaction-related audit objective, design appropriate substantive tests of transactions, considering deficiencies in system of internal control and expected results of the tests of controls. Terms: Four-step approach to reduce assessed control risk Difficulty: Moderate Objective: LO 13-4 AACSB: Reflective thinking

13.5 Learning Objective 13-5 1) There is a direct relationship between the ________ transaction-related audit objective and the ________ balance-related audit objective. A) occurrence; existence B) timing; cutoff C) posting and summarization; detail tie-in D) all of the above Answer: D Terms: Relationship of transaction-related audit objectives to balance-related audit objectives Difficulty: Moderate Objective: LO 13-5 AACSB: Reflective thinking 2) If all transaction-related audit objectives are met, the auditor does not need to perform substantive tests of balances to meet the realizable value audit objective. Answer: FALSE Terms: Relationship of transaction-related audit objectives to balance-related audit objectives Difficulty: Moderate Objective: LO 13-5 AACSB: Reflective thinking 3) The auditor performs tests of controls and substantive procedures to obtain assurance that all audit objectives are achieved for information and amounts included in those disclosures. Answer: TRUE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 13-5 AACSB: Reflective thinking 4) The auditor should design and perform additional audit procedures to evaluate the overall presentation of the financial statements, but not including disclosures, which are the responsibility of management. Answer: FALSE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 13-5 AACSB: Reflective thinking

13.6 Learning Objective 13-6 1) What type of test is used to obtain the most types of evidence? A) substantive tests of transactions B) tests of controls C) risk assessment tests D) tests of details of balances Answer: D Terms: Type of test used to obtain more types of evidence Difficulty: Challenging Objective: LO 13-6 AACSB: Reflective thinking 2) Which phase(s) of the audit uses inquiries of clients as a type of evidence? A) plan and design B) tests of controls and substantive tests of transactions C) completion of the audit and issuance of the audit report D) all of the above Answer: D Terms: Evidence and audit phases Difficulty: Moderate Objective: LO 13-6 AACSB: Reflective thinking 3) Which audit tests involve physical examination and confirmation? A) tests of controls B) tests of transactions C) tests of details of balances D) analytical procedures Answer: C Terms: Audit tests that involve physical examination and confirmation Difficulty: Challenging Objective: LO 13-6 AACSB: Reflective thinking 4) Presentation and disclosure objectives are primarily addressed in the tests of details of balances phase of the audit. Answer: FALSE Terms: Four phases of the audit process Difficulty: Moderate Objective: LO 13-6 AACSB: Reflective thinking

13.7 Learning Objective 13-7 1) Presentation and disclosure related audit objectives would be performed in which phase of the audit process? A) plan and design audit approach B) perform audit tests for controls and transactions C) perform analytical procedures and tests of balances D) complete the audit and issue the audit report Answer: D Terms: Presentation and disclosure-related audit objective performed in what phase of audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 2) Transaction-related audit objectives would most likely be performed in which phase of the audit process? A) plan and design audit approach B) perform tests of controls and substantive tests of transactions C) perform substantive analytical procedures and tests of details of balances D) complete the audit and issue the audit report Answer: B Terms: Transaction-related audit objectives performed in what phase of audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 3) Which of the following is an accurate statement regarding the four phases of the audit process? A) After the planning stage, the auditor should have a well-defined audit strategy and plan and a specific audit program for the entire audit. B) The objective of phase III is to perform tests of controls. C) During phase II, the auditor must evaluate the going-concern assumption. D) All of the above are correct statements. Answer: A Terms: Four phases of the audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking

4) Which of the following tests commonly occur together? A) substantive tests of transactions and tests of controls B) substantive tests of transactions and obtaining an understanding of system of internal controls C) analytical procedures and tests of controls D) tests of controls and tests of details of balances Answer: A Terms: Tests that occur together Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 5) Tests of controls and substantive tests of transactions are an important determinant of the extent of the auditor's use of tests of details of balances. Which of the following is true? A) They are likely to be performed prior to the client's end of the fiscal year. B) They are likely to eliminate the need for tests of details of balances. C) They are likely to have no impact on the planned tests of details of balances. D) They are likely to be used only in the audit of system of internal control. Answer: A Terms: Four parts of AICPA Code of Professional Conduct Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 6) When the auditor has completed the tests of details of balances and enters phase IV of the audit process, she or he must still perform audit procedures for which of the following? A) contingent liabilities and employee compensation B) contingent liabilities and subsequent events C) subsequent events and contractual commitments D) subsequent events and unrecorded liabilities Answer: B Terms: Audit procedures performed in phase 4 of audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 7) Which of the following audit tests would be regarded as a test of controls? A) comparison of the inventory pricing to vendors' invoices B) tests of the signatures on canceled checks to board of directors' authorizations C) tests of the additions to property, plant, and equipment by physical inspections D) review of the specific items making up the balance in a given general ledger account Answer: B Terms: Tests of controls audit tests Difficulty: Moderate Objective: LO 13-7 AACSB: Analytic thinking

8) Which of the following audit tests form the basis for an auditor's report on system of internal control over financial reporting? A) analytical procedures B) tests of transactions C) tests of controls D) tests of details of balances Answer: C Terms: Audit tests that form basis for auditor's report on system of internal control Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 9) Management implements system of internal controls to ensure that all required footnote disclosures are accurate. Auditors tests those controls to provide evidence supporting the ________ of the presentation. A) completeness and valuation B) completeness and accuracy C) rights and obligations and existence D) occurrence and accuracy Answer: B Terms: Phase 4 of audit Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 10) At what point in the audit process are tests of details most appropriately designed? A) plan and design audit approach B) perform audit tests of controls and substantive tests of transactions C) perform substantive analytical procedures and tests of details of balances D) complete the audit and issue the audit report Answer: C Terms: Four phases of the audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 11) Which of the following is not completed during phase IV of the audit? A) Obtain a client representation letter. B) Read information in the annual report to make sure that it is consistent with the financial statements. C) Perform substantive tests of transactions. D) Perform final analytical procedures. Answer: C Terms: Four phases of the audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

12) For clients with highly sophisticated computerized accounting systems, auditors perform tests throughout the year to identify significant or unusual transactions. This approach is called ________ and is frequently used in integrated audits of financial statements and system of internal control for public companies. A) continuous audit program B) continuous auditing C) continuous analytical testing D) continuous audit mix Answer: B Terms: Continuous auditing Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 13) Analytical procedures performed during phase III of the audit A) must be performed before the balance sheet date. B) can be used as a means of planning and directing other audit tests to specific areas. C) should be done after tests of details of balances. D) are expensive and are therefore not frequently used by the auditor. Answer: B Terms: Four phases of the audit process Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 14) The auditor must communicate significant deficiencies in system of internal control only after the entire audit is complete to ensure the auditor has a sufficient understanding of the circumstances surrounding the deficiency. Answer: FALSE Terms: Auditor communicates significant deficiencies in system of internal control Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 15) Subsequent events represent events that occasionally occur after the balance sheet date, but before the issuance of the financial statements and the auditor's report, that have an effect on the financial statements. Answer: TRUE Terms: Subsequent events Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking

16) Substantive tests of balances performed before year-end provide significant assurance and are normally only done when system of internal controls are ineffective. Answer: FALSE Terms: Substantive tests Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 17) It is inappropriate for the auditor to make written suggestions to management to improve business performance upon completion of the audit. Answer: FALSE Terms: Auditor communications with audit committee and management Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 18) In phase IV of the audit, complete the audit and issue an audit report, there are five activities required. List below the activities. Answer: 1. perform additional tests for presentation and disclosure 2. accumulate final evidence 3. evaluate results 4. issue audit report 5. communicate with audit committee and management Terms: Phase 4 of audit Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking 19) In accumulating final evidence upon which to base an audit opinion, the auditor should perform four activities. List the activities below. Answer: 1. perform final analytical procedures 2. evaluate the going concern assumption 3. obtain a client representation letter 4. read information in the annual report to ensure that it is consistent with the financial statements Terms: Accumulating final evidence and final activities Difficulty: Moderate Objective: LO 13-7 AACSB: Reflective thinking

20) Discuss the major activities and procedures performed by the auditor in the plan and design of the audit approach. Answer: The major activities performed in the planning and design phase (Phase I) are: • accept client and perform initial planning • understand the client's business and industry • perform preliminary analytical procedures • set preliminary judgment of materiality and performance materiality • identify significant risks due to fraud or error • assess inherent risk • understand system of internal control and assess control risk • finalize overall audit strategy and audit plan Terms: Major activities and procedures performed by auditor in the plan and design of the audit approach Difficulty: Challenging Objective: LO 13-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 14 Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 14.1 Learning Objective 14-1 1) Which of the following is an account that is not affected by the sales and collection cycle? A) cash B) accounts receivable C) allowance for doubtful accounts D) accounts payable Answer: D Terms: Sales and collection cycle Difficulty: Easy Objective: LO 14-1 AACSB: Reflective thinking 2) The auditor's objectives for the sales and cash collections activities when the client is primarily an e-commerce business as compared to a "brick and mortar" business are A) unchanged. B) expanded. C) mitigated. D) decreased. Answer: A Terms: Auditor's objectives for sales and cash collections Difficulty: Moderate Objective: LO 14-1 AACSB: Analytic thinking 3) The overall objective in the audit of the sales and collection cycle is to evaluate whether the account balances affected by the cycle are fairly presented in accordance with accounting standards. Answer: TRUE Terms: Objective in audit of sales and collection cycle; Account balances fairly presented Difficulty: Easy Objective: LO 14-1 AACSB: Reflective thinking 4) The sales and collection cycle applies to businesses that sell goods to customers or provide services to customers. Answer: TRUE Terms: Sales and collection cycle Difficulty: Moderate Objective: LO 14-1 AACSB: Reflective thinking

5) There are no differences in the nature and the account titles in the sales and collection cycle for a service industry, a retail company, and an insurance company, for example. Answer: FALSE Terms: Sales and collection cycle Difficulty: Moderate Objective: LO 14-1 AACSB: Reflective thinking 6) Name the five classes of transactions included in the sales and collection cycle. Answer: Sales (cash and sales on account); cash receipts; sales returns and allowances; writeoff of uncollectable accounts; and estimate of bad debt expense. Terms: Accounts and transactions in the sales and collection cycle Difficulty: Moderate Objective: LO 14-1 AACSB: Reflective thinking 14.2 Learning Objective 14-2 1) Which of the following is not one of the five classes of transactions included in the sales and collection cycle? A) sales returns and allowances B) write-off of uncollectible accounts C) bad debt expense D) interest income Answer: D Terms: Classes of transactions; Sales and collection cycle Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 2) What event initiates a transaction in the sales and collection cycle? A) receipt of cash B) delivery of product to a customer C) identification of a new customer D) customer request for goods or services Answer: D Terms: Customer request for goods Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

3) A ________ is a document that indicates a request for merchandise by a customer. A) sales invoice B) vendor invoice C) customer order D) sales order Answer: C Terms: Customer order Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 4) A ________ is a document for communicating the description, quantity, and related information for goods ordered by a customer. A) sales order B) customer order C) vendor invoice D) sales invoice Answer: A Terms: Sales order Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 5) What critical event must take place before goods can be shipped in order to assure payment can be reasonably expected? A) determination of correct delivery address B) credit approval C) matching of shipping document with sales invoice D) receipt of sales order from the customer Answer: B Terms: Goods shipped on account; credit approval Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 6) Before goods are shipped on account, a properly authorized person must A) prepare the sales invoice. B) approve the journal entry. C) approve the customer's credit. D) verify that the unit price is accurate. Answer: C Terms: Goods shipped on account; credit approval Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

7) One type of shipping document is the ________, which is a written contract between the carrier and the seller of the receipt and shipment of goods. A) sales order B) bill of lading C) sales invoice D) customer order Answer: B Terms: Document prepared to initiate shipment of goods Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 8) The document used to indicate to the customer the amount of a sale and payment due date is the A) sales invoice. B) bill of lading. C) purchase order. D) sales order. Answer: A Terms: Document used to indicate amount of sale and payment due date Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 9) Which of the following is not an important aspect of billing? A) All shipments made have been billed. B) No shipment has been billed more than once. C) Each customer is billed for the proper amount. D) Credit is approved to customers for sales on account. Answer: D Terms: Sales and collection cycle Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 10) Most companies recognize sales revenue when A) sales are invoiced. B) payment is received from the customer. C) goods are shipped. D) the customer's order is received. Answer: C Terms: Recognize sales revenue Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

11) Which of the following is not a business function within the "Sales" class of transactions? A) processing customer orders B) granting credit C) processing and recording sales returns and allowances D) shipping goods Answer: C Terms: Business function within the sales class of transactions Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 12) The total of the individual account balances in the accounts receivable master file should equal the A) total sales for the period. B) balance of the sales account in the general ledger. C) total sales less the total cash received for the period. D) balance of the accounts receivable account in the general ledger. Answer: D Terms: Accounts receivable master file Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 13) In the accounts receivable master file, the length of time the account has been due can be useful to the client and the auditor in preparing the A) trial balance. B) working trial balance. C) accounts receivable trial balance. D) aged accounts receivable trial balance. Answer: D Terms: Accounts receivable master file Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 14) A document sent to each customer showing his or her beginning accounts receivable balance and the amount and date of each sale, cash payment received, any debit or credit memo issued, and the ending balance is the A) accounts receivable subsidiary ledger. B) monthly statement. C) remittance advice. D) sales invoice. Answer: B Terms: Document sent to customer showing beginning accounts receivable balance Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

15) The document that accompanies the customer's payment is the A) credit memo. B) remittance advice. C) vendor invoice. D) monthly statement. Answer: B Terms: Document that accompanies customer's payment Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 16) A ________ indicates a reduction in the amount due from a customer because of returned goods or an allowance. A) bill of lading B) sales invoice C) credit memo D) monthly statement Answer: C Terms: Credit memos Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 17) A ________ is a list prepared when cash is received by someone who has no responsibility for recording sales, accounts receivable, or cash, and who has no access to the accounting records. A) prelisting of cash receipts B) sales invoice C) packing ticket D) vendor invoice Answer: A Terms: Prelisting of cash receipts Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 18) When dealing with the processing and recording of cash receipts, A) the most important concern is the theft of cash. B) theft can only occur before the receipts are entered into the records. C) cash receipts should be deposited at least monthly. D) the monthly statement is used to prepare the cash receipts journal. Answer: A Terms: Processing and recording cash receipts Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

19) Some companies have customers send payments directly to an address maintained by a bank. This is called a(n) ________ system. A) direct deposit B) funds transfer C) lockbox D) interbank transfer Answer: C Terms: Payments sent to post office box Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 20) Which of the following is a business function related to sales returns and allowances? A) processing customer orders B) writing off uncollectible accounts C) processing and recording credit memos D) granting credit Answer: C Terms: Designing audit procedures sales returns and allowances Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 21) For a firm that practices good internal controls in the sales and collections cycle, the function of indicating credit approval should be recorded on which of the following documents? A) sales order B) sales invoice C) customer order D) remittance advice Answer: A Terms: Good system of internal controls in sales and collection cycle; Credit approval Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking

22) When posting items sold on account from the sales journal A) Details of the journal are posted to Journal totals are posted to The sales account The general ledger B) Details of the journal are posted to The sales account

Journal totals are posted to The accounts receivable subsidiary ledger

Details of the journal are posted to The accounts receivable master file

Journal totals are posted to The general ledger

Details of the journal are posted to The accounts receivable account in the general ledger

Journal totals are posted to The sales account in the general ledger

Answer: C Terms: Posting from sales journal; Details of journal and journal totals posted Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 23) Which document or record is used in the write-off of uncollectible accounts classes of transactions? A) general journal B) remittance advice C) sales transaction file D) sales order Answer: A Terms: Business function within the sales class of transactions Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 24) Who is generally responsible for opening receipts when a company uses a lockbox to speed the handling of cash receipts? A) company personnel B) temporary employees in the town where the lockbox is located C) bank employees D) company controller Answer: C Terms: Opening receipts; Lockbox Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 8 Copyright © 2023 Pearson Education, Inc.

25) Which of the following is a correct statement regarding the shipment of goods? A) The shipping document must be in paper form. B) The shipping document is used to update the perpetual inventory records. C) Only one copy of the shipping document is needed. D) All of the above are correct statements. Answer: B Terms: Shipping records and inventory records Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 26) Which accounts are involved in the sales class of transactions? A) accounts receivable and sales returns and allowances B) cash and allowance for uncollectible accounts C) sales allowances and accounts receivable D) accounts receivable and sales Answer: D Terms: Business function within the sales class of transactions Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 27) A sales invoice is a document that usually indicates credit approval. Answer: FALSE Terms: Sales invoice; Credit approval Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 28) Credit should be approved before a customer's order is received. Answer: FALSE Terms: Credit approved Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 29) Credit should be approved before goods are shipped to a customer. Answer: TRUE Terms: Credit approved Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

30) The receipt of a customer order from a customer is the starting point for the entire sales and collection cycle. Answer: TRUE Terms: Customer order Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 31) The preparation of a sales invoice is the final step in the sales and collection cycle. Answer: FALSE Terms: Sales invoice; Final step in sales and collection cycle Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 32) A bill of lading is a special type of sales invoice used when goods are shipped interstate. Answer: FALSE Terms: Bill of lading; Sales invoice Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 33) The shipping point is critical because it is the first point at which company assets are released to another party. Answer: TRUE Terms: Shipping point critical; Assets released Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 34) A bill of lading is a written contract between the seller and the buyer. Answer: FALSE Terms: Bill of lading; Written contract Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 35) In a lockbox system, bank employees are responsible for opening cash receipts and maintaining records of all payments made by customers at the lockbox address. Answer: TRUE Terms: Lockbox system Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking

36) Sales transactions are the result of the following five functions in the sales and collection cycle: processing customer orders, granting credit, shipping goods, billing customers, and recording sales. Answer: TRUE Terms: Sales and collection cycle Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 37) The prelisting of cash receipts should be prepared by the individual who has primary responsibility for the recording of cash receipts. Answer: FALSE Terms: Prelisting of cash receipts Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 38) A credit memo is a document used internally that indicates authority to write-off an account receivable as uncollectible. Answer: FALSE Terms: Credit memos Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 39) If a company uses a periodic inventory system, the shipping records are used to update the inventory quantities. Answer: FALSE Terms: Shipping records and inventory records Difficulty: Moderate Objective: LO 14-2 AACSB: Analytic thinking 40) The sales journal is generated from the sales transaction file. Answer: TRUE Terms: Sales transaction file and sales journal Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 41) When customers purchase goods by credit card, the issuer of the credit card uses EFT to transfer funds into the company's bank account. Answer: TRUE Terms: EFT transactions Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 11 Copyright © 2023 Pearson Education, Inc.

42) The theft of cash can occur before receipts are entered in the records or after they are entered in the records. Answer: TRUE Terms: Processing and recording cash receipts Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 43) It is equally important that companies maintain and have available to the auditor documents related to the sales and collection cycle in order for the auditor to test the controls in this transaction cycle. Answer: TRUE Terms: Audit trail — documents related to the sales and collection cycle Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 44) The bill of lading is often generated electronically once the goods have been shipped to a customer, and automatically generates the related sales invoice as well as the required entry in the sales journal to record the sale. Answer: TRUE Terms: Shipping documents including bill of lading and the sales invoice Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 45) One of the most important aspects of billing is ensuring all shipments made are billed (completeness); inaccurate billing can always be corrected at a later date. Answer: FALSE Terms: Billing sales correctly Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 46) The term accounts receivable master file is sometimes called the accounts receivable subsidiary ledger or subledger. Answer: TRUE Terms: Accounts receivable master file Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

47) Proper accounting requires an adjustment to the allowance for uncollectible accounts after a customer with an unpaid balance to the company has declared bankruptcy or after the account has been turned over to a collection agency. Answer: TRUE Terms: Writing off uncollectible accounts receivable Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 48) Accounting principles do not require companies to record bad debt expense for the amount of customer receivables on the balance sheet they do not expect to collect until the customer has declared bankruptcy or after the customer's account has been turned over to a collection agency. Answer: FALSE Terms: Providing for bad debts Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking 49) Explain each of the following types of documents and indicate the class of transactions in which they are commonly used. 1. customer order 2. shipping document 3. remittance advice 4. sales returns and allowance journal 5. uncollectible account authorization form Answer: 1. Customer order – request for merchandise by a customer. Appears in the sales class of transactions. 2. Shipping document – document prepared to initiate shipment of goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. Appears in the sales class of transactions. 3. Remittance advice – document that is mailed to the customer and typically returned to the seller with payment. Appears in the cash receipts class of transactions. 4. Sales returns and allowance journal – journal used to record all sales returns and allowances. It performs the same function as the sales journal. Appears in the sales returns and allowance class of transactions. 5. Uncollectible account authorization form – document used internally to indicate authority to write off an account receivable. Appears in the write-off of uncollectible accounts class of transactions. Terms: Documents and class of transactions Difficulty: Easy Objective: LO 14-2 AACSB: Reflective thinking

50) You are an audit manager for Rodgers & Co. and have recently taken on a new client, Manufacturing Company. You are in the initial stages of planning the audit and have decided to start gathering information about the sales/collection cycle of the business. List below the classes of transactions that you need to gather audit evidence for in designing your audit procedures. Answer: The five classes of transactions that comprise the sales and collection cycle are: • sales • cash receipts • sales returns and allowances • write-off of uncollectible accounts • bad debt expense Terms: Classes of transactions; Sales and collection cycle Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 51) Customer billing is a critical process which auditors must understand. What are the most important aspects of billing and what are the related objectives? Answer: The most important aspects of billing are: • to make sure that all shipments made have been billed (completeness) • that no shipment has been billed more than once (occurrence) • that each shipment is billed for the proper amount (accuracy) Terms: Aspects of billing and related objectives Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking 52) Discuss the four business functions that result in sales transactions in a typical sales and collection cycle and, for each function, state the key documents and records involved. Answer: The four business functions that result in sales transactions, and the related key documents and records, are: • Processing customer orders. Key documents include customer order and sales order • Granting credit. Customer order or sales order • Shipping goods. Shipping document (bill of lading) • Billing customers and recording sales. Sales invoice, sales transaction file, sales journal or listing, accounts receivable master file, accounts receivable trial balance, and monthly statements Terms: Business functions that result in sales transactions; Sales and collection cycle; Documents Difficulty: Challenging Objective: LO 14-2 AACSB: Analytic thinking

53) Match seven of the terms for documents and records (a-k) with the descriptions provided below (1-7). a. customer order form b. sales order c. bill of lading d. sales invoice e. summary sales report f. accounts receivable master file g. monthly statement h. remittance advice i. prelisting of cash receipts j. credit memo k. uncollectible account authorization form ________ 1. A list prepared when cash is received by someone who has no responsibility for recording sales, accounts receivable, or cash, and has no access to the accounting records. It is used to verify whether cash received was recorded and deposited at the correct amounts and on a timely basis. ________ 2. A document indicating a reduction in the amount due from a customer because of returned goods or an allowance. ________ 3. A document prepared to initiate shipment of goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. It is a written contract between the carrier and seller of the receipt and shipment of goods. ________ 4. A document for communicating the description, quantity, and related information for goods ordered by a customer. This is frequently used to indicate credit approval and authorization for shipment. ________ 5. A document mailed to the customer and typically returned to the seller with the cash payment. ________ 6. A document used internally to indicate authority to write-off an account receivable as uncollectible. ________ 7. A document or electronic record indicating the description and quantity of goods sold, the price, freight charges, insurance, terms, and other relevant data. Answer: 1. i, 2. j, 3. c, 4. b, 5. h, 6. k, 7. d Terms: Documents and records Difficulty: Moderate Objective: LO 14-2 AACSB: Reflective thinking

14.3 Learning Objective 14-3 1) When designing audit procedures, tracing of source documents to the customer's subsidiary ledger and subsequently to the general ledger is done to satisfy what assertion? A) valuation B) cutoff C) completeness D) classification Answer: C Terms: Tracing of source documents; direction of tests Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking 2) When assessing control risk, the auditor must do all of the following except A) assess control risk for each objective by evaluating the controls and deficiencies for each objective. B) perform the detailed test of balances. C) identify the key system of internal controls and deficiencies. D) associate the key controls and deficiencies with the objectives. Answer: B Terms: Assess control risk Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking 3) When sales invoices are automatically calculated and posted by a computer, the auditor may be able to reduce substantive tests of transactions for which, if any, assertion? A) accuracy B) existence C) completeness D) none of the above Answer: A Terms: Reduce substantive tests of transactions Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking

4) In many audits, no substantive tests of transactions are made for the ________ assertion on the grounds that understatement of sales is not a concern. A) accuracy B) existence C) completeness D) none of the above Answer: C Terms: No substantive tests of transactions; Assertion; understatement of sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 5) Which one the following procedures performed for the billing function provides evidence for the completeness assertion? A) making sure that all shipments have been billed B) making sure that no shipment has been billed more than twice C) making sure that each shipment is billed at the correct amount D) making sure that each shipment is billed to the proper customer Answer: A Terms: Procedures; Billing function; Completeness assertion Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 6) When assessing planned control risk for sales, A) the key system of internal controls and deficiencies for sales will be the same for every company. B) the audit objectives for sales will differ from company to company. C) a flowchart is required to help assess control risk for sales. D) assessing control risk for sales is a highly subjective decision. Answer: D Terms: Access control risk Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

7) Which of the following is an accurate statement relating to separation of duties? A) Management should deny cash access to anyone responsible for entering sales and cash receipts transaction information into the computer. B) All disagreements on the monthly statements should be directed to a designated person who has no responsibility for handling cash or recording sales or accounts receivable. C) The credit granting function should be separate from the sales function. D) All of the above are accurate statements. Answer: D Terms: Separation of duties Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 8) Which of the following is not a key control for sales and cash receipts? A) active board of directors B) adequate separation of duties C) internal verification procedures D) adequate documents and records Answer: A Terms: Key controls Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 9) Which one of the following statements is true? In deciding on substantive tests of transactions, A) some procedures are commonly employed on every audit regardless of the circumstances. B) all procedures are dependent on the adequacy of the controls and the results of the tests of controls. C) results obtained in the prior year's audit will not affect the procedures used this year. D) the materiality of the item will not influence the choice of procedures used. Answer: A Terms: Substantive tests of transactions Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 10) To test for recorded sales for which there were no actual shipments, the auditor vouches from the A) bill of lading to the sales journal. B) sales journal to the shipping documents. C) sales journal to the accounts receivable subsidiary ledger. D) bill of lading to the supporting customer order and sales order. Answer: B Terms: Test for recorded sales with no actual shipments Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

11) An effective procedure to test for unfilled shipments is to trace from the A) sales journal to the shipping documents. B) shipping documents to the sales journal. C) sales journal to the accounts receivable ledger. D) sales journal to the general ledger sales account. Answer: B Terms: Procedure for unbilled shipments Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 12) The auditor traces items from the source documents to the journals in order to accumulate audit evidence that will satisfy the A) existence objective. B) completeness objective. C) ownership objective. D) valuation objective. Answer: B Terms: Trace items from source documents to journals Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 13) In many audits of sales transactions substantive tests of transactions can be reduced in determining the completeness objective because A) understatements of assets and income are a greater concern than overstatements. B) overstatements of assets and income are a greater concern than understatements. C) it doesn't matter if income is understated because the savings on income tax offsets the reduced revenue and net income is correct. D) the unrecorded sales cause a reduction of accounts receivable; therefore, the ratios of the two financial statements will not be misleading. Answer: B Terms: Audit of sales transactions; Substantive tests of transactions; Completeness objective Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

14) To determine that sales are accurately recorded, the unit prices on the duplicate sales invoices are normally compared with A) the original invoices. B) an approved master price list. C) the amounts recorded in the sales journal for that transaction. D) the amounts posted to the customer's account in the accounts receivable master file. Answer: B Terms: Sales accurately recorded Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 15) Prenumbered documents are intended to help A) Prevent the failure to bill or Prevent duplicate billings or record sales recordings of sales Yes Yes B) Prevent the failure to bill or Prevent duplicate billings or record sales recordings of sales No No C) Prevent the failure to bill or Prevent duplicate billings or record sales recordings of sales Yes No D) Prevent the failure to bill or Prevent duplicate billings or record sales recordings of sales No Yes Answer: A Terms: Prenumbered documents Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

16) Prenumbered documents will only be useful for control purposes if A) a different numerical sequence is used for each company. B) the sequence is accounted for periodically. C) employees are allowed to use documents out of numerical sequence. D) the same numerical sequence is used each accounting period. Answer: B Terms: Prenumbered documents; Control purposes Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 17) ________ tests are for omitted transactions, while ________ tests are for nonexistent transactions. A) Tracing; vouching B) Vouching; tracing C) Verifying; tracking D) Tracking; verifying Answer: A Terms: Tests for omitted transactions and nonexistent transactions Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 18) Which one of the following best describes the auditor's responsibilities regarding appropriate authorizations in the sales/collections cycle? A) Credit must be authorized before the sale. B) Goods must be shipped after the authorization. C) Prices must be authorized. D) All of the above should be of concern to the auditor. Answer: D Terms: Authorizations in sales/collection cycle Difficulty: Challenging Objective: LO 14-3 AACSB: Reflective thinking 19) Which type of misstatement is always a fraud? A) sales included in the journals for which no shipment was made B) sales to related parties, such as officers and subsidiaries C) shipments made to nonexistent customers and recorded as sales D) sales recorded more than once Answer: C Terms: Fraud and errors Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

20) An auditor needs to determine whether all customers of an electric utility company are being billed. The auditor should test from the A) sales register to the accounts receivable ledger. B) sales register to the meter department records. C) accounts receivable ledger to the sales register. D) meter department records to the sales register. Answer: D Terms: All customers being billed Difficulty: Challenging Objective: LO 14-3 AACSB: Analytic thinking 21) Which one of the following would the auditor consider to be an incompatible operation if the cashier receives remittances from the mail room? A) The cashier prepares the daily deposit. B) The cashier makes the daily deposit at a local bank. C) The cashier posts the receipts to the accounts receivable subsidiary ledger cards. D) The cashier endorses the checks. Answer: C Terms: Incompatible operation if cashier receives remittance; Segregation of duties Difficulty: Challenging Objective: LO 14-3 AACSB: Reflective thinking 22) Which of the following is the appropriate point at which the auditor deems authorization to be critical? A) Credit granting Price authorization Shipment of goods Yes Yes Yes B) Credit granting Yes

Price authorization No

Shipment of goods Yes

Credit granting No

Price authorization Yes

Shipment of goods No

Credit granting Yes

Price authorization No

Shipment of goods No

23) Which of the following would least concern an auditor regarding the lack of a specific authorization to conduct the sales transaction? A) granting of credit B) shipment of goods C) determination of discounts D) selling of goods for cash Answer: D Terms: Specific authorization to conduct sales transactions Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 24) As a test of control, the auditor examines sales invoices for supporting documents. The relevant transaction-related audit objective is A) accuracy. B) occurrence. C) classification. D) timing. Answer: A Terms: Transaction-related audit objectives Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 25) The accurate recording of sales transactions concerns all of the following except for A) proper credit authorization. B) shipping the amount of goods ordered. C) accurately billing for the amount of goods shipped. D) accurately recording the amount billed in the accounting records. Answer: A Terms: Sales recorded Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

26) Auditors must carefully understand FASB ASC Topic 606, Revenue From Contracts With Customers, in designing their revenue-related auditing procedures. Which of the following is not a best practice the auditor should avoid in auditing revenue subject to this accounting standard? A) Auditors should inspect significant contracts or agreements, but including abstracts or copies of them are not required in their audit documentation. B) Auditors should inspect significant contracts or agreements and include abstracts or copies of them in their audit documentation. C) Auditors should obtain an understanding of the client's contract terms and related procedures implemented by the client to comply with ASC Topic 606. D) Auditors should perform substantive testing with respect to any significant estimates made by the client in recording estimated revenues. Answer: A Terms: Revenue recognition Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking; Analytic thinking 27) Separation of duties in the sales and collection cycle should mandate that the credit-granting function be separate from the sales function. Answer: TRUE Terms: Separation of duties in the sales and collection cycle; credit-granting function Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking 28) Tracing from source documents to the journal is useful for testing the existence objective. Answer: FALSE Terms: Tracing; Existence objective Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 29) The extent of tests of controls in audits of nonpublic companies depends on the effectiveness of the controls and the extent to which the auditor believes they can be relied on to reduce control risk. Answer: TRUE Terms: Tests of controls Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

30) For each key control, one or more tests of controls must be designed to verify its effectiveness. Answer: TRUE Terms: Key controls Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking 31) Misstatements involving the completeness objective for sales lead to overstatements of assets and income. Answer: FALSE Terms: Misstatements involving the completeness objective for sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 32) Violations of the occurrence/existence objective for sales are of greater concern to the auditor than violations of the completeness objective. Answer: TRUE Terms: Violations of the existence objective for sales; violations of the completeness objective Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 33) An effective procedure to test the occurrence/existence objective for sales is to vouch sales journal entries to copies of sales orders, shipping documents, and sales invoices. Answer: TRUE Terms: Procedure to test the existence objective for sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 34) For each significant internal control deficiency identified by the auditor, he or she should design one or more tests of controls to assess the extent of the deficiency and its effect on the financial statements. Answer: TRUE Terms: Significant system of internal control deficiency; Tests of controls Difficulty: Challenging Objective: LO 14-3 AACSB: Reflective thinking

35) The appropriate tests of controls for separation of duties are ordinarily restricted to the auditor's observations of activities and discussions with personnel. Answer: TRUE Terms: Test of controls for separation of duties Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 36) Auditing standards indicate that if the auditor identifies a significant risk at the assertion level, the auditor is not required to perform substantive procedures. Answer: FALSE Terms: Substantive test of transactions Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 37) Computer programs or independent personnel should check that the processing and recording of sales transactions fulfill each transaction-related audit objective. Examples include reviewing financial statements and footnote disclosures for proper aggregation, relevance, and understandability. Answer: TRUE Terms: Internal verification procedures Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 38) If a design test of controls for sales is working (for example, testing internal controls for electronic approval for customer orders after they have been approved for credit), the test of control is to examine the customer order for proper approval. Answer: TRUE Terms: Design tests of controls for sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 39) Certain internal controls related to financial statement presentation and footnote disclosures operate infrequently, such as quarterly or annually when the financial statements are prepared. Answer: TRUE Terms: Design tests of control for sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

40) Common tests of system of internal controls related to financial statement presentation and footnote disclosures include observing or examining an indication of management's review and approval of information presented and disclosed in the financial statements. Answer: TRUE Terms: Design tests of control for sales Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 41) It is not important that the auditor evaluate and test a client's assertions early in the audit with regards to significant or unusual sales transactions, as long as the auditor evaluates and tests these assertions before the audit is completed. Answer: FALSE Terms: Footnote disclosures are relevant and understandable Difficulty: Easy Objective: LO 14-3 AACSB: Reflective thinking 42) FASB ASC Topic 606, Revenue From Contracts With Customers, is one of the most significant changes ever in U.S. GAAP. This principles-based standard requires consideration by the auditor of a five-step framework in designing their auditing procedures. Answer: TRUE Terms: Revenue recognition Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking 43) In designing substantive audit procedures for tests of transactions for sales, the auditor needs to test for evidence of misstatements due to errors or fraud. Describe two potential errors (unintentional) and one intentional (fraud). Answer: 1. Unintentional—sales included in the journals for which no shipment was made and sales that were recorded more than once. 2. Intentional (fraud)—shipments made to nonexistent customers and recorded as sales. Terms: Substantive audit procedures for tests of transactions for sales; Misstatements; Fraud Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

44) For each of the following potential misstatements, provide one potential audit test that could be used to detect the misstatement. • sales included in the journals for which there was no shipment • sale recorded more than once • shipments made to nonexistent customers and recorded as sales Answer: The potential audit tests include the following: • Sales included in the journals for which there was no shipment. Vouch selected entries in the sales journal to related copies of shipping and other supporting documents to make sure they occurred. • Sale recorded more than once. Review a numerically sorted list of recorded sales transactions for duplicate numbers. The auditor can also test for proper cancellation of shipping documents. • Shipments made to nonexistent customers and recorded as sales. Trace customer information on sales invoices to the customer master file. Terms: Audit test used to detect misstatement Difficulty: Challenging Objective: LO 14-3 AACSB: Reflective thinking 45) The auditor is concerned about authorization at three key points. What are the key points? Answer: 1. Credit must be properly authorized before a sale takes place. 2. Goods should be shipped only after proper authorization. 3. Prices including base terms, freight, and discounts must be authorized. Terms: Proper authorization at key points Difficulty: Moderate Objective: LO 14-3 AACSB: Reflective thinking

14.4 Learning Objective 14-4 1) Except for two key differences, the transaction-related audit objectives are essentially the same for the processing of credit memos as they are for sales. Which of the following are the two key differences? A) risk and emphasis on the completeness objective B) materiality and emphasis on the accuracy objective C) risk and emphasis on the classification objective D) materiality and emphasis on the occurrence objective Answer: D Terms: Transaction-related audit objectives for credit memos and sales Difficulty: Moderate Objective: LO 14-4 AACSB: Reflective thinking 2) Smith Manufacturing Company's accounts receivable clerk has a friend who is also a customer of Smith Manufacturing. The accounts receivable clerk has issued fictitious credit memos to his friend for goods supposedly returned. The most effective procedure for preventing this activity is to A) prenumber and account for all credit memorandums. B) require receiving reports that provide evidence of returned inventory items to support all credit memorandums before they are approved. C) have independent sales and accounts receivable departments. D) mail monthly statements to customers. Answer: B Terms: Fictitious credit memos; Procedure to prevent activity Difficulty: Challenging Objective: LO 14-4 AACSB: Analytic thinking 3) When auditors evaluate sales returns and allowances, a primary emphasis is on the objective of occurrence. Answer: TRUE Terms: Sales returns and allowances; Objective of occurrence Difficulty: Easy Objective: LO 14-4 AACSB: Reflective thinking 4) Sales returns and allowances are often ignored by auditors because they are often immaterial. Answer: TRUE Terms: Sales returns and allowances; Immaterial Difficulty: Moderate Objective: LO 14-4 AACSB: Reflective thinking

5) When auditing sales returns and allowances, the emphasis is normally on testing the completeness objective. Answer: FALSE Terms: Auditing sales returns and allowances; Completeness objective Difficulty: Moderate Objective: LO 14-4 AACSB: Reflective thinking 6) When auditing sales returns and allowances, tests performed by the auditor are usually focused on whether the returns and the allowances were appropriately authorized and approved, internally. Answer: TRUE Terms: Auditing sales returns and allowances; Completeness objective Difficulty: Moderate Objective: LO 14-4 AACSB: Reflective thinking 7) The transaction-related audit objectives and the client's methods of controlling misstatements are essentially the same for credit memos as for sales with the exception of two differences. What are the two differences from the auditor's perspective? Answer: The first difference is materiality. In many instances, sales returns and allowances are so immaterial that auditors ignore them. The second difference is the emphasis on the occurrence objective. For sales returns and allowances, auditors usually emphasize testing recorded transactions to uncover any theft of cash from the collection of accounts receivable that was covered up by a fictitious sales return or allowance. Terms: Transaction-related audit objectives for credit memos and sales Difficulty: Moderate Objective: LO 14-4 AACSB: Reflective thinking

14.5 Learning Objective 14-5 1) When an employee who is authorized to make customer entries in the accounts receivable subsidiary ledger purposefully enters cash received into the wrong customer's account, that employee may be suspected of A) kiting. B) lapping. C) floating. D) shorting. Answer: B Terms: Lapping Difficulty: Moderate Objective: LO 14-5 AACSB: Analytic thinking 2) An audit procedure that compares the name, amount, and dates shown on remittance advices with cash receipts journal entries and with related duplicate deposit slips would be effective in detecting A) kiting. B) lapping. C) unauthorized write-offs of customers as uncollectible accounts. D) sales without proper credit authorization. Answer: B Terms: Lapping Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 3) Which of the following tests of controls is useful to test the transaction-related audit objective of posting and summarization? A) Observe whether monthly statements are sent. B) Observe unrecorded cash at a point in time. C) Observe whether the accountant reconciles the bank account. D) Observe endorsement of incoming checks. Answer: A Terms: Posting and summarization transaction-related audit objective Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking

4) The audit procedure referred to as proof of cash receipts is particularly useful to test A) time lags in making deposits. B) whether all recorded cash receipts have been deposited in the bank. C) whether there are cash receipts that have not been recorded in the journals. D) the client's reconciliation between cash receipts and bank deposits. Answer: B Terms: Audit procedure; Proof of cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Analytic thinking 5) Which of the following test of controls is useful to test the completeness objective for cash receipts? A) Compare shipping documents with sales records. B) Observe endorsement of incoming checks. C) Examine evidence that the receivable master file is reconciled to the general ledger. D) Observe if the client reconciles the bank account. Answer: B Terms: Audit procedures; Test completeness objective (assertion) for cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 6) When designing tests of controls and substantive tests of transactions for cash receipts, it is important to remember that A) the test of controls are designed to test for monetary misstatements. B) auditors use the same methodology for designing tests of controls and substantive tests of transactions for cash receipts as they use for sales. C) the tests of controls are not dependent on the controls the auditor identifies. D) the tests of controls are not dependent on whether the company being audited is publicly traded. Answer: B Terms: Designing tests of controls and substantive tests of transactions for cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking

7) Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this fraud and be least likely to be detected by an auditor? A) understating the sales journal by not recording cash sales B) overstating the accounts receivable control account by intentionally misstating prices charged for goods sold C) overstating the accounts receivable subsidiary ledger by not recording payments made by customers D) understating the cash receipts journal by purposely recording incorrect amounts Answer: A Terms: Cash receipts from sales on account; Misappropriated; Fraud Difficulty: Challenging Objective: LO 14-5 AACSB: Reflective thinking 8) Which of the following would offer the best protection for a company that wishes to prevent a reoccurrence of a previously detected "lapping" problem with trade accounts receivable? A) Separate duties so that the bookkeeper in charge of the general ledger has no access to incoming mail. B) Separate duties so that no employee has access to both checks from customers and currency from daily cash receipts. C) Have a mandatory vacation policy for employees who both handle cash and enter cash receipts into the system. D) Request that customer's payment checks be made payable to the company and addressed to the treasurer. Answer: C Terms: Prevent lapping problem Difficulty: Challenging Objective: LO 14-5 AACSB: Reflective thinking 9) The most difficult type of cash embezzlement for auditors to detect is when it occurs A) after the merchandise has been shipped. B) before the merchandise has been shipped. C) before the cash is recorded in the cash receipts journal or other cash listing. D) after the cash is recorded in the cash receipts journal or other cash listing. Answer: C Terms: Cash embezzlement Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking

10) The most difficult type of cash embezzlement for the auditor to detect is when the cash is stolen before it can be recorded in the cash receipts journal. Answer: TRUE Terms: Cash embezzlement Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 11) An essential part of the auditor's responsibility in auditing cash receipts is to identify deficiencies in system of internal control that increase the likelihood of fraud. Answer: TRUE Terms: Cash receipts from sales on account; Misappropriated; Fraud Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 12) It is normal practice for the auditor to trace from prenumbered remittance advices or prelists of cash receipts to the cash receipts journal and the accounts receivable subsidiary records. Answer: TRUE Terms: Determining whether cash received was recorded in the accounting records Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 13) When performing a proof of cash receipts, the auditor will test if the total cash receipts recorded in the cash receipts journal for a given period agree with the actual deposits made to the respective bank account for the same period. A difference found during this test generally signals to the auditor a potential weakness in system of internal controls. Answer: FALSE Terms: Proof of cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 14) A proof of cash receipts is useful in discovering cash receipts that have not been recorded in the cash receipts journal or time lags in the client making deposits to the bank accounts. Answer: FALSE Terms: Proof of cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking

15) A proof of cash receipts may be useful when the auditor concludes internal controls in the cash recording function are deficient. Answer: TRUE Terms: Proof of cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 16) For audit clients having a treasurer, the auditor should inquire whether the treasurer has reviewed the financial statement disclosures related to cash receipts for relevance and understandability. Answer: TRUE Terms: Financial statement disclosures related to cash receipts Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 17) The completeness transaction-related audit objective must be considered when determining key controls for sales. List three of the key controls that must be considered when cash received is recorded in the cash receipts journal. Answer: (1) Is a prelisting of cash receipts prepared? (2) Are checks restrictively endorsed? (3) Are the batch totals of cash receipts compared with the computer summary? (4) Are statements sent to customers each month? Terms: Completeness assertion for cash receipts and existing controls Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking

18) Explain what lapping means, and discuss the internal control deficiency that allows it to occur. Also discuss the procedures the auditor can perform to detect lapping. Answer: Lapping, which is a common type of embezzlement, is the postponement of entries for the collection of receivables to conceal an existing cash shortage. The embezzlement is perpetrated by a person who handles cash receipts and then enters them into the computer system. He or she defers recording the cash receipts from one customer and covers the shortages with subsequent receipts of another. These in turn are covered from the receipts of a third customer a few days later. The employee must continue to cover the shortage through repeated lapping, replace the stolen money, or find another way to conceal the shortage. The embezzlement can be easily prevented by separation of duties and a mandatory vacation policy for employees who handle cash and enter cash receipts into the system. It can be detected by comparing the name, amount, and dates shown on remittance advices with cash receipts journal entries and related duplicate deposit slips. Because this procedure is relatively timeconsuming, it is ordinarily performed only when specific concerns with embezzlement exist because of a deficiency in system of internal control. Terms: Lapping Difficulty: Challenging Objective: LO 14-5 AACSB: Reflective thinking 19) You are part of the audit team that is auditing Hillsburg Hardware Co. and you have been assigned to the sales and collection cycle. You are testing whether the cash receipts are deposited and recorded at the amounts received (accuracy objective). List two tests of controls and one test of transactions that you would do to satisfy yourself regarding the accuracy objective. Answer: Control Tests: 1. Observe whether the accountant reconciles the bank account. 2. Examine file of batch totals for initials of data control clerk. 3. Observe whether monthly statements are sent. Transaction Tests: 1. Obtain prelisting of cash receipts and trace amounts to the cash receipts journal, testing for names, amounts, and dates. 2. Prepare proof of cash receipts. Terms: Sales and collection business process; Tests of controls and test of transactions for accuracy objective Difficulty: Challenging Objective: LO 14-5 AACSB: Reflective thinking

20) In planning the audit, an auditor takes three basic steps in determining the audit procedures to be performed for any business cycle or class of transactions in order to gather audit evidence concerning possible misstatement due to error or fraud. List those three basic steps below. Answer: The three basic steps in designing tests of controls and substantive tests of transactions are: • Determine key system of internal controls for each audit objective. • Design tests of controls for each control used to support a reduced control risk. • Design substantive tests of transactions to test for monetary misstatements for each objective. Terms: Audit procedures performed for business cycle or class of transactions Difficulty: Moderate Objective: LO 14-5 AACSB: Reflective thinking 14.6 Learning Objective 14-6 1) The auditor's primary concern in performing audit procedures of the write-off of uncollectible accounts relates to the risk that the client writes off customer accounts that have already been collected. The primary control for preventing this fraud is A) examining authorized credit memos. B) examining the uncollectible account authorization form. C) examining debit memos. D) examining the vouchers payable register. Answer: B Terms: Audit procedures; Write-off of uncollectible accounts; Fraud Difficulty: Challenging Objective: LO 14-6 AACSB: Reflective thinking 2) Realizable value is an essential balance-related audit objective for accounts receivable because collectibility of receivables is often a significant concern. Which of the following is not an internal control the auditor should evaluate to reduce the likelihood of uncollectible accounts? A) customer credit approval by appropriate personnel B) preparation of an aged trial balance reviewed and followed up by appropriate management personnel C) a written policy of writing off uncollectable receivables D) All of the above are system of internal controls the auditor should evaluate. Answer: D Terms: Audit procedures; Write-off of uncollectible accounts; Fraud Difficulty: Challenging Objective: LO 14-6 AACSB: Reflective thinking

3) The estimation of bad debts expense relates to realizable value and the write-off of uncollectible accounts. Answer: TRUE Terms: Audit test for write-off of uncollectible accounts Difficulty: Easy Objective: LO 14-6 AACSB: Reflective thinking 4) There should generally be correspondence in the client's file establishing the uncollectibility of their account. Answer: TRUE Terms: Audit test for write-off of uncollectible accounts Difficulty: Easy Objective: LO 14-6 AACSB: Reflective thinking 5) Realizable value is an essential balance-related audit objective for accounts receivable. Answer: TRUE Terms: Realizable value for accounts receivable Difficulty: Easy Objective: LO 14-6 AACSB: Reflective thinking 6) The auditor's primary concern in the audit of the write-off of uncollectible accounts receivable is the possibility of client personnel covering up an embezzlement by writing off accounts receivable that have already been collected. Answer: TRUE Terms: Audit procedures; Write-off of uncollectible accounts; Fraud Difficulty: Challenging Objective: LO 14-6 AACSB: Reflective thinking

14.7 Learning Objective 14-7 1) The most significant effect of the results of the tests of controls and substantive tests of transactions in the sales and collection cycle is on A) bad debt expense. B) the analytical tests to be performed. C) the confirmation of accounts receivable. D) the impact of processing cash receipts. Answer: C Terms: Effect of results of tests of controls and substantive tests of transactions in the sales and collection cycle Difficulty: Moderate Objective: LO 14-7 AACSB: Reflective thinking 2) The parts of the audit most affected by the results of the tests of controls and substantive tests of transactions in the sales and collection cycle include each of the following except for A) accounts payable. B) cash. C) allowance for doubtful accounts. D) bad debt expense. Answer: A Terms: Effect of results of tests of controls and substantive tests of transactions in the sales and collection cycle Difficulty: Moderate Objective: LO 14-7 AACSB: Reflective thinking 3) At the completion of the tests of controls and substantive tests of transactions, auditors must analyze each exception to determine its cause and the implication of the exception on assessed control risk. Answer: TRUE Terms: Effect of results of tests of controls and substantive tests of transactions in the sales and collection cycle Difficulty: Moderate Objective: LO 14-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 15 Audit Sampling for Tests of Controls and Substantive Tests of Transactions 15.1 Learning Objective 15-1 1) A sample in which the characteristics of the sample are the same as those of the population is a(n) A) variables sample. B) representative sample. C) attributes sample. D) random sample. Answer: B Terms: Sample in which characteristics of sample are same as population Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 2) When the auditor decides to select less than 100 percent of the population for testing, the auditor is said to use A) audit sampling. B) representative sampling. C) poor judgment. D) estimation sampling. Answer: A Terms: Auditor selects less than 100 percent of population for testing Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 3) To determine if a sample is truly representative of the population, an auditor would be required to A) conduct multiple samples of the same population. B) never use sampling because of the expense involved. C) audit the entire population. D) use systematic sample selection. Answer: C Terms: Sample truly representative of population Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking

4) One of the causes of nonsampling risk is A) choosing the wrong sample size. B) ineffective audit procedures. C) inadequate sample size. D) exceptions being found in the sample. Answer: B Terms: Nonsampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 5) One of the causes of nonsampling risk is A) choosing the wrong sample size. B) failure to recognize exceptions. C) inadequate sample size. D) exceptions being found in the sample. Answer: B Terms: Nonsampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 6) Which one of the choices below is most correct regarding a cause of sampling risk? A) ineffective use of audit procedures B) testing less than the entire population C) use of extensive tests of controls D) use of random sampling Answer: B Terms: Sampling risk Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking

7) An auditor can increase the likelihood that a sample is representative by using care in A) Designing the sampling process Designing the sample selection Yes Yes B) Designing the sampling process No

Designing the sample selection No

C) Designing the sampling process Yes

Designing the sample selection No

D) Designing the sampling process No

Designing the sample selection Yes

Answer: A Terms: Increased likelihood that sample is representative Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 8) Which of the following is the risk that audit tests will not uncover existing exceptions in a sample? A) sampling risk B) nonsampling risk C) audit risk D) detection risk Answer: B Terms: Risk that audit tests will not uncover existing exceptions Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 9) Which of the following is the risk that an auditor will reach an incorrect conclusion because a sample is not representative of the population? A) sampling risk B) nonsampling risk C) audit risk D) detection risk Answer: A Terms: Risk auditor will reach an incorrect conclusion Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 3 Copyright © 2023 Pearson Education, Inc.

10) Sampling risk may be controlled by A) Adjusting the sample size Using an appropriate method of selecting sample items Yes Yes B) Adjusting the sample size No

Using an appropriate method of selecting sample items No

C) Adjusting the sample size Yes

Using an appropriate method of selecting sample items No

D) Adjusting the sample size No

Using an appropriate method of selecting sample items Yes

Answer: A Terms: Sampling risk controlled by Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 11) Which of the following statements is most correct? A) A sample of all items of a population will eliminate sampling risk, but increase nonsampling risk. B) The use of an appropriate sample selection technique ensures a representative sample. C) The auditor's failure to recognize an exception is a significant cause of sampling risk. D) The use of inappropriate audit procedures is a significant cause of nonsampling risk. Answer: D Terms: Sample selection; Sampling and nonsampling risk Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking

12) One of the causes of nonsampling risk is A) choosing the wrong sample size. B) effective audit procedures. C) inadequate sample size. D) failure to recognize exceptions. Answer: D Terms: Nonsampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 13) Sampling risk results from the auditor's failure to recognize exceptions in transaction data. Answer: FALSE Terms: Sampling risk Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 14) If an auditor does a test in the wrong direction, sampling risk will increase. Answer: FALSE Terms: Nonsampling risk Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 15) If a particular internal control is not followed by the client exactly 6% of the time, and the auditor's tests of that control find three control violations in a sample of 50, the sample is considered to be representative. Answer: TRUE Terms: Sample considered to be representative Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 16) Assume that the auditor accepts a particular internal control as effective based on tests of controls with a sample of 200 items that had ten exceptions. The auditor has decided that this particular internal control is not effective if there is a population exception rate of 4%. The auditor correctly accepted the population in this situation. Answer: FALSE Terms: Sample considered to be representative Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking

17) In practice, auditors do not know whether a sample is representative, even after all testing is complete. Answer: TRUE Terms: Representative sample Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 18) One way to control sampling risk is to increase sample size. Answer: TRUE Terms: Control sampling risk is with sample size Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 19) A sample of all items in a population will have a zero sampling risk. Answer: TRUE Terms: Sample of all items in a population will have zero sampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 20) It is virtually impossible to reduce sampling risk to zero. Answer: TRUE Terms: Sampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 21) A representative sample means the sampled items are similar to the items not sampled. Answer: TRUE Terms: Representative sample Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 22) Assume a client's internal controls require each sales invoice to be supported by a shipping document prepared by an outside company, but the clerk preparing sales invoices fails to follow this procedure exactly 3 percent of the time. If the auditor selects a sample of 100 sales invoices and finds two or four sales invoices are missing a shipping document, the sample is nonrepresentative of the population. Answer: FALSE Terms: Representative sample Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

23) It is never possible to know whether a sample is truly representative of a population. Answer: FALSE Terms: Representative sample Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 24) Auditors can increase the likelihood of a sample being representative by using professional care in the design of the sampling process, in the selection of the sample, and in the evaluation of the sample results. Answer: TRUE Terms: Representative sample Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 25) Assume the auditor decides a control is not effective if there is a population exception rate of 3%. Assume the auditor accepts this control as effective based on test of control with a sample of 100 items that had 2 exceptions. If the population actually has a 6% exception rate, the auditor correctly accepted the population because the sample was representative of the population. Answer: FALSE Terms: Sampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 26) A sample of all the items in a population still has sampling risk for the auditor. Answer: FALSE Terms: Sampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 27) Using an appropriate sample selection method does not increase the likelihood of representativeness of the sample. Answer: FALSE Terms: Sampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking

28) Assume an important control is shipping documents being attached to invoices. An effective audit procedure for detecting exceptions to this control would be to examine a sample of shipping documents and determining whether each is attached to a duplicate sales invoice. Answer: TRUE Terms: Nonsampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking 29) Discuss what is meant by "sampling risk" and "nonsampling risk." Answer: Sampling risk is the risk that an auditor reaches an incorrect conclusion because the sample is not representative of the population. Sampling risk is an inherent part of sampling that results from testing less than the entire population. Nonsampling risk is the risk that the auditor reaches an incorrect conclusion for any reason not related to the sampling risk. The two causes of nonsampling risk are the auditor's failure to recognize exceptions and inappropriate or ineffective audit procedures. Terms: Sampling and nonsampling risks Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 30) List the two ways auditors can control sampling risk. Answer: Auditors can control sampling risk by: 1. adjusting the sample size. 2. using an appropriate method of selecting sample items from the population. Terms: Sampling risk controlled by Difficulty: Easy Objective: LO 15-1 AACSB: Reflective thinking 31) Discuss two causes of nonsampling risk. Also discuss ways the auditor can control nonsampling risk. Answer: The two causes of nonsampling risk are (1) the auditor's failure to recognize exceptions and (2) inappropriate or ineffective audit procedures. Careful design of audit procedures, proper instruction, supervision, and review are ways to control nonsampling risk. Terms: Nonsampling risk Difficulty: Moderate Objective: LO 15-1 AACSB: Reflective thinking

15.2 Learning Objective 15-2 1) There are three phases in both statistical and nonstatistical sampling. The first phase is to A) generate random numbers for the sample. B) evaluate the results. C) plan the sample. D) select the sample. Answer: C Terms: Statistical and nonstatistical sampling Difficulty: Easy Objective: LO 15-2 AACSB: Reflective thinking 2) Which of the following statements is most correct concerning the quantification of sampling risk? A) Sampling risk cannot be quantified. B) Sampling risk can be quantified only when nonprobabilistic selection techniques are used to select the sample. C) Sampling risk can be quantified only when probabilistic selection techniques are used to select the sample. D) None of the above is correct. Answer: C Terms: Quantification of sampling risk Difficulty: Easy Objective: LO 15-2 AACSB: Reflective thinking 3) Which of the following statements is most correct with respect to the evaluation of nonprobabilistic sample results? A) It is acceptable to make nonprobabilistic evaluations only when probabilistic sample selection is used. B) It is acceptable to make nonprobabilistic evaluations only if the auditor cannot quantify sampling risk. C) It is never acceptable to evaluate a nonprobabilistic sample using statistical methods. D) All of the above are correct. Answer: C Terms: Evaluation of nonprobabilistic sample results Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking

4) Which of the following is not a phase in the planning of both statistical and nonstatistical sampling? A) Plan the sample. B) Determine the probability that fraud has occurred. C) Select the sample and perform the tests. D) Evaluate the results. Answer: B Terms: Statistical and nonstatistical sampling Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 5) Which of the following statements is not correct regarding probabilistic and nonprobabilistic sample selection? A) In probabilistic selection, every population item has a known chance of being selected. B) It is acceptable to evaluate a nonprobabilistic sample using statistical methods. C) Probabilistic selection is required for all statistical sampling methods. D) Both probabilistic and nonprobabilistic methods are acceptable and commonly used. Answer: B Terms: Probabilistic and nonprobabilistic sample selection Difficulty: Challenging Objective: LO 15-2 AACSB: Reflective thinking 6) Which of the following is a correct statement regarding probabilistic versus nonprobabilistic sample selection? A) Auditors may make nonstatistical evaluations when using probabilistic sample selection. B) The AICPA recommends probabilistic sample selection. C) Nonstatistical sampling can't provide results that are as effective as a statistical sample. D) There is only one type of nonprobabilistic sample selection method. Answer: A Terms: Probabilistic and nonprobabilistic sample selection Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 7) An advantage of using statistical sampling techniques is that such techniques A) quantify sampling risk. B) eliminate the need for judgmental decisions. C) define the values of precision and reliability required to provide audit satisfaction. D) have been established in the courts to be superior to judgmental sampling. Answer: A Terms: Advantage of using statistical sampling techniques Difficulty: Challenging Objective: LO 15-2 AACSB: Reflective thinking 10 Copyright © 2023 Pearson Education, Inc.

8) Auditors who prefer statistical to nonstatistical sampling believe that the principal advantage of statistical sampling flows from its ability to A) quantify sampling risk. B) promote a more legally defensible procedural approach. C) define the precision required to provide audit satisfaction. D) establish conclusive audit evidence with decreased audit effort. Answer: A Terms: Advantage of statistical sampling over nonstatistical sampling Difficulty: Challenging Objective: LO 15-2 AACSB: Reflective thinking 9) Which of the following is an accurate statement regarding sampling? A) A 95 percent confidence level provides a 5 percent sampling risk. B) The auditor can perform the audit tests only after the sample items are selected. C) The purpose of planning the sample is to make sure that the audit tests are performed in a manner that provides the desired sampling risk and minimizes the likelihood of nonsampling errors. D) All of the above are accurate statements. Answer: D Terms: Statistical and nonstatistical sampling Difficulty: Easy Objective: LO 15-2 AACSB: Reflective thinking 10) It is equally acceptable under professional auditing standards for auditors to use either statistical or nonstatistical sampling methods. Answer: TRUE Terms: Equally acceptable to use statistical or nonstatistical sampling methods Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 11) When using nonstatistical sampling, the sample must be a probabilistic one. Answer: FALSE Terms: Nonstatistical sampling; sample must be probabilistic Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking

12) Statistical sampling differs from nonstatistical sampling in that, by applying mathematical rules, the auditor can measure sampling risk in planning the sample; however, mathematical rules cannot then be applied in evaluating the sample results. Answer: FALSE Terms: Nonstatistical vs. statistical sampling Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 13) A 95 percent confidence level in statistical sampling means there is more than a 5 percent sampling risk which the auditor needs to address in the sampling design. Answer: FALSE Terms: Statistical sampling Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 14) Describe the differences between statistical and nonstatistical sampling in terms of (1) the sample selection methods used, and (2) quantification of sampling risk. Answer: Nonstatistical sampling differs from statistical sampling in that nonprobabilistic sampling can be used for nonstatistical sampling, but not for statistical sampling. In addition, sampling risk can be quantified when using statistical sampling but not when using nonstatistical sampling. Terms: Differences between statistical and nonstatistical sampling applying sample selection methods and quantification of sampling risk Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking 15) List the three phases in audit sampling for both statistical and nonstatistical sampling. Answer: • Plan the sample. • Select the sample and perform the tests. • Evaluate the results. Terms: Statistical and nonstatistical sampling Difficulty: Moderate Objective: LO 15-2 AACSB: Reflective thinking

15.3 Learning Objective 15-3 1) A sample in which every possible combination of items in the population has an equal chance of constituting the sample is a A) random sample. B) statistical sample. C) judgment sample. D) representative sample. Answer: A Terms: Sample in which every possible combination has equal chance of constituting sample Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking 2) The process which requires the calculation of an interval and then selects the items based on the size of the interval is A) statistical sampling. B) random sample selection. C) systematic sample selection. D) computerized sample selection. Answer: C Terms: Process which requires calculation of an interval Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking 3) In systematic sample selection, the population size is divided by the number of sample items desired in order to determine the A) sampling interval. B) tolerable exception rate. C) computed upper exceptions rate. D) mean. Answer: A Terms: Systematic sample selection Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking

4) Which of the following methods of sample selection is appropriately used when selecting a random sample? A) Auditor's judgmental Use of random number Generalized audit selection of items generators software Yes No Yes B) Auditor's judgmental selection of items No

Use of random number generators Yes

Generalized audit software Yes

Auditor's judgmental selection of items Yes

Use of random number generators No

Generalized audit software No

D) Auditor's judgmental selection of items No

Use of random number generators Yes

Generalized audit software No

Answer: B Terms: Methods of sample selection in selecting a random sample Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 5) Simple random sampling A) is used when there is a need to emphasize one or more types of population items. B) requires both input and output parameters to be set when using a random number generator. C) is generally used with replacement sampling. D) is a probabilistic sampling method. Answer: D Terms: Random sampling Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking

6) When a population is divided into subpopulations, usually by dollar size, and larger samples are taken from the subpopulation with the larger sizes, ________ is being used. A) sampling with probability proportional to size B) stratified sampling C) block sampling D) haphazard sampling Answer: B Terms: Probabilistic sample selection methods Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 7) The advantage of systematic sample selection is that A) it is easy to use. B) there is limited possibility of it being biased. C) it is unnecessary to determine if the population is arranged randomly. D) it automatically selects items material to the financial statements. Answer: A Terms: Advantage of systematic sample selection Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 8) In performing a review of a client's cash disbursements, an auditor uses systematic sample selection with a random start. The primary disadvantage of this technique is population items A) may occur twice in the sample. B) must be reordered in a systematic pattern before the sample can be drawn. C) may occur in a systematic pattern, thus negating the randomness of the sample. D) must be replaced in the population after sampling to permit valid statistical inference. Answer: C Terms: Disadvantage of systematic sample selection with random start Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 9) Which of the following is a correct statement regarding block sampling? A) It is acceptable to use block sampling only if a reasonable number of blocks are used. B) Block sampling uses sampling with replacement. C) Block sampling is a probabilistic sampling method. D) There is considerable cost and time involved when block sampling is used. Answer: A Terms: Block sampling Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking

10) The most serious shortcoming of the haphazard sample selection method is A) it is not subject to statistical sampling methods. B) it is time consuming to use. C) it is costly to use. D) it is difficult to remain completely unbiased in the selection. Answer: D Terms: Haphazard sample selection Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking 11) Which of the following statements regarding block sampling is least likely to be true? A) Block sampling is the selection of several items in sequence. B) It is acceptable to use block sampling for tests of transactions only if a reasonable number of blocks is used. C) Only one block should be selected to increase the probability of a representative sample. D) Once the first item in the block is selected, the remainder of the block is chosen automatically. Answer: C Terms: Block sampling Difficulty: Challenging Objective: LO 15-3 AACSB: Reflective thinking 12) When the auditor goes through a population and selects items using nonprobabilistic selection methods, without regard to their size, source, or other distinguishing characteristics, it is called A) block sample selection. B) haphazard selection. C) systematic sample selection. D) statistical selection. Answer: B Terms: Nonprobabilistic selection methods Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking 13) When auditors wish to evaluate a sample statistically, an acceptable selection method is A) systematic sample selection. B) judgmental selection. C) haphazard selection. D) block sample selection. Answer: A Terms: Sample statistically Difficulty: Easy Objective: LO 15-3 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

14) Which is not a method used by auditors to generate random numbers? A) electronic spreadsheets B) systematic sample generators C) random number generators D) generalized audit software Answer: B Terms: Random sampling Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 15) When selecting a sample, random numbers may be obtained either with replacement or without replacement. Although both selection methods are theoretically sound, auditors rarely use replacement sampling. Answer: TRUE Terms: Selecting same with random numbers Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 16) Although systematic sample selection is easy to use, its primary disadvantage is that it is not a probabilistic sampling method. Answer: FALSE Terms: Systematic sample selection; probabilistic sampling method Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 17) Nonprobabilistic sampling methods are not based on mathematical probabilities, and therefore the representativeness of the sample may be difficult to determine. Answer: TRUE Terms: Nonprobabilistic selection methods Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 18) The use of haphazard sample selection is encouraged under professional auditing standards. Answer: FALSE Terms: Haphazard sample selection Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking

19) Directed sample selection, block sample selection, and haphazard sample selection are three types of probabilistic sample selection methods. Answer: FALSE Terms: Probabilistic sample selections; Directed sample selection, block sample selection and haphazard selections Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 20) When generating random numbers, the random numbers must be obtained with replacement. Answer: FALSE Terms: Random numbers with or without replacement Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 21) Sound statistical theory consistently supports random number sampling with or without replacement. Answer: TRUE Terms: Random numbers with or without replacement Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 22) Haphazard and block sampling are often used in situations where the nature of the data makes the data more difficult to use a probabilistic sampling method. Answer: TRUE Terms: Haphazard and block sampling Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 23) Auditors prefer to use probabilistic sample selection methods for nonstatistical sample applications involving tests of controls and substantive tests of transactions to improve the likelihood of selecting a representative sample. Answer: TRUE Terms: Probabilistic sample selection methods Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking

24) What is the key advantage and disadvantage associated with systematic sample selection? How must auditors address this disadvantage? Answer: The key advantage is its ease of use. In most populations, a systematic sample can be drawn quickly and the approach automatically puts the numbers in sequence, making it easy to develop the appropriate documentation. The key disadvantage is the possibility for bias. Because of the way systematic selection is done, once the first item in the sample is selected, all other items are chosen automatically. This causes no problem if the characteristic of interest is distributed randomly throughout the population, but this may not always be the case. Therefore, when auditors use systematic selection, they must consider possible patterns in the population data that can cause sample bias. Terms: Systematic sample selection Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 25) Describe each of the four types of sample selection methods commonly associated with statistical audit sampling. Answer: Four types of sample selection methods commonly associated with statistical audit sampling are: • Simple random sample selection. Every possible combination of elements in the population has an equal chance of being included in the sample. • Systematic sample selection. A probabilistic method of sampling in which the auditor calculates an interval (the population size divided by the number of sample items desired) and selects the items for the sample based on the size of the interval and a randomly selected number between zero and the interval size. • Probability proportional to size sample selection. The probability of selecting any individual population item is proportional to its recorded amount. • Stratified sample selection. A probabilistic method of sampling in which the population is divided into subpopulations, and samples are taken from each of the subpopulations. Terms: Types of sample selection methods associated with statistical audit sampling Difficulty: Challenging Objective: LO 15-3 AACSB: Reflective thinking 26) Auditors most often generate random numbers by using one of three computer sample selection techniques. Name these three computer sample selection techniques. Answer: Three types of sample selection methods commonly associated with statistical audit sampling are: • Electronic spreadsheets • Random number generators • Generalized audit software Terms: Random number generators Difficulty: Moderate Objective: LO 15-3 AACSB: Reflective thinking 19 Copyright © 2023 Pearson Education, Inc.

15.4 Learning Objective 15-4 1) Which of the following occurrences would be least likely to warrant further audit attention for the auditor? A) deviations from client's established control procedures B) deviations from client's budgeted values C) monetary misstatements in populations of transaction data D) monetary misstatements in populations of account balance details Answer: B Terms: Warrant further audit attention for auditor Difficulty: Easy Objective: LO 15-4 AACSB: Reflective thinking 2) Which of the following statements is correct when dealing with sampling for exception rates? A) The term exception refers to both deviations from the client's control procedures and amounts that are not monetarily correct. B) When used with sampling, the term deviation is synonymous with the term exception. C) The actual population exception rate is the same as the sample exception rate. D) In using audit sampling for exception rates, the auditor is most concerned with the confidence interval. Answer: A Terms: Sample exception rate Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking 3) In using audit sampling for exception rates A) the auditor wants to know the most the exception rate is likely to be. B) sampling error is the likelihood that the auditor will miss a monetary misstatement. C) the upper limit of the interval estimate is known as the sampling risk. D) the computed upper exception rate (CUER) cannot be considered in the context of specific audit objectives. Answer: A Terms: Sample exception rate Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking

4) Which of the following is most correct when using audit sampling for exception rates? A) The auditor is concerned with the lowest rate. B) The auditor is concerned with the highest rate. C) The auditor is concerned with the average on previous audits. D) The auditor is not concerned with the exception rate for audits of nonpublic companies. Answer: B Terms: Auditing sampling for exception rates Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking 5) The upper limit of the probable population exception rate is the A) upper exception rate. B) estimated population exception rate. C) computed upper exception rate. D) tolerable exception rate. Answer: C Terms: Highest estimated exception rate in population Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking 6) You are determining the significance of the following: you set a 5% risk of assessing control risk too low and your computation of the upper deviation risk is 7%. What could you conclude? A) There is a 95% chance the deviation rate in the population is less than 5%. B) There is a 5% chance the deviation rate in the population is less than 7%. C) There is a 95% chance the deviation rate in the population exceeds 95%. D) There is a 5% chance the deviation rate in the population exceeds 7%. Answer: D Terms: Risk of assessing control risk low and computation of upper deviation risk Difficulty: Challenging Objective: LO 15-4 AACSB: Reflective thinking 7) If the auditor concludes that the computer upper exception rate (CUER) is 5% at an 8% sampling risk, this means that the exception rate in the population is no greater than 5% with an 8% risk of the exception rate exceeding 5%. Answer: TRUE Terms: Estimate of population exception rate Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking

8) The upper limit of the interval estimate is also known as the confidence interval. Answer: FALSE Terms: Computed upper exception rate (CUER) Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking 9) Deviation refers to a departure from prescribed controls or amounts that are not monetarily correct. Answer: FALSE Terms: Deviation Difficulty: Easy Objective: LO 15-4 AACSB: Reflective thinking 10) Deviation rate and tolerable deviation are used instead of exception rate when referring to tests of controls. Answer: TRUE Terms: Deviation rate and tolerable deviation rate Difficulty: Easy Objective: LO 15-4 AACSB: Reflective thinking 11) The auditor focuses on the lower limit of the interval estimate, which is called the estimated computed lower exception rate (CLER) in tests of controls and substantive tests of transactions. Answer: FALSE Terms: Computed upper exception rate (CUER) Difficulty: Easy Objective: LO 15-4 AACSB: Reflective thinking 12) An auditor might conclude that the computed upper exception rate (CUER) for missing shipping documents is 4 percent at a 5 percent sampling risk, meaning the auditor concludes that the exception rate in the population is no greater than 5 percent with a 4 percent risk of the exception rate exceeding 5 percent. Answer: FALSE Terms: Computed upper exception rate (CUER) Difficulty: Easy Objective: LO 15-4 AACSB: Reflective thinking

13) What types of exceptions are auditors most concerned with when evaluating populations of accounting data? Answer: There are three types of exceptions that auditors are generally concerned with when evaluating populations of accounting data. They are: 1. deviations from client's established controls. 2. monetary misstatements in populations of transaction data. 3. monetary misstatements in populations of account balance details. Terms: Types of exceptions and concern when evaluating populations of accounting data Difficulty: Moderate Objective: LO 15-4 AACSB: Reflective thinking 15.5 Learning Objective 15-5 1) The risk which the auditor is willing to take in accepting a control as effective when the true population exception rate is greater than a tolerable exception rate is the A) finite correction factor. B) tolerable exception rate. C) acceptable risk of overreliance. D) estimated population exception rate. Answer: C Terms: Risk auditor is willing to take in accepting a control as being effective Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking 2) The exception rate the auditor will permit in the population and still be willing to conclude the control is operating effectively is the A) tolerable exception rate. B) estimated population exception rate. C) acceptable risk of overreliance. D) sample exception rate. Answer: A Terms: Exception rate auditor will permit and still be willing to reduce assessed level of control risk Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking

3) If the auditor decides to assess control risk at the moderate level in a private company audit, when in previous years the auditor set control risk at the maximum level, then tests of controls for the current year would be A) increased in number. B) reduced in number. C) not performed. D) unchanged from prior planned settings. Answer: A Terms: Assess control risk Difficulty: Easy Objective: LO 15-5 AACSB: Analytic thinking 4) When the computed upper exception rate (CUER) is greater than the tolerable exception rate (TER), it is necessary for the auditor to take specific action. Which of the following courses of action would be most difficult to justify? A) Reduce the tolerable exception rate so as to accept the sample results. B) Expand the sample size and perform more tests. C) Revise the assessed control risk upward. D) Write a letter to management which outlines the control deficiencies. Answer: A Terms: Computed upper exception rate is greater than tolerable exception rate Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking 5) Which of the following would have the least impact in determining sample size? A) acceptable risk of overreliance B) risk of assessing control risk too low C) tolerable exception rate D) population size Answer: D Terms: Least impact on determining sample size Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking

6) Which of the following represents the best description of the tolerable exception rate? A) the highest exception rate the auditor will permit in the control being tested and still conclude it is operating effectively B) the highest exception rate the auditor expects to find in the population C) the number of exceptions found in the sample divided by the sample size D) the highest estimated exception rate in a population at a given estimated population exception rate Answer: A Terms: Tolerable exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 7) When analyzing individual exceptions, the auditor should keep in mind that A) all exceptions must be reported to management. B) they should determine the breakdown in the system of internal controls that allowed the exceptions to occur. C) the nature of an exception and its causes have no effect on the qualitative evaluation of the system. D) exceptions do not need to be analyzed if it is too costly. Answer: B Terms: Sample size and analyzing exceptions Difficulty: Moderate Objective: LO 15-5 AACSB: Analytic thinking 8) The exception rate that the auditor will permit in the population and still be willing to use the preliminary control risk assessment is called the A) acceptable exception rate. B) estimated population exception rate. C) sample exception rate. D) tolerable exception rate. Answer: D Terms: Exception rate; Preliminary control risk assessment Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

9) Auditors often use the ________ to determine the estimated population exception rate. A) current year's audit results B) tolerable exception rate C) preceding year's audit results D) estimated computed by management Answer: C Terms: Estimate of population exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 10) Place the following steps in their proper order: 1. Analyze exceptions. 2. Select the sample. 3. Define attributes and exception conditions. 4. State the objectives of the audit test. 5. Specify the tolerable exception rate. A) 1, 3, 2, 4, 5 B) 4, 3, 1, 2, 5 C) 4, 3, 5, 2, 1 D) 1, 2, 3, 4, 5 Answer: C Terms: Auditing sampling steps Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 11) If an auditor judgmentally selects a sample of one hundred items from a population and finds two exceptions, the auditor A) can conclude that the sample exception rate is 2%. B) can conclude that the population exception rate is 2%. C) can calculate the highest exception rate expected in the population. D) cannot make any conclusions about either the sample or the population. Answer: A Terms: Sample selected from population and found exceptions Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

12) When planning the audit sample, A) one objective of the tests of controls is to test the effectiveness of the controls. B) audit sampling applies to analytical procedures. C) audit sampling generally applies to automated controls. D) the auditor must generalize from the sample to the population. Answer: A Terms: Planning the audit sample Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 13) Which of the following is the exception rate that the auditor expects to find before testing? A) sample exception rate B) estimated population exception rate C) computed exception rate D) tolerable exception rate Answer: B Terms: Exception rate auditor expects to find before testing Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 14) Which of the following is not a term related to evaluating results in audit sampling until after a sample is tested and evaluated? A) sample exception rate B) estimated population exception rate C) computed upper exception rate D) exception Answer: B Terms: Term not related to evaluating results in audit sampling Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 15) The relationship of tolerable exception rate (TER) to sample size is A) direct (larger TER = larger sample). B) inverse (larger TER = smaller sample). C) variable (sometimes larger, sometimes smaller). D) not determinable. Answer: B Terms: Relationship of tolerable exception rate (TER) to sample size Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

16) Which of the following must be set prior to testing a sample? A) sample exception rate B) achieved upper precision limit C) computed exception rate D) tolerable exception rate Answer: D Terms: Set prior to testing sample Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 17) The acceptable risk of overreliance A) is the risk that the auditor will erroneously conclude that the controls are less effective than they actually are. B) is less of a concern to the auditors than the risk of underreliance. C) represents the auditor's measure of sampling risk. D) is determined by a statistical formula, and not by professional judgment. Answer: C Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 18) The sample exception rate equals A) the number of exceptions in the population divided by the sample size. B) the number of items in the population multiplied by the number of exceptions in the sample. C) the number of exceptions in the sample divided by the sample size. D) the number of exceptions in the population divided by the population size. Answer: C Terms: Sample exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 19) When defining the population, A) it may be necessary to define separate populations for different audit procedures. B) the auditor may generalize only about the population that has been sampled. C) auditors can define the population to include any items they want. D) all of the above Answer: D Terms: Population considered acceptable based on acceptable risk of assessing control risk too low; Upper exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

20) One way to evaluate sampling risk when nonstatistical sampling is used is to A) subtract the sample exception rate from the tolerable exception rate. B) add the sample exception rate and the tolerable exception rate. C) subtract the sample exception rate from the acceptable risk of overreliance. D) add the sample exception rate and the acceptable risk of overreliance. Answer: A Terms: Sampling risk Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 21) A danger in setting the acceptable risk of overreliance too low is A) The risk that the auditor is willing The risk that the auditor is willing to to take of accepting a control as take of accepting a control as ineffective when it is effective effective when it is ineffective Yes Yes B) The risk that the auditor is willing The risk that the auditor is willing to to take of accepting a control as take of accepting a control as ineffective when it is effective effective when it is ineffective No No C) The risk that the auditor is willing The risk that the auditor is willing to to take of accepting a control as take of accepting a control as ineffective when it is effective effective when it is ineffective Yes No D) The risk that the auditor is willing The risk that the auditor is willing to to take of accepting a control as take of accepting a control as ineffective when it is effective effective when it is ineffective No Yes Answer: D Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

22) When using statistical sampling, the auditor would most likely require a smaller sample if the A) population increases. B) desired reliability decreases. C) desired precision interval narrows. D) expected exception rate increases. Answer: B Terms: Statistical sampling; Auditor requires smaller sample Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 23) Whenever auditors use sampling, they risk making incorrect conclusions about the population. The risk that the auditor concludes that controls are more effective than they actually are is known as the A) risk of overreliance. B) risk of underreliance. C) risk that the sample is not representative of the population. D) risk that the sample conclusions cannot be useful because of nonprobability sampling. Answer: A Terms: Sampling and the risk of making incorrect conclusions about the population Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 24) When choosing the appropriate acceptable risk of overreliance, the auditor needs to A) rely on his/her professional judgment. B) err on the side of conservatism. C) consult the professional standards. D) follow SEC guidelines. Answer: A Terms: Acceptable risk of overreliance Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 25) When planning the audit sample, the ________ is (are) those items about which the auditor wishes to generalize. A) attributes B) sampling unit C) population D) sample Answer: C Terms: Population and sampling unit Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 30 Copyright © 2023 Pearson Education, Inc.

26) If the result obtained from a particular sample for control and substantive tests of transactions is critical to the formation of an audit opinion, which of the following is the most important to the auditor in concluding of the appropriateness and sufficiency of evidence gathered? A) acceptable risk of overreliance B) estimated population exception rate C) tolerable exception rate D) size of the population Answer: A Terms: Control and substantive tests of transactions; Important in concluding appropriateness and sufficiency of evidence Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 27) There is a(n) ________ relationship between acceptable risk of overreliance and planned sample size. A) direct B) inverse C) proportional D) exponential Answer: B Terms: Acceptable risk of overreliance Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 28) Which of the following results in a larger sample size? A) Decrease the estimated population exception rate and decrease the tolerable exception rate. B) Increase the estimated population exception rate and decrease the tolerable exception rate. C) Decrease the estimated population exception rate and increase the tolerable exception rate. D) Increase the estimated population exception rate and increase the tolerable exception rate. Answer: B Terms: Results in larger sample size Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

29) When determining tolerable exception rate (TER), A) the auditor considers the degree of reliance to be placed on the control and the significance of the control to the audit. B) if only one internal control is used to support a low control risk assessment for an objective, TER will be higher for the attribute than if multiple controls are used to support a low control risk assessment for the same objective. C) control deviations increase both the risk of material misstatements in the accounting record, and will always result in misstatements. D) a smaller sample size is needed for a low TER than for a high TER. Answer: A Terms: Tolerable exception rate Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 30) The acceptable risk of overreliance A) is normally assessed at a high level when auditing an accelerated filer public company. B) and the extent of tests of controls depend on assessed control risk for accelerated filer public companies. C) and the control risk will be assessed as low for audits where there is extensive reliance on system of internal controls. D) does not impact the effectiveness of the audit. Answer: C Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 31) A survey of sampling experts at the six largest audit firms provided a number of insights into the sampling policies of these firms. Which of the following is not an insight determined in this survey? A) Firms tend to use a level of confidence of 80-85 percent, which is consistent with a high level of confidence. B) Half of the firms use a statistical approach when sampling for tests of controls. C) Firms using a nonstatistical approach sample sizes are comparable to those using a statistical approach. D) The majority of the firms use the AICPA Audit Sampling Guide to determine sample sizes for tests of controls. Answer: A Terms: Tests of controls audit tests Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking

32) The auditor must use the same TER and ARO levels for all attributes of an audit test. Answer: FALSE Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 33) The tolerable exception rate is the rate that the auditor will permit in the population and still be willing to conclude a control is effective. Answer: TRUE Terms: Tolerable exception rate Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking 34) The only way to know with certainty whether a sample is representative is to subsequently audit the entire population. Answer: TRUE Terms: Know with certainty whether sample is representative is to audit entire population Difficulty: Moderate Objective: LO 15-1 and LO 15-5 AACSB: Reflective thinking 35) Acceptable risk of overreliance is the risk that the auditor is willing to take in accepting a control as effective when the true population exception rate is greater than the estimated population exception rate. Answer: FALSE Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 36) Acceptable risk of overreliance is normally lower for a public company audit than a private company audit. Answer: TRUE Terms: Acceptable risk of overreliance Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 37) When the estimated population exception rate exceeds the sample exception rate, the auditor can conclude that the sample results do not support the preliminary assessed control risk. Answer: FALSE Terms: Sample exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 33 Copyright © 2023 Pearson Education, Inc.

38) When the sample exception rate is greater than the tolerable exception rate in attributes sampling, one possible appropriate course of action is to increase sample size. Answer: TRUE Terms: Sample exception rate and tolerable exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 39) Tolerable exception rate (TER) is inversely related to sample size. Answer: TRUE Terms: Tolerable exception rate and sample size relationship Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 40) When the sample exception rate (SER) exceeds the tolerable exception rate (TER), the auditor should decide whether to increase sample size or to revise assessed control risk on the basis of cost versus benefit. Answer: FALSE Terms: Control risk assessment Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 41) In nonstatistical sampling, the calculated sampling error is the difference between the tolerable exception rate and the sample exception rate. Answer: TRUE Terms: Nonstatistical sampling; Calculated sampling error Difficulty: Challenging Objective: LO 15-5 AACSB: Reflective thinking 42) The sampling unit is the physical unit that corresponds to the random numbers the auditor generates. Answer: TRUE Terms: Sampling unit Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

43) The sum of the tolerable exception rate and the estimated population exception rate is the precision of the initial sample estimate. Answer: FALSE Terms: Determining sample size Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 44) Audit sampling can be applied for reviewing sales transactions for large and/or unusual amounts, and also for observing whether the duties and responsibilities of the receivables clerk are separate from the handling of cash (a test of control). Answer: FALSE Terms: Deciding whether audit sampling applies Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 45) Audit sampling can be applied to manual controls when application of the control produces documentary evidence of performance. Answer: TRUE Terms: Deciding whether audit sampling applies Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 46) When audit evidence is in electronic format, the auditor can use data analytics to test the entire population, rather than testing a sample of the population. Answer: TRUE Terms: Deciding whether audit sampling applies Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 47) The auditor uses professional judgment in establishing the tolerable exception rate for an attribute being tested in a population. Answer: TRUE Terms: Tolerable exception rate Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

48) As the auditor performs statistical procedures and finds material weaknesses in internal controls, it is important to communicate in writing to those at the audit client charged with governance. Answer: TRUE Terms: Communications with the audit committee or management Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 49) The auditor finds material weaknesses in system of internal controls before year end. In these situations, the auditor must issue an adverse opinion in the audit report on internal controls, even if the auditor is able to test management's corrected controls before year-end. Answer: FALSE Terms: Communications with the audit committee or management Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking 50) You are determining the appropriate sample size to test accounts receivable. What three factors are the most important to consider? Answer: 1. tolerable exception rate (TER) 2. acceptable risk of overreliance (ARO) 3. estimated population exception rate (EPER) Terms: Factors to determine appropriate sample size Difficulty: Easy Objective: LO 15-5 AACSB: Reflective thinking 51) Explain the effect on sample size of increasing each of the following: (1) tolerable exception rate, (2) estimated population exception rate, (3) acceptable risk of overreliance, and (4) population size. Answer: The tolerable exception rate and acceptable risk of overreliance are inversely related to sample size; that is, as TER or ARO increase, sample size will decrease. The estimated population exception rate and the population size are directly related to sample size; that is, as EPER increases, sample size will also increase, and as population size increases, sample size may slightly increase. Terms: Effects on sample size when increasing tolerable exception, estimated population exception rate, acceptable risk of assessing control risk too low, and population size Difficulty: Moderate Objective: LO 15-5 AACSB: Reflective thinking

15.6 Learning Objective 15-6 1) Rodgers CPA believes that the rate of client billing errors is 4% and has established a tolerable deviation rate of 6%. In auditing client invoices, Rodgers should use A) stratified sampling. B) classical sampling. C) proportional sampling. D) attributes sampling. Answer: D Terms: Auditing client invoices Difficulty: Easy Objective: LO 15-6 AACSB: Analytic thinking 2) Attributes sampling would be an appropriate method to use on which one of the following procedures in an audit program? A) Review sales transactions for large and unreasonable amounts. B) Observe whether the duties of the accounts receivable clerk are separate from handling cash. C) Examine a sample of duplicate sales invoices for credit approval by the credit manager. D) Review the aged schedule of accounts receivable to determine if receivables from officers are included. Answer: C Terms: Attributes sampling Difficulty: Moderate Objective: LO 15-6 AACSB: Reflective thinking 3) Attributes sampling is based on the ________ distribution, in which each possible sample in the population has one of two possible values, such as yes or no. A) random B) binomial C) statistical D) nonstatistical Answer: B Terms: Attribute sampling and binomial distribution Difficulty: Easy Objective: LO 15-6 AACSB: Reflective thinking

4) For which of the following audit procedures would audit sampling not be appropriate? A) Review sales transactions for large and unusual amounts. B) Examine a sample of duplicate sales invoices for credit approval. C) Compare the quantity on duplicate sales invoices with the quantity on related shipping documents. D) Audit sampling is appropriate for each of the above procedures. Answer: A Terms: Audit sampling not appropriate for which audit procedure Difficulty: Challenging Objective: LO 15-6 AACSB: Reflective thinking 5) Which of the following is one of the main differences between attributes sampling and nonstatistical sampling? A) the number of steps involved B) the calculation of the initial sample sizes C) determining the objectives of the audit test D) defining the population Answer: B Terms: Differences between attributes sampling and nonstatistical sampling Difficulty: Moderate Objective: LO 15-6 AACSB: Reflective thinking 6) Which of the following is an accurate statement regarding sampling distribution? A) A sampling distribution is a sample with characteristics the same as those of the population. B) Sampling distributions allow the auditor to make probability statements about the likely representativeness of any sample that is in the distribution. C) Each population exception rate and sample size has the same sampling distribution. D) Auditors cannot use sampling distributions to draw statistical conclusions about the unknown population being sampled. Answer: B Terms: Sampling distribution Difficulty: Moderate Objective: LO 15-6 AACSB: Reflective thinking 7) Auditors base their statistical inferences on sampling distributions. Answer: TRUE Terms: Sampling distribution Difficulty: Moderate Objective: LO 15-6 AACSB: Reflective thinking

8) Attributes sampling is based on the binomial distribution, in which each possible sample in the population has one of two possible values, such as control deviation or no control deviation. Answer: TRUE Terms: Attribute sampling and binomial distribution Difficulty: Moderate Objective: LO 15-6 AACSB: Reflective thinking 15.7 Learning Objective 15-7 1) A principal advantage of statistical methods of attributes sampling over nonstatistical methods is that they provide a quantifiable basis for establishing the A) risk of assessing control risk too low. B) tolerable exception rate. C) expected population exception rate. D) sample size. Answer: D Terms: Advantage of statistical methods of attributes sampling Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking 2) In using sampling distribution for attributes, which one of the following must be known to evaluate the sample results? A) estimated dollar value of the population B) standard exception of the values in the population C) actual exception rate of the attribute in the population D) sample size Answer: D Terms: Estimation sampling for attributes Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking 3) When evaluating the results of attributes sampling, A) the acceptable risk of overreliance (ARO) is set at high or low. B) tables are used to compute the computed upper exception rate (CUER). C) if the sample size is not equal to those provided for in the attributes sampling evaluation tables, the tables cannot be used. D) the true exception rate is computed from various tables. Answer: B Terms: Attributes sampling application Difficulty: Challenging Objective: LO 15-7 AACSB: Reflective thinking

4) When deciding the acceptability of the population, A) the methodology for deciding the acceptability of the population for attributes differs from determining the acceptability for nonstatistical sampling. B) before the population can be considered acceptable, the CUER determined on the basis of the actual sample results must be less than or equal to TER when both are based on the same ARO. C) when the CUER is greater than the TER, the auditor must increase the sample size. D) the CUER is compared with the TER in total, not for each attribute. Answer: B Terms: Acceptability of the population and attribute sampling Difficulty: Challenging Objective: LO 15-7 AACSB: Reflective thinking 5) When planning the sample, A) auditors using attributes sampling assign a low, medium, or high acceptable risk of overreliance. B) tables are used by the auditor in statistical sampling to determine initial sample size. C) most auditors use attributes sampling for medium to small populations. D) the tolerable exception rate does not need to be specified for statistical sampling. Answer: B Terms: Planning the audit sample Difficulty: Challenging Objective: LO 15-7 AACSB: Reflective thinking 6) As the auditor, you are assessing the proper sample size to use in testing controls. When using attributes sampling, which of the following is most correct? A) A 10% change in population size will have the least effect on sample size. B) A 10% change in the tolerable deviation rate will have the least effect on sample size. C) A 10% change in the expected deviation rate will have the least effect on sample size. D) A 10% change in the tolerable deviation rate will have the most effect on sample size. Answer: A Terms: Attributes sampling Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking

7) In attributes sampling, an estimate of the expected population exception rate is necessary to plan the sample size. The relationship of expected population exception rate (EPER) to sample size is A) direct (small EPER = small sample). B) inverse (small EPER = large sample). C) a variable (sometimes small, sometimes large) dependent on other factors present. D) indeterminate. Answer: A Terms: Attributes sampling; Expected population exception rate and sample size Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking 8) Which of the following is true regarding statistical sampling including the auditor's use of professional judgment? A) The final evaluation of the adequacy of the application of sampling is based on high-level professional judgment. B) To select the initial sample size for a statistical sample, professional judgment is not required. C) The estimated population exception rate does not require professional judgment. D) None of the following statements is true. Answer: A Terms: Planning the audit sample Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking; Analytic thinking 9) Statistical sampling eliminates any professional judgment for the auditor. Answer: FALSE Terms: Statistical sampling and professional judgment Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking 10) Because attributes sampling is a statistical sampling approach, it allows the auditor to quantify the allowance for sampling risk and the upper exception rate. Answer: TRUE Terms: Evaluating sample results Difficulty: Moderate Objective: LO 15-7 AACSB: Reflective thinking

11) In selecting the sample, probabilistic methods must be used for both statistical and nonstatistical sampling. Answer: FALSE Terms: Selecting the sample size Difficulty: Easy Objective: LO 15-7 AACSB: Reflective thinking 12) There are 14 steps to attributes sampling, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss the three steps that comprise the "evaluate the results" section. Answer: The steps that comprise the "evaluate the results" section in attributes sampling are: 1. Generalize from the sample to the population. Tables can be used to determine the upper precision limit (computed upper exception rate) at a specified acceptable risk of overreliance. 2. Analyze exceptions. In this step, the auditor should analyze individual exceptions to determine the breakdown in the system of internal controls that caused them. 3. Decide the acceptability of the population. In the final step, the auditor compares the computed upper exception rate with the tolerable exception rate for each attribute. If the computed upper exception rate is less than or equal to the tolerable exception rate, then the population is considered acceptable. Terms: Steps that comprise evaluate the results section of 14 steps to attributes sampling Difficulty: Challenging Objective: LO 15-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 16 Completing the Tests in the Sales and Collection Cycle: Accounts Receivable 16.1 Learning Objective 16-1 1) The two primary classes of transactions in the sales and collection cycle are A) sales and sales discounts. B) sales and cash receipts. C) sales and sales returns. D) sales and accounts receivable. Answer: B Terms: Classes of transactions; Sales and collection cycle Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 2) The appropriate evidence to be obtained from tests of details of balances must be decided on an A) efficiency basis. B) effectiveness basis. C) objective-by-objective basis. D) none of the above Answer: C Terms: Tests of details Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 3) Auditors are especially concerned with three aspects of system of internal control for the sales and collection cycle. Which of the following is not one of their major concerns? A) controls over cutoff B) controls that prevent or detect embezzlements C) controls over sales discounts D) controls related to the allowance for uncollectible accounts Answer: C Terms: Sales and collection cycle Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking

4) For sales, the occurrence transaction-related audit objective affects which balance-related audit objective? A) existence B) completeness C) rights D) detail tie-in Answer: A Terms: Sales transaction-related audit objective Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 5) For cash receipts, the occurrence transaction-related audit objective affects which balancerelated audit objective? A) existence B) completeness C) rights D) detail tie-in Answer: B Terms: Cash receipts transaction-related objective Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 6) Which of the following is an accurate statement regarding the risk assessment process of phase I of the audit process for the sales and collection cycle? A) Auditors must perform substantive tests related to assertions deemed to have significant risks. B) The auditor must relate control risk for transaction-related audit objectives to balance-related audit objectives in deciding planned inherent risk. C) The realizable value balance-related audit objectives are affected by assessed control risk for classes of transactions. D) All of the above are accurate statements. Answer: A Terms: Risks in the sales and collection cycle Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 7) For sales, the completeness transaction-related audit objective affects the existence balancerelated audit objective. Answer: FALSE Terms: Completeness transaction-related audit objective; Existence balance-related audit objective Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

8) Recording a sale that did not occur violates the occurrence transaction-related audit objective and the existence balance-related audit objective. Answer: TRUE Terms: Cash receipts; Occurrence transaction-related audit objective; existence balance-related audit objective Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 9) The accounts receivable balance-related audit objective net realizable value is not affected by assessed control risk for sales or cash receipts. Answer: TRUE Terms: Accounts receivable balance-related audit objective net realizable value; Assessed control risk Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking 10) The results of the tests of controls determine whether assessed control risk for sales and cash receipts needs to be revised. Answer: TRUE Terms: Tests of controls and control risk Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 11) Auditors use the results of the substantive tests of transactions of sales and the collection cycle to determine the extent to which inherent risk is satisfied for each accounts receivable balance-related audit objective. Answer: FALSE Terms: Tests of controls and substantive tests of transactions Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 12) For most audits, revenue recognition is considered to be a significant risk. Answer: TRUE Terms: Revenue recognition and fraud Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking

13) The auditor studies the client's industry and external environment, and also evaluates management objectives and business processes to identify significant client risks that could affect the accounts receivable balance. Answer: TRUE Terms: Assessing risk of material misstatement for accounts receivable Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 14) The auditor assesses inherent risk for accounts receivable, considering client risk and the nature of the audit client and the nature of the industry which the client is operating in. Answer: TRUE Terms: Assessing risk of material misstatement for accounts receivable Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 15) It is not common for audit clients to misstate cutoff either by error or through fraud. Answer: FALSE Terms: Assessing risk of material misstatement for accounts receivable Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 16) It is common for clients to unintentionally or fraudulently misstate the allowance for doubtful accounts due to the difficulty in estimating the correct balance in this account. Answer: TRUE Terms: Assessing risk of material misstatement for accounts receivable Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 17) When allocating the preliminary judgment about materiality for the financial statements, accounts receivable is typically one of the most material accounts in the financial statements for companies selling on credit. Answer: TRUE Terms: Setting performance materiality for accounts receivable Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking

18) If sales returns and allowances and write-off of uncollectible accounts receivable are significant, the assessed control risk must be considered for these two classes of transactions. Answer: TRUE Terms: Assessing control risk for the sales and collection cycle Difficulty: Easy Objective: LO 16-1 AACSB: Reflective thinking 19) Name the nine balance-related general audit objectives specifically applied to an audit of accounts receivable: Answer: 1. Accounts receivable on the aged trial balance agree with the general ledger balance (detail tie-in). 2. Recorded accounts receivable exists (existence). 3. Existing accounts receivable are included (completeness). 4. Accounts receivable are accurate (accuracy). 5. Cutoff for accounts receivable is correct (cutoff). 6. Accounts receivable are stated at realizable value (realizable value). 7. Accounts receivable are correctly classified (classification). 8. Client has the rights to accounts receivable (rights). 9. Accounts receivable are appropriate aggregated, clearly described, and related financial statement disclosures are relevant and understandable (presentation). Terms: Accounts receivable balance-related objectives Difficulty: Moderate Objective: LO 16-1 AACSB: Reflective thinking

16.2 Learning Objective 16-2 1) Which of the following types of receivables would not deserve the special attention of the auditor? A) accounts receivables with credit balances B) accounts that have been outstanding for a long time C) receivables from related parties D) Each of the above would receive special attention. Answer: D Terms: Receivables; Special attention Difficulty: Easy Objective: LO 16-2 AACSB: Reflective thinking 2) Analytical procedures are substantive tests and, if the results of the analytical procedures are favorable, the auditor would normally A) reduce the extent of tests of details of balances. B) reduce the extent of tests of controls. C) reduce the tests of transactions. D) reduce all of the other tests. Answer: A Terms: Analytical procedures; Substantive tests Difficulty: Moderate Objective: LO 16-2 AACSB: Reflective thinking 3) Analytical procedures A) are only done during the planning of the audit and when performing detailed tests. B) performed during the detailed testing phase are done before tests of details of balances. C) performed during the detailed testing phase are done before the balance sheet date. D) are performed only on accounts receivable, not on the entire sales and collection cycle. Answer: B Terms: Analytical procedures Difficulty: Moderate Objective: LO 16-2 AACSB: Reflective thinking

4) Which of the following is a correct statement regarding analytical procedures? A) If an auditor identifies a possible misstatement in sales using analytical procedures, accounts payable will be the likely offsetting misstatement. B) Auditors should also compare the results of their analytical procedures to budgets and industry trends. C) If sales are overstated, the income statement will be incorrect, but the balance sheet will be correct. D) If an analytical procedure uncovers an unusual fluctuation, the auditor must assume fraud is involved. Answer: B Terms: Analytical procedures Difficulty: Moderate Objective: LO 16-2 AACSB: Reflective thinking 5) An auditor is comparing the write-off of uncollectible accounts as a percentage of total accounts receivable with previous years. A possible misstatement this procedure could uncover is A) overstatement or understatement of sales. B) overstatement or understatement of accounts receivable. C) overstatement or understatement of bad debt expense. D) overstatement or understatement of sales returns and allowances. Answer: C Terms: Understatement of sales and accounts receivable Difficulty: Challenging Objective: LO 16-2 AACSB: Analytic thinking 6) Favorable results from analytical procedures may reduce the extent to which the auditor needs to test details of balances. Answer: TRUE Terms: Analytical procedures; Test details of balances Difficulty: Easy Objective: LO 16-2 AACSB: Reflective thinking 7) When analytical procedures in the sales and collection cycle uncover unusual fluctuations, the auditor should make additional inquiries of management. Answer: TRUE Terms: Analytical procedures; Sales and collection cycle Difficulty: Easy Objective: LO 16-2 AACSB: Reflective thinking

8) A high inherent risk increases planned detection risk and decreases planned substantive tests. Answer: FALSE Terms: Analytical procedures Difficulty: Moderate Objective: LO 16-2 AACSB: Reflective thinking 9) Auditors perform both planning and substantive analytical procedures for the entire sales and collection cycle, not just accounts receivable. Answer: TRUE Terms: Designing and performing substantive audit procedures Difficulty: Easy Objective: LO 16-2 AACSB: Reflective thinking 10) Below are listed possible misstatements that could occur in the sales and collections cycle. Provide the analytical procedure that would be most useful in detecting the possible misstatement. a. overstatement of sales and accounts receivable b. uncollectible accounts receivable that have not been provided for c. overstatement of sales returns and allowances Answer: a. compare gross margin percentage with previous year by product line; compare sales by month (by product line), over time b. compare bad debt expense as a percentage of gross sales from previous years c. compare sales returns and allowances as a percentage of gross sales with previous years (by product line) Terms: Analytical procedures; Sales and collection cycle Difficulty: Moderate Objective: LO 16-2 AACSB: Analytic thinking 11) Name three data visualization techniques which can be used by the auditor for evaluating disaggregated data which may be helpful in identifying unexpected amounts, relationships, or trends in accounts receivable. Answer: Bar charts; trend lines; scatterplots; and other types of graphical displays such as multiple regression plots or lines. Terms: Designing and performing substantive analytical procedures Difficulty: Easy Objective: LO 16-2 AACSB: Reflective thinking

16.3 Learning Objective 16-3 1) The understatement of sales and accounts receivable is best uncovered by A) testing system of internal controls. B) testing the aged accounts receivable trial balance. C) substantive tests of transactions for shipments made but not recorded. D) substantive tests of transactions for bad debts. Answer: C Terms: Understatement of sales and accounts receivable Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 2) Tests of which balance-related audit objective are normally performed first in an audit of the sales and collection? A) accuracy B) completeness C) rights D) detail tie-in Answer: D Terms: Tests of balance-related audit objective; Sales and collection Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 3) A listing of the balances in the accounts receivable database at the balance sheet date, including individual customer balances outstanding and a breakdown of each balance by the time passed between the date of the sale and the balance sheet date, is the A) customer list. B) aged trial balance. C) accounts receivable ledger. D) schedule of accounts receivable. Answer: B Terms: Listing of balances in accounts receivable database Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking

4) Testing the information on the aged trial balance for detail tie-in is a necessary audit procedure, which would normally include A) Test-footing the total column Comparing the total of the aged trial balance and the columns depicting the with the general ledger accounts receivable aging account Yes Yes B) Test-footing the total column and the columns depicting the aging No

Comparing the total of the aged trial balance with the general ledger accounts receivable account No

Test-footing the total column and the columns depicting the aging Yes

Comparing the total of the aged trial balance with the general ledger accounts receivable account No

Test-footing the total column and the columns depicting the aging No

Comparing the total of the aged trial balance with the general ledger accounts receivable account Yes

Answer: A Terms: Detail tie-in; Audit procedure Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 5) Audit procedures designed to uncover credit sales made after the client's fiscal year-end that relate to the current year being audited provide evidence for which of the following audit objectives? A) realizable value B) accuracy C) cutoff D) existence Answer: C Terms: Audit procedures to uncover credit sales Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking

6) Cutoff misstatements occur when A) The auditor fails to obtain Subsequent period the end-of-year bank transactions are statement directly from the recorded in the bank, obtaining instead the current period statement which includes the two succeeding weeks Yes Yes B) The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks Yes C) The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks No D) The auditor fails to obtain the end-of-year bank statement directly from the bank, obtaining instead the statement which includes the two succeeding weeks No

Current period transactions are recorded in the subsequent period

Subsequent period transactions are recorded in the current period

Current period transactions are recorded in the subsequent period

Yes

Subsequent period transactions are recorded in the current period

Current period transactions are recorded in the subsequent period

Yes

Subsequent period transactions are recorded in the current period

Current period transactions are recorded in the subsequent period

Yes

Answer: C Terms: Cutoff misstatements Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking

7) Cutoff misstatements occur A) either by error or fraud. B) by error only. C) by fraud only. D) randomly without causes related to errors or fraud. Answer: A Terms: Cutoff misstatements Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 8) Which of the following is likely to be determined first when performing tests of details for accounts receivable? A) Recorded accounts receivable exist. B) Accounts receivable in the aged trial balance agree with related database amounts, and the total is correctly added and agrees with the general ledger. C) The client has a right to the accounts receivable. D) Existing accounts receivable are included. Answer: B Terms: Tests of details for accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 9) An auditor is performing a credit analysis of customers with balances over 60 days due. She/he is most likely obtaining evidence for which audit-related objective? A) realizable value B) existence C) completeness D) occurrence Answer: A Terms: Audit-related objective Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 10) The most important test of details of balances to determine the existence of recorded accounts receivable is A) tracing details of sales invoices to shipping documents. B) tracing the credits in accounts receivable to bank deposits. C) tracing sales returns entries to credit memos issued and receiving room reports. D) the confirmation of customers' balances. Answer: D Terms: Test of details of balances; Existence of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 12 Copyright © 2023 Pearson Education, Inc.

11) Because of its central role in auditing of accounts receivable, which of the following would normally be one of the first items tested? A) accounts receivable database B) customer file C) aged trial balance D) sales register Answer: C Terms: Central role in auditing accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 12) Confirmation of accounts receivable selected from the trial balance is the most common test of details of balances for the ________ of accounts receivable. A) presentation B) valuation C) accuracy D) detail tie-in Answer: C Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 13) Most tests of accounts receivable are based on what schedule, file, or listing? A) sales database B) aged accounts receivable trial balance C) accounts receivable database D) accounts receivable general ledger account Answer: B Terms: Tests of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 14) If the client's system of internal control for recording sales returns and allowances is evaluated as ineffective, A) a larger sample may be needed to verify cutoff. B) sampling is not appropriate. C) all sales returns must be traced to supporting documentation. D) all sales returns must be confirmed with the customer. Answer: A Terms: Internal control; Sales returns and allowances Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

15) A customer mails and records a check to a client for payment of an unpaid account on December 30. The client receives and records the amount on January 2. The records of the two organizations will be different on December 31. This represents A) A cutoff misstatement A timing difference Yes Yes B) A cutoff misstatement No

A timing difference No

A cutoff misstatement Yes

A timing difference No

A cutoff misstatement No

A timing difference Yes

Answer: D Terms: Records will be different Difficulty: Moderate Objective: LO 16-3 AACSB: Analytic thinking 16) Which of the following audit procedures would not likely detect a client's decision to pledge or factor accounts receivable? A) a review of the minutes of the board of directors' meetings B) discussions with the client C) confirmation of receivables D) examination of correspondence files Answer: C Terms: Audit procedures; Pledge or factor accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

17) When do most companies record sales returns and allowances? A) during the month in which the sale occurs B) during the accounting period in which the return occurs C) whenever the customer contacts the company regarding the credit D) during the month after the sale occurs Answer: B Terms: Record sales returns and allowances Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 18) Cutoff misstatements can occur for A) Sales Sales returns and allowances Yes Yes B) Sales No

Sales returns and allowances No

Sales Yes

Sales returns and allowances No

Sales No

Sales returns and allowances Yes

Answer: A Terms: Cutoff misstatements Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 19) The most important aspect of evaluating the client's method of obtaining a reliable cutoff is to A) perform extensive detailed testing of cutoff. B) evaluate the client's control procedures around cutoff. C) confirm a sample of transactions near period end with customers. D) confirm transaction with customers. Answer: B Terms: Reliable cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

20) Which of the following audit procedures would normally be included in the audit plan when auditing the allowance for doubtful accounts? A) Send positive confirmations. B) Inquire of the client's credit manager. C) Send negative confirmations. D) Examine sales invoices. Answer: B Terms: Auditing allowance for doubtful accounts Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 21) Generally accepted accounting principles require that sales returns and allowances be matched with related sales A) if practical. B) if required by industry practice. C) if the amounts are material. D) any of the above Answer: C Terms: Generally accepted accounting principles Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 22) For which of the following accounts is cutoff least important? A) sales B) sales returns and allowances C) cash collections D) inventory Answer: C Terms: Cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 23) Which of the following most likely would be detected by a review of a client's sales cutoff? A) excessive sales discounts B) unrecorded sales for the year C) unauthorized goods returned for credit D) lapping of year-end accounts receivable Answer: B Terms: Sales cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Analytic thinking

24) How might the auditor determine whether a client has limited rights to accounts receivable? A) Review minutes from board of directors' Inquiries of the client meetings Yes Yes B) Review minutes from board of directors' meetings No C) Review minutes from board of directors' meetings Yes D) Review minutes from board of directors' meetings No

Inquiries of the client No

Inquiries of the client Yes

Answer: A Terms: Limited rights to accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 25) You are reviewing sales to discover cutoff problems. If the client's policy is to record sales when title to the merchandise passes to the buyer, then the books and records would contain errors if the December 31 entries were for sales recorded A) before the merchandise was shipped. B) at the time the merchandise was shipped. C) several days subsequent to shipment. D) at a time after the point at which title passed. Answer: A Terms: Cutoff problems Difficulty: Challenging Objective: LO 16-3 AACSB: Analytic thinking

26) A procedure to test for a cash receipts cutoff error is A) reconciling the bank statement. B) performing a four-column proof-of-cash. C) observing the counting of cash at the balance sheet date. D) tracing recorded cash receipts to subsequent period bank deposits on the bank statement. Answer: D Terms: Test for cash receipts cutoff Difficulty: Challenging Objective: LO 16-3 AACSB: Reflective thinking 27) If material, all of the following are required to be separately disclosed in the financial statements except for A) accounts receivable from officers. B) accounts receivable from affiliates. C) sales and assets for different business segments. D) sales for the last ten days of the fiscal year. Answer: D Terms: Accounts receivable presentation and disclosure Difficulty: Easy Objective: LO 16-3 AACSB: Analytic thinking 28) For effective system of internal control, employees maintaining the accounts receivable subsidiary ledger should not also approve A) employee overtime wages. B) credit granted to customers. C) write-offs of customer accounts. D) cash disbursements. Answer: C Terms: Internal control; Accounts receivable Difficulty: Challenging Objective: LO 16-3 AACSB: Reflective thinking 29) For most audits, a proper cash receipts cutoff is less important than the sales cutoff because the improper cutoff of cash A) is detected and correct when cash is separately audited. B) is unlikely to have a material impact on the balance sheet or the income statement. C) affects items on the balance sheet but does not affect net income. D) rarely occurs given the control consciousness of most entities. Answer: C Terms: Cash receipts cutoff; Sales cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

30) One of the shortcomings in evaluating the allowance for uncollectible accounts by reviewing individual noncurrent balances on the aged trial balance is I. it is difficult to compare the results of the current year with those of the previous year. II. current accounts are ignored in establishing the adequacy of the allowance. A) I only B) II only C) both I and II D) neither I nor II Answer: C Terms: Accounts receivable; Realizable value Difficulty: Moderate Objective: LO 16-3 AACSB: Analytic thinking 31) An auditor selects a sample from the file of shipping documents to determine whether invoices were prepared. This test is to satisfy the audit objective of A) accuracy. B) existence. C) control. D) completeness. Answer: D Terms: Sample of shipping documents; Audit objective Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 32) When designing tests of details of balances, an important point to remember is A) auditors emphasize income statement accounts. B) the audit procedures selected depends heavily on whether planned evidence for a given objective is low, medium, or high. C) if accounts receivable are overstated, then sales will be understated. D) sales cutoff is the most important test of details of accounts receivable. Answer: B Terms: Accounts receivable audit evidence Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking

33) The net realizable value of accounts receivable is equal to A) gross accounts receivable less allowance for uncollectible accounts. B) gross accounts receivable less bad debt expense. C) gross accounts receivable less returns and allowances. D) gross accounts receivable less sales discounts. Answer: A Terms: Realizable value for accounts receivable Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 34) When an auditor tests to determine if all existing accounts receivable are included in the aged trial balance, A) they cannot rely on the self-balancing nature of the accounts receivable database. B) if all sales to a customer are omitted from the sales journal, it is easy to uncover the understatement of accounts receivable by tests of details of balances. C) auditors rarely send accounts receivable confirmations to customers with zero balances. D) unrecorded sales to a new customer are easy to identify for confirmation because that customer is included in the accounts receivable database. Answer: C Terms: Existing accounts receivable are included Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 35) Tests of detail tie-in are normally conducted last in the audit of the sales and collections cycle. Answer: FALSE Terms: Tests of details tie-in; Sales and collections cycle Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking 36) The criterion used by most merchandising and manufacturing clients for determining when revenue recognition takes place is whether title to the goods has passed. Answer: FALSE Terms: Revenue recognition Difficulty: Easy Objective: LO 16-3 AACSB: Reflective thinking

37) After the auditor is satisfied with the allowance for uncollectible accounts, it is easy to verify bad debt expense. Answer: TRUE Terms: Allowance for doubtful accounts and bad debts Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 38) Tests of the presentation and disclosure-related objectives are generally done as part of the completion phase of the audit. Answer: TRUE Terms: Tests of presentation and disclosure-related objectives; Completion phase of audit Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 39) Confirmation is the most common test of details of balances for the accuracy of accounts receivable. Answer: TRUE Terms: Confirmation; Test of details of balances Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 40) Tests of the realizable value balance-related audit objective are for the purpose of evaluating the allowance for doubtful accounts. Answer: TRUE Terms: Tests of realizable value balance-related audit objective Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 41) For most audits, a proper cash receipts cutoff is less important than either the sales or the sales returns and allowances cutoff since cash only affects the balance sheet, and not earnings. Answer: TRUE Terms: Cash receipts cutoff; Sales or sales returns and allowances cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

42) As a test of the occurrence transaction-related audit objective for sales and the accuracy balance-related audit objective for accounts receivable, auditors can use audit data analytics to match, for example, cash receipts to invoiced sales amounts. Answer: TRUE Terms: Audit data analytics for the accuracy of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 43) Audit data analytics can be used to test accuracy of invoices outstanding at the end of the year by matching these invoices to subsequent cash receipts after year-end. Answer: TRUE Terms: Audit data analytics for the accuracy of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 44) The auditor can use audit data analytics to identify potential situations where sales returns are understated or the allowance for doubtful accounts is understated for specific customers. Answer: TRUE Terms: Audit data analytics for the accuracy of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 45) Many manufacturing and merchandising audit clients record sales based on shipment of goods criterion and make the necessary adjustments at period end to record revenues in the proper period. Answer: TRUE Terms: Sales cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 46) If sales are made FOB (free on board) shipping point or FOB destination at a period end, revenue does not need to be adjusted in either situation. Answer: FALSE Terms: Sales cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

47) For retailers, the auditor should examine supporting documentation for a sample of sales returns and allowances recorded for several weeks after year end to determine if the allowance for returns and allowances is adequate. Answer: TRUE Terms: Sales returns and allowances cutoff Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 48) It is acceptable under generally accepted accounting principles for the client to include material related party receivables together with trade receivables on the balance sheet. Answer: FALSE Terms: Classification of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 49) Significant credit balances in accounts receivable should be reclassified as accounts payable. Answer: TRUE Terms: Classification of accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 50) The auditor must have a thorough understanding of the accounting standards, including presentation and disclosure requirements, for accounts receivable when performing the audit of accounts receivable. Answer: TRUE Terms: Accounts receivable presentation and disclosure Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 51) Describe how the auditor tests the accuracy objective for accounts receivable. Answer: Confirmation of accounts selected from the trial balance is the most common test of details of balances for the accuracy of accounts receivable. When customers do not respond to confirmation requests, auditors examine supporting documents to verify shipment of goods and evidence of subsequent cash receipts to determine whether the accounts were collected. Auditors perform tests of the debits and credits to individual customers' balances by examining supporting documentation for shipments and cash receipts. Terms: Auditors test the accuracy objective for accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

52) Cutoff misstatements can occur for sales, sales returns, and cash receipts. List below the threefold approach an auditor performs for each account above to determine the reasonableness of the cutoff. Answer: 1. Decide on the appropriate criteria for cutoff. 2. Evaluate whether the client has established adequate procedures to ensure a reasonable cutoff. 3. Test whether the cutoff was correct. Terms: Cutoff for Accounts Receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Analytic thinking 53) Discuss the audit procedures performed when testing the detail tie-in objective for accounts receivable, and explain why this objective is ordinarily tested before any other objectives for accounts receivable. Answer: When testing the detail tie-in objective for accounts receivable, the total column and the columns depicting the aging on the aged trial balance must be test footed, and the total on the trial balance is compared with the general ledger. In addition, a sample of individual balances on the aged trial balance should be traced to supporting documents, such as duplicate sales invoices, to verify the customer's name, balance, and proper aging. Auditors test the information on the aged trial balance for detail tie-in before any other tests to verify that the population being tested agrees with the general ledger and accounts receivable database. Terms: Audit objectives for accounts receivable Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking 54) Assuming the client's system of internal controls are effective, describe how the auditor can verify proper cutoff of sales transactions. Answer: Assuming the client's system of internal controls are effective, the auditor can verify proper cutoff of sales transactions by obtaining the shipping document number for the last shipment made at the end of the period and comparing this number with current and subsequent period recorded sales. Terms: Adequate system of internal controls; Cutoff of sales transactions Difficulty: Moderate Objective: LO 16-3 AACSB: Reflective thinking

16.4 Learning Objective 16-4 1) Which of the following is the principle "weakness" of using negative confirmations for the tests of details of balances for accounts receivable? A) They can only be used for large balance accounts. B) They cannot be used when account balances "bunch" around a mean value. C) Conclusions drawn from receiving no reply may not be correct. D) Response rates are generally too low to draw any conclusions. Answer: C Terms: Negative confirmations; Tests of details of balances of accounts receivable Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking 2) Communication addressed to the debtor requesting him or her to confirm whether the balance as stated on the communication is correct or incorrect is a A) representation letter. B) negative confirmation. C) bank confirmation. D) positive confirmation. Answer: D Terms: Confirm balance Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking 3) A type of positive confirmation known as a blank confirmation A) requests the recipient to fill in the amount of the balance. B) is considered less reliable than the regular positive confirmation. C) generates as high a response rate as the regular positive confirmation form. D) is used when the auditor is confirming several small balances. Answer: A Terms: Positive confirmation; Blank confirmation Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking 4) The most effective audit evidence gathered for accounts receivable is the A) detail tie-in of the records. B) analysis of the allowance for doubtful accounts. C) confirmation of accounts receivable. D) examination of sales invoices. Answer: C Terms: Accounts receivable audit evidence Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 25 Copyright © 2023 Pearson Education, Inc.

5) The audit procedure that provides the auditor with the most appropriate evidence when performing test of details of balances for accounts receivable is A) confirmations. B) recalculation of the aged receivables and uncollectible accounts. C) tracing credit memos for returned merchandise to receiving room reports. D) tracing from shipping documents to journals to the accounts receivable ledger. Answer: A Terms: Tests of balances for accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 6) When should auditors not perform alternative procedures in testing the accounts receivable balance? A) when customers do not return positive confirmation requests B) when customers do not return negative confirmation requests C) when confirmations are deemed to be ineffective as an audit procedure D) when confirmations are too costly to use Answer: B Terms: Alternative procedures in testing accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 7) A positive confirmation is more reliable evidence than a negative confirmation because A) fewer confirmations can be sent out. B) the auditor has a document which can be used in court. C) the debtor's lack of response indicates agreement with the stated balance. D) follow-up procedures are performed if a response is not received from the debtor. Answer: D Terms: Positive confirmation; Negative confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

8) When positive confirmations are used, auditing standards require alternative procedures for confirmations not returned by the customer. Which of the following would not be considered an alternative procedure? A) Send a second confirmation request. B) Examine subsequent cash receipts to determine if the receivable has been paid. C) Examine shipping documents to verify that the merchandise was shipped. D) Examine sales invoice to verify the actual issuance of a sales invoice and the actual date of the billing. Answer: A Terms: Positive confirmations; Alternative procedures Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 9) The positive (as opposed to the negative) form of receivables confirmation may be preferred when A) internal control surrounding accounts receivable is considered to be effective. B) there is reason to believe that a substantial number of accounts may be in dispute. C) a large number of small balances are involved. D) the auditor believes that the recipients of the confirmations will give the requests adequate consideration. Answer: B Terms: Positive confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 10) An auditor should perform alternative procedures to substantiate the existence of accounts receivable when A) no reply to a positive confirmation request is received. B) no reply to a negative confirmation request is received. C) collectibility of the receivables is in doubt. D) pledging of the receivables is probable. Answer: A Terms: Auditor performs alternative procedures to substantiate existence of accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

11) Confirmation of accounts receivable balances normally provides evidence concerning the A) valuation of the balances. B) rights of the balances. C) existence of the balances. D) completeness of the balances. Answer: C Terms: Confirmation of accounts receivable balances Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 12) If the auditor decides not to confirm accounts receivable that are material, the auditor should A) always use alternative procedures to audit the accounts receivable. B) include copies of customer statements in the audit files. C) document the reasons for such a decision in the audit files. D) include copies of customer sales invoices in the audit files. Answer: C Terms: Confirm accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 13) The most reliable evidence from confirmations is obtained when they are sent A) as close to the balance sheet date as possible. B) at various times throughout the year to different segments of the sample, so that the entire sample is representative of account balances scattered throughout the year. C) several months before the year-end, so the auditor will have adequate time to perform alternate procedures if they are required. D) at various times throughout the year to the same group in the sample, so that the sample will not have a time bias. Answer: A Terms: Reliable evidence from confirmations Difficulty: Challenging Objective: LO 16-4 AACSB: Reflective thinking 14) A type of positive confirmation in which an individual invoice is confirmed, rather than the customer's entire accounts receivable balance, is the ________ confirmation. A) invoice B) specific C) balance D) voucher Answer: A Terms: Confirmations Difficulty: Challenging Objective: LO 16-4 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

15) Confirmation of accounts receivable provides evidence related to the ________ objectives. A) existence B) accuracy C) cutoff D) all of the above Answer: A Terms: Confirmation of accounts receivable; Existence, accuracy, and cutoff objectives Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 16) When determining the timing of the accounts receivable confirmations, A) the receivables cannot be confirmed at an interim date. B) if accounts receivable are confirmed before year-end, the auditor typically prepares a rollforward schedule. C) if the receivables are confirmed at an interim date, they must also be confirmed at year-end. D) if system of internal controls are adequate, the accounts receivable must be confirmed at yearend. Answer: B Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 17) When making the sampling decisions for accounts receivable confirmations, A) it is important to sample some items for every material segment of the population. B) if management refuses to allow the auditor to send confirmation requests to certain customers, the auditor must withdraw from the engagement. C) inherent risk does not impact the sample size. D) stratification of the sample is discouraged under current auditing standards. Answer: A Terms: Sample size for confirming accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 18) A confirmation is a type of audit evidence. Answer: TRUE Terms: Confirmation of accounts receivable balances Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking

19) The auditor should perform procedures to verify the addresses used for the accounts receivable confirmations. Answer: TRUE Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 20) Both U.S. and international auditing standards require the use of confirmations for accounts receivable. Answer: FALSE Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 21) Blank confirmations are considered less reliable than standard positive confirmations. Answer: FALSE Terms: Blank confirmations; Standard positive confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 22) Negative confirmations are less expensive, and less reliable, than positive confirmations. Answer: TRUE Terms: Negative confirmations; Positive confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 23) It is common to use a combination of positive and negative confirmations by sending the latter to accounts with large balances and the former to those with small balances. Answer: FALSE Terms: Positive confirmation; Negative confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 24) If auditors consider confirmations of accounts receivable to be ineffective evidence because response rates will be inadequate or unreliable, they need not confirm accounts receivable. Answer: TRUE Terms: Confirmations of accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

25) Negative confirmations normally require a larger sample size than positive confirmations. Answer: TRUE Terms: Negative confirmations; Positive confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 26) When sending confirmations during most audits of accounts receivable, the emphasis is often on confirming larger and older accounts. Answer: TRUE Terms: Confirmations of accounts receivable Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 27) When a customer disagrees with the amount shown on an account receivable confirmation, the auditor should not ask the client to reconcile the difference. Answer: FALSE Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 28) Auditors must maintain control of confirmations until they are returned from the customer. Answer: TRUE Terms: Control of confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 29) The confirmations must be mailed by the auditor, but should contain the return address of the client. Answer: FALSE Terms: Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 30) Stratification of accounts receivable is desirable when using confirmations. Answer: TRUE Terms: Stratification of accounts receivable Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking

31) Each client misstatement in accounts receivable must be analyzed to determine whether it was consistent with the original assessed level of control risk. Answer: TRUE Terms: Alternative procedures; Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 32) U.S. auditing standards indicate that auditors should use external confirmations for accounts receivable. However, there are certain circumstances where confirmation may not be appropriate. List these three situations. Answer: The three situations are: 1. The overall accounts receivable balance is immaterial. 2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. 3. The auditor's assessed level of the risk of material misstatement (represented by the combined level of inherent risk and control risk) is low and other substantive evidence can be accumulated to provide sufficient evidence. Terms: Exceptions to auditing standards requiring confirmations Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking 33) Describe the differences between positive and negative confirmations. Which type is generally viewed as more reliable? Answer: A positive confirmation is a letter, addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect, and, if incorrect, by what amount. In contrast, a negative confirmation requests the debtor to respond only if the recipient disagrees with the amount of the stated account balance. Positive confirmations are more reliable because the auditor can perform follow-up procedures if a response is not received from the customer. With a negative confirmation, failure to reply must be regarded as a correct response, even though the debtor may have ignored the confirmation request. Terms: Positive and negative confirmations Difficulty: Easy Objective: LO 16-4 AACSB: Reflective thinking

34) Discuss the alternative procedures an auditor can perform to test the existence objective for accounts receivable when customers do not respond to confirmation requests. Answer: For any positive confirmation not returned, the auditor can examine the following to verify the existence of individual sales transactions making up the ending balance in accounts receivable: • Subsequent cash receipts—evidence of the receipt of cash subsequent to the confirmation date includes examining remittance advices, entries in the cash receipts records, or even subsequent credits in the accounts receivable database. • Duplicate sales invoices—useful in verifying the actual issuance of a sales invoice and the actual date of the billing. • Shipping documents—these are important in establishing whether the shipment was actually made and as a test of cutoff. • Correspondence with the client—used to discover disputed and questionable receivables not uncovered by other means. Terms: Alternative procedures; Existence objective for accounts receivable; Confirmation requests Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 35) Discuss the advantages and disadvantages of using negative accounts receivable confirmations rather than positive confirmations. Answer: The primary advantage of negative confirmations is that they are less expensive than positive confirmations because there are no second requests and no follow-up of nonresponses. The primary disadvantage of negative confirmations is that they are less reliable than positive confirmations because a nonresponse must be regarded as a correct response, even though the debtor may have ignored the confirmation request. The determination of which type of confirmation to use is an auditor's decision and it should be based on the facts in the audit. Terms: Negative accounts receivable confirmations; Positive confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

36) Briefly describe the circumstances in which it is acceptable to use negative confirmation requests. Answer: It is acceptable to use negative confirmation requests only when all of the following circumstances are present: • The auditor has assessed the risk of material misstatements as low and has obtained sufficient appropriate evidence regarding the design and operating effectiveness of controls relevant to the assertion being tested by the confirmation procedures. • The population of items subject to negative confirmation procedures is made up of a large number of small, homogeneous account balances, transactions, or other items. • The auditor expects a low exception rate. • The auditor reasonably believes that recipients of negative confirmation requests will give the request adequate consideration. Terms: Negative confirmations Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking 37) Describe each of the following types of confirmations: • positive confirmation • blank confirmation • invoice confirmation • negative confirmation Answer: • Positive confirmations are communications addressed to a debtor requesting the recipient to confirm whether the balance as stated on the confirmation is correct or incorrect. • A blank confirmation is a type of positive confirmation that does not state the amount on the confirmation, but requests the recipient to fill in the balance or furnish other information. • An invoice confirmation is a type of positive confirmation in which an individual invoice is confirmed rather than a customer's entire accounts receivable balance. • Negative confirmations are addressed to debtor, but request a response only when the debtor disagrees with the stated amount. Terms: Positive confirmation; Blank confirmation; Invoice confirmation; Negative confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

38) List three of the major factors affecting sample size for confirming accounts receivable. Answer: The factors include: • performance materiality • inherent risk (e.g., relative size of total accounts receivable, number of accounts, prior-year results, and expected misstatements) • control risk • achieved detection risk from other substantive tests (extent and results of substantive tests of transactions, analytical procedures, and other tests of details) • type of confirmation (negatives normally require a larger sample size) Terms: Sample size for confirming accounts receivable Difficulty: Challenging Objective: LO 16-4 AACSB: Reflective thinking 39) When an auditor uses negative confirmations, several factors must be considered. What are those factors? Answer: When negative confirmations are used, the auditor puts considerable emphasis on • the effectiveness of system of internal controls. • substantive tests of transactions. • analytical procedures as evidence of the fairness of accounts receivable. • assuming that the large majority of recipients will provide a conscientious reading and response to the confirmation request. Terms: Negative confirmations Difficulty: Challenging Objective: LO 16-4 AACSB: Reflective thinking

40) Match seven of the terms (a-k) with the definitions provided below (1-7). a. accounts receivable balance-related audit objectives b. aged trial balance c. alternative procedures d. blank confirmation form e. cutoff misstatements f. evidence planning worksheet g. negative confirmation h. positive confirmation i. realizable value of accounts receivable j. timing difference in an account receivable confirmation k. invoice confirmation ________ 1. the follow-up of a positive confirmation not returned by the debtor with the use of documentation evidence to determine whether the recorded receivable exists ________ 2. a letter, addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect and, if incorrect, by what amount ________ 3. misstatements that take place as a result of current period transactions being recorded in a subsequent period, or subsequent period transactions being recorded in the current period ________ 4. a letter, addressed to the debtor, requesting the recipient to fill in the amount of the accounts receivable balance ________ 5. a letter, addressed to the debtor, requesting a response only if the recipient disagrees with the amount of the stated account balance ________ 6. a reported difference in a confirmation from a debtor that is determined to be a timing difference between the client's and debtor's records and therefore not a misstatement ________ 7. a listing of the balances in the accounts receivable database at the balance sheet date broken down according to the amount of time that has passed between the date of sale and the balance sheet date Answer: 1. c, 2. h, 3. e, 4. d, 5. g, 6. j, 7. b Terms: Alternative procedures; Positive and negative confirmations; Aged trial balance; Cutoff misstatements; Timing difference; Accounts receivable confirmation Difficulty: Moderate Objective: LO 16-4 AACSB: Reflective thinking

16.5 Learning Objective 16-5 1) Which audit procedure would be used to test for the existence balance-related audit objective? A) Trace ten accounts from the aged trial balance to the accounts receivable database. B) Confirm accounts receivable. C) Review large sales returns and allowances before and after the balance sheet date. D) Trace ten accounts from the trial balance to the accounts on the database. Answer: B Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking 2) The auditor is reviewing the receivables listed on the aged trial balance for notes and related party receivables. Which balance-related audit objective is he trying to satisfy? A) detail tie-in B) existence C) classification D) all of the above Answer: C Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking 3) The auditor has a balance-related audit objective to determine that accounts receivable are appropriately aggregated, and related financial statement disclosures are relevant and understandable. Which of the following audit procedures would the auditor not perform in connection with this audit objective? A) Trace receivables from related parties on the aged trial balance to proper disclosure in the footnotes to the financial statements. B) Read footnote disclosures made by management related to accounts receivable. C) Evaluate footnote disclosures made by management for related party receivables. D) Use audit software to foot and cross-foot the aged accounts receivable trial balance. Answer: D Terms: Balance-related audit objectives including presentation audit objective Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking

4) Which audit procedure would the auditor use to test for the cutoff balance-related audit objective? A) Review minutes of the board of directors' meetings. B) Review the accounts receivable trial balance for large items. C) Use audit software to foot and cross-foot the aged trial balance. D) Select the last 20 sales transaction from the current year's sales journal and the first 20 from the subsequent year's and trace each to the related shipping documents. Answer: D Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking 5) If the balance-related audit objective for accounts receivable is determining that accounts receivable on the aged trial balance are aged properly, this is an example of A) classification. B) accuracy. C) realizable value. D) rights. Answer: A Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking; Analytic thinking 6) If the balance-related audit objective for accounts receivable is determining that accounts receivable are appropriately aggregated, this is an example of A) presentation. B) accuracy. C) realizable value. D) rights. Answer: A Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking; Analytic thinking

7) If the balance-related audit objective for accounts receivable is the trial balance agrees with the related database amounts, this is an example of A) detail tie-in. B) accuracy. C) realizable value. D) rights. Answer: A Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking; Analytic thinking 8) To determine if the client has rights to the accounts receivable on the trial balance, the auditor should inquire of management if any receivables are pledged or factored. Answer: TRUE Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking 9) To test for the completeness balance-related audit objective, the auditor should review the accounts receivable trial balance for large or unusual items. Answer: FALSE Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking 10) Describe three audit procedures an auditor would use to test for the realizable value balancerelated audit objective. Answer: Audit procedures would include: • Trace accounts from the aged trial balance to the accounts receivable database to test for correctness of aging and the balance. • Use audit software to foot and cross-foot the aged trial balance. • Discuss with the credit manager the likelihood of collecting older accounts. Examine subsequent cash receipts and the credit file on all accounts over 90 days and evaluate whether the receivables are collectible. • Evaluate whether the allowance is adequate after performing other audit procedures for collectibility of receivables. Terms: Balance-related audit objectives and audit procedures for sales and collection cycle Difficulty: Moderate Objective: LO 16-5 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 17 Audit Sampling for Tests of Details of Balances 17.1 Learning Objective 17-1 1) Both sampling and nonsampling risks are associated with A) Tests of controls. Substantive tests of transactions. Yes Yes B) Tests of controls. No

Substantive tests of transactions. No

Tests of controls. Yes

Substantive tests of transactions. No

Tests of controls. No

Substantive tests of transactions. Yes

Answer: A Terms: Sampling and nonsampling risks Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking

2) Tests for rates of occurrence are appropriately used in all but which of the following situations? A) Testing of system of Substantive testing of Substantive testing of internal controls transactions details of balances Yes Yes Yes B) Testing of system of internal controls No

Substantive testing of transactions Yes

Substantive testing of details of balances Yes

C) Testing of system of internal controls Yes

Substantive testing of transactions Yes

Substantive testing of details of balances No

D) Testing of system of internal controls No

Substantive testing of transactions No

Substantive testing of details of balances Yes

Answer: C Terms: Tests for rates of occurrence Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 3) Auditors perform test of controls and substantive tests of transactions for several reasons. Which of the following is not one of those reasons? A) for larger public company audits, to conclude the control is operating effectively B) to reduce assessed control risk and thereby reduce tests of details of balances C) to determine whether the exception rate in the population is sufficiently low D) to use rate of occurrence tests in the tests of details of balances Answer: D Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 4) In the test of details of balances, the auditor wants to make inferences about the entire population based on a sample. Answer: TRUE Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

5) Sampling, not nonsampling risks, is important for tests of controls, substantive tests of transaction, and test of details of balances. Answer: FALSE Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 6) To address sampling risk, auditors can use either nonstatistical or statistical methods for tests of controls, substantive tests of transactions, and test of details of balances. Answer: TRUE Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 7) Auditors generally use rate of occurrence tests in tests of details of balances. Answer: FALSE Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 8) When using sampling methods, the auditor is focused on obtaining results in dollar terms. Answer: TRUE Terms: Tests of details of balances Difficulty: Easy Objective: LO 17-1 AACSB: Reflective thinking 9) The most important difference among tests of controls, substantive tests of transactions, and tests of details of balances lies in what the auditor wants to measure. Explain what each type of test attempts to measure. Answer: Tests of controls focus on testing the operating effectiveness of system of internal controls. In substantive tests of transactions, the auditor is concerned about both the operating effectiveness of system of internal controls and the monetary correctness of transactions in the accounting system. In tests of details of balances, the concern is determining whether the dollar amount of an account balance is materially misstated. Terms: Difference among tests of controls, substantive tests of transactions, and tests of details of balances Difficulty: Moderate Objective: LO 17-1 AACSB: Reflective thinking

10) Auditors perform tests of controls and substantive tests of transactions for several reasons. Describe those reasons. Answer: To determine whether the exception rate in the population is sufficiently low; to reduce assessed risk and thereby reduce tests of details of balances; and for larger public companies, to conclude that the control is operating effectively for purposes of auditing system of internal controls over financial reporting. Terms: Difference among tests of controls, substantive tests of transactions, and tests of details of balances Difficulty: Moderate Objective: LO 17-1 AACSB: Reflective thinking 17.2 Learning Objective 17-2 1) When selecting a sample size for substantive tests of balances, which factor, other factors being equal, would result in a larger sample? A) a decrease in the tolerable misstatement B) small expected misstatements C) an increase in the tolerable misstatement D) an increase in the acceptable risk of incorrect acceptance Answer: A Terms: Selecting sample size for substantive tests of balance Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 2) The auditor's principal objective when using a sample of tests of details of balances is whether the A) account balance being audited is fairly stated. B) transactions being audited are free of misstatements. C) controls being tested are operating effectively. D) transactions and account balances being audited are fairly stated. Answer: A Terms: Principal objective when using sample of tests of details of balances Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking

3) What is the purpose of applying stratified sampling to a population? A) To avoid items that may To emphasize certain items contain misstatements and deemphasize others Yes Yes B) To avoid items that may contain misstatements No

To emphasize certain items and deemphasize others No

To avoid items that may contain misstatements Yes

To emphasize certain items and deemphasize others No

To avoid items that may contain misstatements No

To emphasize certain items and deemphasize others Yes

Answer: D Terms: Purpose of stratified sampling of populations Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 4) If an auditor desires a greater level of assurance in auditing a balance, the acceptable risk of incorrect acceptance A) is reduced. B) is increased. C) is not changed. D) may be reduced or increased depending upon other circumstances. Answer: A Terms: Greater level of assurance; Acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

5) In estimating the population misstatement, the first step in projecting from the sample to the population is to A) make a point estimate. B) revise the upper error bound. C) calculate the precision interval. D) determine the population mean. Answer: A Terms: Estimating population misstatement; First step in projecting sample to population Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 6) Tolerable misstatement is used to A) Determine sample size Select the sample Yes Yes

Evaluate results No

B) Determine sample size No

Select the sample Yes

Evaluate results No

C) Determine sample size No

Select the sample No

Evaluate results Yes

D) Determine sample size Yes

Select the sample No

Evaluate results Yes

Answer: D Terms: Tolerable misstatement Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 7) The word below that best explains the relationship between required sample size and the acceptable risk of incorrect acceptance is A) inverse. B) direct. C) proportional. D) indeterminate. Answer: A Terms: Relationship between required sample size and acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

8) The final step in the evaluation of the audit results is the decision to A) accept the population as fairly stated or to require further action. B) determine sampling error and calculate the estimated total population error. C) project the point estimate. D) determine the error in each sample. Answer: A Terms: Final step in evaluation of audit results Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 9) Which of the following does not have to be considered in determining the initial sample size of a test of details? A) tolerable misstatement B) acceptable risk of incorrect rejection C) estimate of misstatements in the population D) inherent risk Answer: B Terms: Not considered in determining initial sample size of test of details Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 10) If an auditor concludes that system of internal controls are likely to be effective, the preliminary assessment of control risk can be reduced, leading to which of the following impacts on the acceptable risk of incorrect acceptance? A) The acceptable risk of incorrect acceptance will be reduced. B) The acceptable risk of incorrect acceptance will be increased. C) The acceptable risk of incorrect acceptance will be eliminated. D) The acceptable risk of incorrect acceptance will not be impacted. Answer: B Terms: Auditor concludes system of internal controls are effective Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 11) If acceptable audit risk is increased, acceptable risk of incorrect acceptance should be A) increased. B) reduced. C) unaffected. D) modified. Answer: A Terms: Acceptable audit risk is increased, acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 7 Copyright © 2023 Pearson Education, Inc.

12) You are auditing Raji and Company. You discover an item of inventory with an audited value of $5,000 with a recorded amount of $3,000. If this is the only error you discover, the projected misstatement for the sample would be A) $5,000. B) $2,000. C) $3,000. D) $4,000. Answer: B Terms: Projected misstatement for sample for audited value and recorded amount Difficulty: Moderate Objective: LO 17-2 AACSB: Analytic thinking 13) One of the steps involved in planning the sample for the tests of details of balances is to A) select the sample. B) perform the audit procedures. C) define a misstatement. D) analyze the misstatements. Answer: C Terms: Steps in the audit sampling for tests of details of balances Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 14) The risk the auditor is willing to take of accepting a balance as correct when the true misstatement in the balance under audit is greater than the tolerable misstatement is A) the upper bound. B) the tolerable risk. C) the acceptable risk of incorrect acceptance. D) the lower bound. Answer: C Terms: Acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

15) As the amount of misstatements expected in the population approaches tolerable misstatement, the planned sample size will A) decrease. B) increase. C) vary based on characteristics of the population. D) be unaffected. Answer: B Terms: Effect on planned sample size of amount of misstatements expected in population approached tolerable misstatement Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 16) An auditor using nonstatistical sampling cannot formally measure sampling error and therefore must subjectively consider the possibility that the true population misstatement exceeds a tolerable amount. Which of the following factors should be considered by the auditor in making this assessment? A) The dollar difference between the The extent to which items in the point estimate and tolerable population have been audited 100 percent misstatement Yes Yes B) The dollar difference between the The extent to which items in the point estimate and tolerable population have been audited 100 percent misstatement No No C) The dollar difference between the The extent to which items in the point estimate and tolerable population have been audited 100 percent misstatement Yes No D) The dollar difference between the The extent to which items in the point estimate and tolerable population have been audited 100 percent misstatement No Yes Answer: A Terms: Nonstatistical sampling; Auditor subjectively consider possibility of true population misstatements Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 9 Copyright © 2023 Pearson Education, Inc.

17) Which of the following is an accurate statement regarding how the acceptable risk of overreliance (ARO) and the acceptable risk of incorrect acceptance (ARIA) interact to affect evidence accumulation? A) If system of internal controls are likely to be effective, preliminary control risk can be increased. B) A lower control risk requires a lower ARO in testing the controls, which requires a smaller sample size. C) If controls are found to be effective, control risk can remain low, which permits the auditor to increase ARIA, thereby requiring a smaller sample size in the substantive tests of details of balances. D) If misstatements are considered unlikely, ARIA will decrease, and the sample size will also decrease. Answer: C Terms: Acceptable risk of incorrect acceptance; Acceptable risk of overstatement; Evidence accumulation Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 18) When errors are found in a sample, auditors in practice generally assume A) that the population errors cannot be determined. B) that the population errors are larger than the sample errors. C) that the population errors are smaller than the sample errors. D) that the actual sample errors are representative of the population errors. Answer: D Terms: Errors found in sample assumption Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

19) Which of the following needs to be considered when the auditor generalizes from the sample to the population? A) Acceptable risk of incorrect Sampling error acceptance Yes Yes B) Acceptable risk of incorrect acceptance No

Sampling error

Acceptable risk of incorrect acceptance Yes

Sampling error

Acceptable risk of incorrect acceptance No

Sampling error

Yes

Answer: A Terms: Factors considered when auditor generalizes from sample to populations Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 20) Which of the following would lead to a larger sample size? A) low inherent risk B) low control risk C) larger tolerable misstatement D) unsatisfactory results in other related substantive procedures Answer: D Terms: Factors influencing sample sizes for tests of details of balances Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

21) While performing a substantive test of details during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was not materially misstated. It was, in fact, materially misstated. This situation illustrates the risk of A) incorrect rejection. B) incorrect acceptance. C) assessing control risk too low. D) assessing control risk too high. Answer: B Terms: Substantive test of details; incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 22) While performing a substantive test of details during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was materially misstated. Which of the following is the least likely auditor reaction to this discovery? A) perform expanded audit tests in the relevant areas B) increase detection risk in the relevant areas C) increase the sample size D) take no action until tests of other audit areas are completed Answer: B Terms: Performing substantive test of details; Sample results support conclusion that account balance was materially misstated Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 23) ________ is a method of projecting from the sample to the population to estimate the population misstatement. It assumes misstatements in the unaudited population are proportional to the misstatements found in the sample. A) Mean-per-unit estimation B) Point estimate C) Monetary unit D) Basic precision Answer: B Terms: Point estimate Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

24) Factors considered by an auditor to determine the possibility that the true population misstatement exceeds a tolerable amount in a nonstatistical sample include all of the following except for A) the extent to which items in the population have been audited 100%. B) the difference between the point estimate and acceptable control risk. C) whether misstatements tend to be offsetting or in only one direction. D) the amounts of individual misstatements. Answer: B Terms: Generalize from the sample to the population Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 25) When defining the population and the sampling unit for tests of details of balances, A) the population is defined as all of the transactions in the journal for the period. B) the sampling unit must be the same for all balance sheet accounts. C) if sampling for completeness, the sampling unit will be customers with zero balances. D) if sampling for completeness, the sampling unit will be the items making up the recorded population. Answer: C Terms: Population and sampling unit Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 26) Which of the following is a correct statement? A) When system of internal controls are effective, control risk can be reduced, and therefore the auditor will decrease the ARIA. B) There is a direct relationship between ARIA and the required sample size. C) A lower control risk requires a lower ARO in testing the controls. D) ARO measures the auditor's desired assurance for an account balance. Answer: C Terms: Acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 27) If no exceptions were found in the substantive tests of transactions, A) ARIA would stay the same. B) the sample size would stay the same. C) ARIA would increase. D) the sample size would increase. Answer: C Terms: Acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

28) If analytical procedures are performed with no indications of likely misstatements, ARIA will ________ and the sample size will ________. A) remain the same; increase B) decrease; decrease C) increase; decrease D) decrease; increase Answer: C Terms: Sample sizes, ARIA and analytical procedures Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking 29) Which of the following conditions would lead to a larger sample size? A) larger tolerable misstatement B) low inherent risk C) high control risk D) smaller account balance Answer: C Terms: Factors influencing sample sizes for tests of details of balances Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking 30) When analyzing misstatements, the auditor will determine A) the implications of the misstatements on other audit areas. B) the potential impact on the financial statements. C) the effect on company operations. D) all of the above. Answer: D Terms: Analyzing misstatements Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 31) If the population is not considered acceptable, one step the auditor is likely to take is to A) retest all internal controls. B) ask the client to adjust the account balance. C) test the entire population. D) decrease inherent risk. Answer: B Terms: Action when a population is rejected Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

32) The auditor must do misstatement analysis to decide whether any modification of the audit risk model is needed. Answer: TRUE Terms: Misstatements Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 33) The larger the sample size, the more confident the auditor can be that the point estimate is close to the true population value. Answer: TRUE Terms: Evaluating sample results Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 34) Acceptable risk of incorrect acceptance is directly affected by acceptable audit risk. Answer: TRUE Terms: Acceptable risk of incorrect acceptance and acceptable audit risk Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 35) Tolerable misstatement is inversely related to sample size. Answer: TRUE Terms: Tolerable misstatements related to sample size Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 36) Acceptable risk of incorrect acceptance (ARIA) and sample size are inversely related; that is, as ARIA increases, sample size decreases. Answer: TRUE Terms: Relation of acceptable risk of incorrect acceptance and sample size Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 37) Estimated misstatement in the population and sample size are inversely related; that is, as estimated misstatement increases, sample size decreases. Answer: FALSE Terms: Relation of estimated misstatement in the population and sample size Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking

38) The purpose of stratification is to permit auditors to emphasize certain aspects of a population and deemphasize others. Answer: TRUE Terms: Purpose of stratification Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 39) An auditor using nonstatistical sampling cannot formally measure sampling error. Answer: TRUE Terms: Nonstatistical sampling Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 40) If the misstatement in a population is larger than tolerable misstatement without considering sampling error, the population will be considered unacceptable. Answer: FALSE Terms: Population not considered acceptable Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 41) If a population is not considered acceptable, and the analysis indicates an individual error is unique or most of the misstatements are of a specific type, it may be appropriate to restrict the additional audit effort to the problem area. Answer: TRUE Terms: Action when a population is rejected Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 42) Required sample size increases as the auditor's tolerable misstatement for an account balance or class of transactions decreases. Answer: TRUE Terms: Required sample size and tolerable misstatement Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 43) The primary factor affecting the auditor's decision about acceptable risk of incorrect acceptance (ARIA) is assessed inherent risk. Answer: FALSE Terms: Acceptable risk of incorrect acceptance Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

44) In stratified sampling, a maximum of four stratum can be used. Answer: FALSE Terms: Stratified sampling Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 45) ARIA measures the auditor's desired assurance for an account balance. Answer: TRUE Terms: Acceptable risk of incorrect acceptance Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 46) Acceptable audit risk and acceptable risk of incorrect acceptance are inversely related; that is, as AAR increases, ARIA decreases. Answer: FALSE Terms: Acceptable risk of incorrect acceptance and acceptable audit risk Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking 47) An increased sample size will always cause the population to be accepted. Answer: FALSE Terms: Sample size and analyzing exceptions Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 48) When using audit sampling for tests of details of balances, the acceptable risk of overreliance must be determined. Answer: FALSE Terms: Sampling used for tests of details of balances Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 49) Auditors may find that the use of data analysis techniques allows them to test the entire population of an account balance for certain audit objectives. Answer: TRUE Terms: Stratified sampling Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking

50) The auditor may be able to use computer software to test the accuracy of each customer's account balance by taking each customer's beginning balance, adding sales made on account, subtracting payments received, and adding/subtracting other account adjustments to calculate each customer's ending balance. Answer: TRUE Terms: Stratified sampling Difficulty: Easy Objective: LO 17-2 AACSB: Reflective thinking 51) There are 14 steps to audit sampling for tests of details of balances, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss each of the steps included in the "evaluate the results" section for nonstatistical sampling. Answer: The steps included in the "evaluate the results" section are: 1. Generalize from the sample to the population. This involves (1) projecting misstatements found in the sample to the population and (2) allowing for sampling risk. 2. Analyze the misstatements. The auditor should evaluate the nature and cause of each misstatement found in the sample. 3. Decide the acceptability of the population. If the auditor concludes that the misstatement in a population may be larger than tolerable misstatement after considering sampling risk, the population is not considered acceptable. The auditor then has several possible courses of action, including, taking no action until tests of other audit areas are completed, perform expanded audit tests in specific areas, increase the sample size, adjust the account balance, request the client to correct the population, and refuse to give an unmodified opinion. Terms: Steps included in the Evaluate the Results section for nonstatistical sampling Difficulty: Moderate Objective: LO 17-2 AACSB: Reflective thinking 52) Consider the steps in sampling for tests of details and for tests of controls. Explain the differences in applying sampling to these two types of tests. Answer: The differences are as follows: Tests of Details 1. Define a misstatement. 2. Specify tolerable misstatement. 3. Specify acceptable risk of incorrect acceptance. 4. Estimate misstatements in the population. 5. Analyze misstatements.

Tests of Controls 1. Define attributes and exception conditions. 2. Specify tolerable exception rate. 3. Specify acceptable risk of overreliance. 4. Estimate population exception rate. 5. Analyze exceptions.

53) Identify each of the seven factors that influence sample size for nonstatistical tests of details of balances, and state whether each factor is directly or inversely related to sample size. Answer: Factors that influence sample size for nonstatistical tests are: • Control risk. Control risk is directly related to sample size; as control risk increases, sample size also increases. • Results of other substantive procedures related to the same assertion. Directly related to sample size; as these risks increase, sample size also increases. • Dollar amount of the population. Directly related to sample size; smaller account balances lead to smaller sample size and larger account balances lead to larger sample sizes. • Tolerable misstatement for a specific account. Inversely related; as tolerable misstatement increases, sample size decreases. • Inherent risk. Directly related; as inherent risk increases, sample size also increases. • Expected size and frequency of misstatements. Directly related; as the size and frequency of expected misstatements increase, sample size also increases. • Number of items in the population. Almost no effect on sample size unless population is very small. Terms: Factors that influence sample size for nonstatistical tests of details of balances Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking

54) There are 14 steps to audit sampling for tests of details of balances, divided into three sections: plan the sample, select the sample and perform the audit procedures, and evaluate the results. Discuss 5 of the 9 steps included in the "plan the sample" section for nonstatistical sampling. Answer: The steps comprising the "plan the sample" section are: 1. State the objectives of the audit test. For tests of details of balances, the objective is to determine whether the account balance being audited is fairly stated. 2. Decide whether audit sampling applies. In certain situations, the auditor may choose to test all large items and no small items. In those situations, the auditor has not sampled. 3. Define a misstatement. A misstatement exists whenever a sample item is misstated. 4. Define the population. The population is defined as the items making up the recorded dollar population. 5. Define the sampling unit. For nonstatistical sampling in tests of details of balances, the sampling unit is almost always the items making up the account balance. 6. Specify tolerable misstatement. This is the application of performance materiality to a particular sampling procedure. 7. Specify the acceptable risk of incorrect acceptance (ARIA). This is the risk that the sample supports the conclusion that the recorded account balance is not materially misstated when it is materially misstated. ARIA measures the auditor's desired assurance for an account balance. 8. Estimate misstatements in the population. The auditor typically makes this estimate based on prior experience with the client and by assessing inherent risk, considering the results of test of controls, substantive tests of transactions, and analytical procedures already performed. 9. Determine the initial sample size. In nonstatistical sampling, this is determined judgmentally considering the previous eight factors. Terms: Audit sampling for tests of details of balances Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking 55) When using nonstatistical sampling, the auditor must subjectively consider whether the true population misstatement exceeds a tolerable amount. This is done by considering five factors. One factor is the difference between the point estimate and tolerable misstatement. State the other four factors the auditor must consider. Answer: Other factors the auditor must consider are: • The extent to which items in the population have been audited 100%. • Whether misstatements tend to be offsetting or in only one direction. • The amounts of individual misstatements. • The sample size. Terms: Factors to consider whether population misstatement exceeds tolerable misstatement Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking

56) Discuss each of the six possible courses of action the auditor can take when he or she has concluded that the population is misstated by more than a tolerable amount. Answer: The six possible courses of action the auditor can take when he or she has concluded that the population is misstated by more than a tolerable amount are: • Take no action until tests of other audit areas are completed. If offsetting misstatements are found in other parts of the audit, the auditor may conclude that the population is acceptable. • Perform expanded audit tests in specific areas. • Increase the sample size. As sample size increases, sampling error is reduced if the rate of misstatements in the expanded sample, their dollar amount, and their direction are similar to those in the original sample. This may result in the population being acceptable. • Adjust the account balance. In some circumstances, if the client corrects the misstatements discovered by the auditor, the book value of the account may become acceptable. • Request the client to correct the population. • Refuse to give an unmodified opinion. If none of the prior courses of action results in an acceptable population, the auditor will have to qualify the audit report in an appropriate manner. Terms: Possible courses of action auditor can take when conclusion that population is misstated by more than tolerable amount Difficulty: Challenging Objective: LO 17-2 AACSB: Reflective thinking 17.3 Learning Objective 17-3 1) In monetary unit sampling, a sampling interval of 900 means that A) every 900th item will be selected. B) every 900th dollar in the account will be sampled. C) expected misstatement is 900. D) tolerable misstatement is 900. Answer: B Terms: Monetary unit sampling; Sampling interval Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking 2) Monetary unit sampling is not particularly effective at detecting A) overstatements. B) understatements. C) errors in current assets. D) errors in noncurrent assets. Answer: B Terms: Monetary unit sampling not effective at detecting Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking

3) The auditor must consider the possibility that the true population misstatement is greater than the amount of misstatement that is tolerable when the auditor is performing A) Nonstatistical sampling Monetary unit sampling Yes Yes B) Nonstatistical sampling No

Monetary unit sampling No

Nonstatistical sampling Yes

Monetary unit sampling No

Nonstatistical sampling No

Monetary unit sampling Yes

Answer: D Terms: Auditor must consider the possibility that the true population misstatement is greater than the amount of misstatement that is tolerable Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking 4) The most commonly used method of statistical sampling for tests of details of balances is A) attributes sampling. B) systematic sampling. C) discovery sampling. D) monetary unit sampling. Answer: D Terms: Most commonly used method of statistical sampling for details of balances Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 5) When using monetary unit sampling, the recorded dollar population is a definition of all the items in the A) population. B) population which the auditor has included in the sample. C) population which contain errors. D) sample which contain errors. Answer: A Terms: Monetary unit sampling; Recorded dollar population Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

6) When the sample selection is done using probability proportional to size sample selection (PPS), A) the actual number of units selected for testing may be more than the computed sample size. B) the auditor must use systematic selection, rather than random selection of dollars. C) population items with a zero recorded balance have no chance of being selected. D) negative balances must be treated as positive balances. Answer: C Terms: Probability proportional to sample size Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 7) An accounts receivable population contains a total of four customers. The accounts, the amounts, and the cumulative total are shown below. Monetary unit sampling is to be used. Account Name Blue Brown Gray Green

Recorded Amount $357 281 60 574

Cumulative Total $357 638 698 1,272

Based on the information above, the population size is A) 4. B) 574. C) 1,272. D) 2,684. Answer: C Terms: Using monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Analytic thinking 8) An auditor uses monetary unit sampling with a sampling interval of $20,000 and detects an item with a recorded amount of $10,000 with an audited value of $4,000. The projected misstatement of the sample is A) $12,000. B) $6,000. C) $10,000. D) $3,000. Answer: A Terms: Monetary unit sampling; projected misstatement Difficulty: Moderate Objective: LO 17-3 AACSB: Analytic thinking 23 Copyright © 2023 Pearson Education, Inc.

9) An auditor is confirming a population of accounts receivable for monetary correctness. The population totals $2,000,000 and a sample of 200 confirmations is obtained. Upon audit, no misstatements are uncovered in the sample. Assuming an ARIA of 10%, the confidence factor would be 2.31. Applied to a sampling interval of $10,000, the upper misstatement bound is calculated as A) $462. B) $4,329. C) $23,100. D) $865,801. Answer: C Terms: Upper misstatement bound Difficulty: Moderate Objective: LO 17-3 AACSB: Analytic thinking 10) Which balance-related audit objective cannot be assessed using monetary unit sampling? A) accuracy B) completeness C) existence D) All of the above can be assessed using monetary unit sampling. Answer: B Terms: Balance-related audit objective that cannot be assessed using monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 11) PPS samples can be obtained in an efficient manner using all but which of the following? A) hand selection by the auditor B) computer software C) random number tables D) systematic sampling techniques Answer: A Terms: PPS samples obtained Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking

12) Which of the following item(s) are needed to determine the sample size using MUS? A) A point estimate for Recorded population A confidence factor misstatements value No Yes No B) A point estimate for misstatements Yes

Recorded population A confidence factor value No Yes

A point estimate for misstatements No

Recorded population A confidence factor value Yes Yes

A point estimate for misstatements Yes

Recorded population A confidence factor value No No

Answer: C Terms: Determining sample size Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 13) An estimate of the largest likely overstatement in a population at a given ARIA, using monetary unit sampling is the A) point estimates. B) precision intervals. C) confidence intervals. D) misstatement bound. Answer: D Terms: Maximum misstatements in monetary unit sampling Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking

14) When using monetary unit sampling, evaluating the likelihood of unrecorded items in the population is A) unnecessary. B) impossible. C) possible but difficult. D) an automatic outcome of the process. Answer: B Terms: Likelihood of unrecorded items in population in monetary unit sampling Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 15) The statistical methods used to evaluate monetary unit samples A) neither exclude nor include units twice. B) may permit the inclusion of a unit in the sample more than once. C) do not permit a unit to be included in the sample more than once. D) ignore the possibility that a unit may be included in a sample more than once. Answer: B Terms: Statistical methods used to evaluate monetary unit samples Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 16) Which of the following is not a problem with monetary unit selection? A) population items with a zero recorded balance B) population items that should have a zero balance but do not C) accounts with negative balances D) accounts with small recorded balances that are significantly understated Answer: B Terms: Not a problem with monetary unit selection Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 17) The allowance for sampling risk when no misstatements are found in the sample is A) tolerable risk of misstatement. B) basic precision. C) confidence factor. D) population variance. Answer: B Terms: Basic precision and MUS Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

18) To calculate the sample size in monetary unit sampling, A) the confidence factor is multiplied by the tolerable misstatement as a percentage of the population value. B) the confidence factor is divided by the tolerable misstatement as a percentage of the population value. C) the tolerable misstatement is divided by the population recorded value. D) the tolerable misstatement is multiplied by the population recorded value. Answer: B Terms: Sample size Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 19) Calculating the sample size using monetary unit sampling depends on which of the following factors? A) Estimated population misstatement Recorded population value Yes Yes B) Estimated population misstatement No

Recorded population value No

Estimated population misstatement Yes

Recorded population value No

Estimated population misstatement No

Recorded population value Yes

Answer: A Terms: Sample size and monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

20) Using statistical sampling to assist in verifying the year-end accounts payable balance, an auditor has accumulated the following data:

Population: Sample:

Number of accounts

Book balance

4,000 200

$5,000,000 $250,000

Balance determined by the auditor ? $300,000

Projecting the misstatement to the population, the auditor's estimate of year-end accounts payable balance would be A) $5,050,000. B) $5,125,000. C) $6,000,000. D) $6,150,000. Answer: C Terms: Using statistical sampling project the misstatement to the population Difficulty: Challenging Objective: LO 17-3 AACSB: Analytic thinking 21) Why do auditors find MUS appealing? A) MUS increases the likelihood of selecting a balance of high and low dollar items. B) MUS is easy to use in the audit environment. C) MUS provides a nonstatistical, rather than a statistical, conclusion. D) When misstatements are found, MUS rarely produces bounds in excess of materiality. Answer: B Terms: MUS appeal to auditors Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 22) In monetary unit sampling, the relationship between tolerable misstatement size and required sample size is A) direct. B) inverse. C) varied. D) indeterminable. Answer: B Terms: Monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

23) To determine the sampling interval, the population is divided by the confidence factor. Answer: FALSE Terms: Sample size and monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 24) MUS has the statistical simplicity of attributes sampling, yet provides a statistical result expressed as a percentage. Answer: FALSE Terms: Monetary unit sampling Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking 25) In monetary unit sampling, the likelihood of high dollar items from the population being included in the sample is lower than the likelihood for small dollar items. Answer: FALSE Terms: Monetary unit sampling Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking 26) When auditors apply MUS to a sample, the sample is selected using random sampling techniques. Answer: FALSE Terms: MUS applied to a sample; Random sampling techniques Difficulty: Easy Objective: LO 17-3 AACSB: Reflective thinking 27) The use of monetary unit sampling is most appropriate when the auditor expects to find many errors and when a monetary result is desired. Answer: FALSE Terms: Monetary unit sampling; most appropriate Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 28) When using MUS, the projected misstatement is the percentage misstatement times the sampling interval. Answer: TRUE Terms: Monetary unit sampling; projected misstatement Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

29) Accounts with zero or negative year-end balances have no chance of being included in a standard probability proportional to size (PPS) sample. Answer: TRUE Terms: Standard probability proportionate to size (PPS) sample Difficulty: Challenging Objective: LO 17-3 AACSB: Reflective thinking 30) If the misstatement bound exceeds tolerable misstatement, the population is considered acceptable. Answer: FALSE Terms: Monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 31) The auditor uses monetary unit sampling to select a sample of expense items for testing from a population of expenses. Subsequent to selecting this sample of expense items, the client identifies additional expenses not included in the population and included in the audited financial statements. The auditor in this situation must include these additional expenses as part of the population subject to the sampling and select a revised sample of expense items for testing. Answer: TRUE Terms: Monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 32) An example where an auditor might be found to fail to obtain sufficient and appropriate evidence for a sample of expense items being tested would include the auditor failing to determine whether the sample expenses were recorded in the correct period and in the correct general ledger accounts. Answer: TRUE Terms: Monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 33) As the ratio of expected misstatements in the population to tolerable misstatements increases, the confidence factors which the auditor should apply decreases. Answer: FALSE Terms: Ratio of estimated population misstatement to tolerable misstatement and confidence factor Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

34) As the Acceptable Risk of Incorrect Acceptance (ARIA) decreases, the confidence factors increase. Answer: TRUE Terms: Ratio of estimated population misstatement to tolerable misstatement and confidence factor Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 35) A higher confidence factor increases the sample size, which increases the "confidence" that the sample is representative of the population. Answer: TRUE Terms: Ratio of estimated population misstatement to tolerable misstatement and confidence factor Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 36) Explain the decision rule used in monetary unit sampling to determine whether the population is acceptable. Answer: The results are considered acceptable if the upper misstatement bound amount is less than the tolerable misstatement. If the upper misstatement bound exceeds tolerable misstatement, the population is not acceptable based on the results of the sample. Terms: Monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 37) Explain why monetary unit sampling, or probability proportional to size sampling, is not useful for detecting understatements. Answer: Monetary unit sampling is a technique that assigns physical units to an item in the population based on the dollar value of the item. Larger dollar items are more likely to be chosen for the sample than smaller items. So, if a client has understated an item, there is less likelihood that the item will be selected. Consequently, auditors do not commonly use monetary unit sampling when they are concerned with potential understatements. Terms: Monetary unit sampling; Probability proportional to size sampling; Detecting understatements Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

38) Discuss the advantages and disadvantages of monetary unit sampling over other sampling methods. Answer: Advantages of monetary unit sampling: • It automatically increases the likelihood of selecting high dollar items from the population being audited. • It frequently reduces the cost of doing the audit testing because several sample items are tested at once. • It is easy to apply. • It provides a statistical conclusion rather than a nonstatistical one, which aids auditors in making better and more defensible conclusions. Disadvantages of monetary unit sampling: • The total misstatement bounds resulting when misstatements are found may be too high to be useful to the auditor. • It is cumbersome to select probability proportional to size samples from large populations without computer assistance. Terms: Advantages and disadvantages of monetary unit sampling Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking 39) How might auditors include negative balances when using monetary unit sampling to evaluate a population? Answer: There are two basic alternatives to testing negative balances when using MUS. First, the auditor may choose to ignore negative balances for MUS selection and test those amounts by some other means. Second, the auditor could treat the negative balances as positive and add them to the number of monetary units being tested. However, this complicates the evaluation process. Terms: Monetary unit sampling to evaluate population with negative balances Difficulty: Moderate Objective: LO 17-3 AACSB: Reflective thinking

17.4 Learning Objective 17-4 1) You are auditing Nelson and Company and determined that the sample results support a conclusion that the account is materially misstated, when in fact it was not misstated. This illustrates the risk of A) incorrect acceptance. B) incorrect rejection. C) control risk too low. D) control risk too high. Answer: B Terms: Sample results support conclusion that account is materially misstated Difficulty: Easy Objective: LO 17-4 AACSB: Reflective thinking 2) The method used to measure the estimated total misstatement amount in a population when there is both a recorded value and an audited value for each item in the sample is A) difference estimation. B) mean-per-unit estimation. C) ratio estimation. D) monetary unit sampling. Answer: A Terms: Method used to measure estimated total error amount in a population Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 3) The auditor is concerned with the audited value rather than the misstatement amount of each item in the sample when using A) difference estimation. B) mean-per-unit estimation. C) ratio estimation. D) monetary unit sampling. Answer: B Terms: Auditor concerned with audited value rather than error amount of each item Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking

4) Acceptable risk of incorrect rejection affects auditors' action only when they conclude that a population is A) fairly stated. B) acceptable. C) not fairly stated. D) acceptable after certain adjustments. Answer: C Terms: Acceptable risk of incorrect rejection Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 5) If the auditor believes that there will be more than just a few exceptions discovered, and desires an accurate estimate of the dollar value of the exceptions, he or she will use A) attributes sampling. B) monetary unit sampling. C) block sampling. D) variables sampling. Answer: D Terms: Variables sampling Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 6) The acceptable risk of incorrect rejection is important only when there is a ________ cost to increasing the sample size. A) high B) low C) moderate D) marginal Answer: A Terms: Risk of incorrect rejection Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 7) Stratified sampling is applicable to difference, mean-per-unit, and ratio estimation, but it is most commonly used with A) ratio estimation. B) discovery sampling. C) difference estimation. D) mean-per-unit estimation. Answer: D Terms: Stratified sampling; Difference, mean-per-unit, and ratio estimation Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 34 Copyright © 2023 Pearson Education, Inc.

8) Which of the following sampling plans would be designed to estimate a numerical measurement of a population, such as a dollar value? A) numerical sampling B) discovery sampling C) attributes sampling D) variables sampling Answer: D Terms: Sampling plan designed to estimate a numerical measurement of population Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 9) When dealing with variables sampling and sampling risk, it is important to understand that A) for variables sampling, auditors use ARIA but not ARIR. B) ARIR is of serious concern to the auditor because of potential legal implications. C) ARIA is a one-tailed statistical test. D) the confidence coefficients for ARIA are the same as the confidence level. Answer: C Terms: Sampling risk Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 10) When working with the different variables methods, A) difference estimation frequently results in larger sample sizes than any other method. B) ratio estimation is the method preferred by most auditors since it is simpler to calculate confidence intervals. C) the difference between the mean-per-unit estimate and the difference estimate is the definition of what is being measured. D) stratification can only be used with difference estimation. Answer: C Terms: Variables sampling Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking

11) Which of the following is not a type of statistical method that provides results in dollar terms? A) variables sampling B) attributes sampling C) monetary unit sampling D) sampling with probability proportional to size Answer: B Terms: Not a type of statistical method that provides results in dollar terms Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 12) When drawing statistical inferences about the population when using variables sampling, A) a confidence interval cannot be calculated. B) there is always a possibility that the sample is not sufficiently representative of the population to provide a sample mean or standard deviation reasonably close to those of the population. C) the auditor does not know the reliability for the statistical inference process that is used to draw the conclusions. D) all of the above are correct. Answer: B Terms: Sampling plan designed to estimate a numerical measurement of population Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 13) When making statistical inferences, the auditor must remember that A) the true population value must always be known. B) auditors can state the conclusions drawn from a confidence interval in different ways. C) there can be no possibility that the sample is not sufficiently representative of the population. D) the knowledge of sampling distributions does not help the auditors to draw statistical conclusions. Answer: B Terms: Statistical inferences Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 14) Acceptable risk of incorrect rejection is the statistical risk that the auditor has concluded that a population is materially misstated when it is not. Answer: TRUE Terms: Acceptable risk of incorrect rejection Difficulty: Easy Objective: LO 17-4 AACSB: Reflective thinking

15) Difference estimation frequently results in smaller sample sizes than any other variables sampling method. Answer: TRUE Terms: Difference estimation Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 16) Auditors can state the conclusions drawn from a confidence interval using statistical inference in different ways. Answer: TRUE Terms: Statistical inferences Difficulty: Easy Objective: LO 17-4 AACSB: Reflective thinking 17) The confidence coefficients for ARIA are different from the confidence level. Answer: TRUE Terms: Sampling risk Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking 18) Auditors should attempt to minimize ARIA and maximize ARIR. Answer: FALSE Terms: Sampling risk Difficulty: Easy Objective: LO 17-4 AACSB: Reflective thinking 19) Explain acceptable risk of incorrect acceptance and acceptable risk of incorrect rejection within the context of variables sampling. Answer: After an audit test is performed and statistical results are calculated, the auditor must conclude either that the population is or is not materially misstated. ARIA is the statistical risk that the auditor has accepted a population that is, in fact, materially misstated. This is a serious concern to auditors because of the potential legal implications of concluding that an account balance is fairly stated when it is misstated by a material amount. ARIR is the statistical risk that the auditor has concluded that a population is materially misstated when it is not. ARIR affects the auditors' actions only when they conclude that a population is not fairly stated. ARIR is important only when there is a high cost to increasing the sample size or performing other tests. Terms: Variables sampling Difficulty: Challenging Objective: LO 17-4 AACSB: Reflective thinking 37 Copyright © 2023 Pearson Education, Inc.

20) Match six of the terms (a-l) with the definitions provided below (1-6). a. acceptable risk of incorrect acceptance b. acceptable risk of incorrect rejection c. difference estimation d. misstatement bounds e. monetary unit sampling f. mean-per-unit estimation g. point estimate h. probability proportional to size sample selection i. ratio estimation j. statistical inferences k. stratified sampling l. variable sampling ________ 1. conclusions drawn from sample results based on knowledge of sampling distributions ________ 2. sampling techniques for tests of details of balances that use the statistical inference processes ________ 3. the risk that the auditor is willing to take of rejecting a balance as incorrect when it is not misstated by a material amount ________ 4. a statistical sampling method that provides misstatement bounds expressed in monetary amounts ________ 5. a method of variables sampling in which the auditor estimates the population misstatement by multiplying the average misstatement in the sample by the total number of population items and also calculates sampling risk ________ 6. the risk that the auditor is willing to take of accepting a balance as correct when the true misstatement in the balance exceeds the tolerable misstatement Answer: 1. j, 2. l, 3. b, 4. e, 5. c, 6. a Terms: Acceptable risk of incorrect acceptance; Acceptable risk of incorrect rejection Difficulty: Moderate Objective: LO 17-4 AACSB: Reflective thinking

17.5 Learning Objective 17-5 1) An important statistic to consider when using a statistical sampling audit plan is the population variability. The population variability is measured by the A) sample mean. B) standard deviation. C) standard error of the sample mean. D) estimated population total minus the actual population. Answer: B Terms: Population variability Difficulty: Challenging Objective: LO 17-5 AACSB: Reflective thinking 2) When using difference estimation, the precision interval is calculated by a statistical formula. Answer: TRUE Terms: Precision interval Difficulty: Moderate Objective: LO 17-5 AACSB: Reflective thinking 3) To calculate the sample size using difference estimation sampling, it is not necessary for the auditors to have an advance population standard deviation estimate. Answer: FALSE Terms: Sample size Difficulty: Moderate Objective: LO 17-5 AACSB: Reflective thinking 4) In difference estimation sampling, the confidence limits are calculated by combining the point estimate of the total misstatements and the computed precision interval at the desired confidence level. Answer: TRUE Terms: Difference estimation sampling; Confidence limits Difficulty: Moderate Objective: LO 17-5 AACSB: Reflective thinking 5) The population standard deviation has a significant effect on the computed precision interval. Answer: FALSE Terms: Difference estimation; Population standard deviation; Computed precision interval Difficulty: Moderate Objective: LO 17-5 AACSB: Reflective thinking

6) There are four steps to generalize from the sample to the population using difference estimation sampling. Identify each of these four steps. Answer: The four steps to generalize from the sample to the population using difference estimation sampling are: 1. Compute the point estimate of the total misstatement. 2. Compute an estimate of the population standard deviation. 3. Compute the precision interval. 4. Compute the confidence limits. Terms: Four steps to generalize sample to population using difference estimation sampling Difficulty: Moderate Objective: LO 17-5 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 18 Audit of the Acquisition and Payment Cycle: Tests of Controls, Substantive Tests of Transactions, and Accounts Payable 18.1 Learning Objective 18-1 1) The overall objective in the audit of the acquisition and payment cycle is A) to ensure the reliability of the affected accounts. B) to ensure the accuracy of the affected accounts. C) to evaluate whether the affected accounts are fairly presented in accordance with accounting standards. D) to evaluate whether fraudulent payments were made. Answer: C Terms: Overall objective of audit of acquisition and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 2) Which of the following accounts is not part of the acquisition and payment cycle? A) prepaid expenses B) accounts payable C) sales returns and allowances D) property, plant, and equipment Answer: C Terms: Overall objective of audit of acquisition and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 3) Which of the following is not one of the classes of transactions in the acquisition and payment cycle? A) acquisition of common stock B) acquisition of goods and services C) cash disbursements D) purchase returns and allowances and purchase discounts Answer: A Terms: Acquisition and payment cycle and class of transactions Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking

4) Which of the following accounts is not included in the acquisitions class of transactions? A) inventory B) prepaid expenses C) sales discounts D) accounts payable Answer: C Terms: Account not included in acquisition class of transactions Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 5) The acquisition and payment cycle consists of one class of transactions. Answer: FALSE Terms: Acquisition and payment cycle and class of transactions Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 6) The cash account is not part of the acquisitions and payment cycle. Answer: FALSE Terms: Cash account and acquisitions and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 7) Auditing the acquisition and payment cycle often takes more time than any other cycle. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 8) Inadequate controls over purchases and accounts payable can result in opportunities to embezzle from the organization. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 9) Companies may deliberately understate accounts payable to overstate financial performance. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

18.2 Learning Objective 18-2 1) What typically initiates the acquisitions and payment cycle? A) issuance of a purchase requisition or request for purchase of goods or services B) issuance of payment to vendor C) approval of a new vendor D) purchase requisition Answer: A Terms: Initiates acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 2) What typically ends the acquisitions and payment cycle? A) issuance of a purchase requisition or request for purchase of goods/services B) issuance of a payment on accounts payable C) approval of a new vendor D) purchase requisition Answer: B Terms: Ends acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 3) A document indicating a reduction in the amount owed to a vendor because of returned goods is A) a debit memo. B) a credit memo. C) a receiving report. D) a contractual adjustment form. Answer: A Terms: Document indicating a reduction in the amount owed to a vendor for returned goods Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 4) A document used by organizations to establish a formal means of recording and controlling acquisitions which usually contains a package of documents about the acquisition is the A) voucher. B) purchase order. C) receiving report. D) purchase requisition. Answer: A Terms: Document used to establish formal means of recording and controlling acquisitions Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 3 Copyright © 2023 Pearson Education, Inc.

5) The computer-generated file which records acquisitions, disbursements, and allowances for each vendor is the A) accounts payable database. B) cash disbursements file. C) acquisitions transaction file. D) purchase approval file. Answer: A Terms: Computer-generated file which records acquisitions, disbursements and allowances for vendor Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 6) Which of the following business functions is not considered to be part of the acquisitions class of transactions? A) processing purchase orders B) recognizing liabilities C) receiving goods and services D) processing cash disbursements Answer: D Terms: Business function not a part of acquisitions class of transactions Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 7) Smaller privately held companies may not maintain an accounts payable database by vendor. These companies pay on the basis of A) vendors' monthly statements. B) individual vendors' invoices. C) the accounts payable account in the general ledger. D) dunning letters. Answer: B Terms: Accounts payable database and small companies Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking

8) After a purchase requisition is approved, a ________ must be initiated to purchase the goods or services. A) purchase order B) vendor order C) call order D) vendor invoice Answer: A Terms: Purchase requisition Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 9) A document generally received from the vendor which indicates a reduction in the amount owed due to the company granting an allowance is a A) vendor invoice. B) debit memo. C) credit adjustment form. D) credit memo. Answer: B Terms: Document received from vendor which indicates a reduction of amount owed Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 10) Absent disputed amounts and minor timing differences, the vendor's statements should reconcile to the A) acquisition journal. B) accounts payable database. C) cash disbursements amount for purchases. D) vouchers payable amount for vendors. Answer: B Terms: Vendor's statements and accounts payable database Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 11) At what point in the acquisition and payment cycle do most companies first recognize the acquisition and related liability on their records? A) when the purchase requisition is received by the accounting department B) when the purchase order is prepared C) when the company receives the invoice from the vendor D) when the company receives the goods or services from the vendor Answer: D Terms: Recognize acquisition and liability Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

12) In the processing and recording of cash disbursements, A) after a check includes the signature of an authorized person, it is a liability. B) when a check cashed by the vendor has cleared the bank, it is called an outstanding check. C) in many cases, the company submits payment to the vendor electronically through an electronic funds transfer (EFT) between the company's bank and the vendor's bank. D) the accounts payable database is a computer-generated file that includes all cash disbursement transaction processed by the accounting system for a period. Answer: C Terms: Process which requires calculation of an interval Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 13) List the following documents or records in the order they are typically processed with regards to purchase order processing: a. Purchase requisition b. Purchase order c. Receiving report A) c, b, a B) a, b, c C) b, a, c D) c, a, b Answer: B Terms: Order of processing purchase order processing related documents in the acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 14) The acquisition and payment cycle typically begins with the initiation of a purchase requisition for goods and services from an authorized individual. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 15) A vendor invoice is normally prepared at the time tangible goods are received and indicates the description of goods, the quantity received, the date received, and other relevant data. Answer: FALSE Terms: Vendor invoice Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking

16) A document received from the vendor indicating such things as the description and quantity of goods and services received, price including freight, cash discount terms, and date of billing is called the voucher. Answer: FALSE Terms: Voucher Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 17) An acquisitions transaction file is a computer-generated file that includes all information entered into the system regarding acquisition transactions. Answer: TRUE Terms: Acquisition transaction file Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 18) The acquisition and payment cycle ends with the receiving of the goods or services. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 19) Purchase returns and allowances and purchase discounts business functions are also part of the acquisition and payment cycle. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 20) Purchase returns and allowances and purchase discounts business functions are generally not significant in amount for most companies. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking

21) For companies using Electronic Data Interface (EDI), the invoice is transmitted from the supplier electronically. EDI affects how the auditor evaluates audit evidence in this transaction cycle. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 22) The total of the unpaid individual account balances in the accounts payable database should equal the total accounts payable balance in the general ledger. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 23) Most companies maintain an accounts payable database by vendor. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 24) It is possible to use Electronic Data Interface (EDI) to process payments to vendors electronically using Electronic Funds Transfer (EFT) between the company's bank and the vendor's bank. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 25) After a check prepared for payment to a vendor includes the signature of an authorized person, the check is now a liability. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking

26) After a check is cashed by a vendor and clears the vendor's and the client's bank, the check is now a cancelled check and is no longer a liability, but now is a document. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-2 AACSB: Reflective thinking 27) List the four business functions in the acquisition and payment cycle. Answer: 1. processing purchase orders 2. receiving goods and services 3. recognizing the liability 4. processing and recording cash disbursements Terms: Functions in acquisition and payment cycle Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking 28) Discuss each of the four business functions that comprise the acquisition and payment cycle. Answer: The four business functions that comprise the acquisition and payment cycle are: • Processing purchase orders. This function involves the preparation of a purchase requisition and a purchase order to acquire goods and services. • Receiving goods and services. When goods are received, a receiving report is prepared that indicates the description of goods, the quantity received, the date received, and other relevant data. • Recognizing the liability. In most companies, the liability for acquisitions is recognized when the goods and services are received. The initial recording affects the financial statements and the actual cash disbursement; therefore, companies must take care to include all acquisition transactions, only acquisitions that occurred, and at the correct amount. • Processing and recording cash disbursements. This function involves the signing and mailing of the check for payment of the acquisition and recording of the cash disbursement in the cash disbursements journal. Terms: Business functions of the acquisition and payment cycle Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking

29) Describe purchase requisitions and purchase orders. What is a key difference between the two documents? Answer: Purchase requisitions represent requests for goods and services by an authorized employee. Requisitions may originate from any authorized company employee such as a storeroom supervisor or manufacturing manager. Purchase orders are documents that are used to order goods and services from vendors. It includes the description, quantity, and other related information for goods or services that the company intends to purchase and is often used to indicate authorization of the acquisition. Unlike requisitions, purchase orders are directed to specific vendors. The purchase order is often used to indicate authorization of the acquisition. Terms: Purchase requisitions and purchase orders Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking

30) Match seven of the terms for documents and records (a-m) used in the acquisitions and cash disbursement cycle with the descriptions provided below (1-7). a. purchase requisition b. purchase order c. receiving report d. acquisitions journal e. summary acquisitions report f. vendor's invoice g. debit memo h. voucher i. accounts payable database j. accounts payable trial balance k. vendor's statement l. check m. cash disbursements journal ________ 1. a document indicating a reduction in the amount owed to a vendor because of returned goods or an allowance granted ________ 2. a document received from the vendor which shows the amount owed for an acquisition ________ 3. a document prepared by the purchasing department indicating the description, quantity, and related information for goods and services that the company intends to purchase ________ 4. a listing of the amount owed to each vendor at a point in time ________ 5. a document used to establish a formal means of recording and controlling acquisitions; it includes a cover sheet and a package of relevant documents ________ 6. a document used to request goods and services by an authorized employee ________ 7. the listing or report that includes all cash payments for a given period Answer: 1. g, 2. f, 3. b, 4. j, 5. h, 6. a, 7. m Terms: Purchase requisition; Purchase order; Vendor's invoice; Debit memo; Voucher; Accounts payable trial balance; Cash disbursements journal Difficulty: Moderate Objective: LO 18-2 AACSB: Reflective thinking

18.3 Learning Objective 18-3 1) You have been assigned to the accounts payable transaction cycle as part of your auditing responsibilities. You have decided to vouch a sample of entries in the accounts payable database to supporting documents. Which assertion is this test of controls most likely to support? A) accuracy B) classification C) completeness D) occurrence Answer: D Terms: Assertion for test of controls Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 2) An auditor is gathering evidence on the completeness assertion. To do so, she performs a test to verify that all goods received by the company have been recorded properly. The document population for this test would consist of all A) vendor invoices. B) purchase orders. C) receiving reports. D) cash disbursements for accounts payable. Answer: C Terms: Evidence on completeness assertion to verify all goods received are recorded properly Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 3) Which of the following is not an accurate statement regarding the acquisition and payment cycle? A) The personnel in the receiving department should be independent of the storeroom personnel. B) Goods received should be physically controlled from the time of their receipt until their use or disposal. C) Accounting records should transfer responsibility for the goods each time they are moved. D) The accounting department should be responsible for receiving goods and preparing the receiving report. Answer: D Terms: Internal control test to detect erroneous recording of purchase Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking

4) When reviewing the controls and procedures in the acquisition and payment cycle, A) companies cannot record the liability for the acquisition until the invoice is received from the vendor. B) the purchasing department has the responsibility for verifying for appropriateness of the acquisition. C) personnel who record the acquisitions should not have access to cash or other assets. D) the accounts payable department should account for all receiving reports to assure that the occurrence objective is satisfied. Answer: C Terms: Tests of controls for cash disbursement system; Audit procedures Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 5) A written purchase order is a contractual document that is A) an offer to buy goods or services. B) not enforceable if it is not in writing. C) prepared by the receiving department. D) an acceptance of a vendor's catalog offer to sell. Answer: A Terms: Written purchase order is a legal contractual document Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 6) Which one of the following duties should not be assigned to the purchasing department? A) finding the lowest cost vendor B) reviewing vendors' catalog descriptions and prices for standardized items C) designing the purchase order form D) authorizing the acquisition of goods Answer: D Terms: Duties not to be assigned to the purchases department Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

7) The accounts payable department usually has responsibility for approving acquisitions for payment by comparing the details on the A) vendor's invoice and the receiving report. B) vendor's invoice and the purchase requisition. C) purchase order, receiving report, and vendor's invoice. D) purchase requisition, purchase order, and receiving report. Answer: C Terms: Accounts payable department responsibility for approving acquisitions for payment by comparing details Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 8) A substantive test of transactions for acquisitions that would be used to provide evidence regarding the occurrence assertion would be to A) compare the classification with the chart of accounts by referring to vendors' invoices. B) recompute the clerical accuracy on the vendors' invoices. C) review the acquisitions journal for large or unusual amounts. D) trace from a file of receiving reports to the acquisition journal. Answer: C Terms: Substantive test of accounts payable to provide evidence regarding occurrence assertion Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 9) When testing the controls for the completeness transaction-related audit objectives, A) failure to record the acquisition of goods or services will generally understate net income. B) failure to record the acquisition of goods or services has no impact on the balance sheet. C) it is generally easy for the auditor to determine whether unrecorded transactions exist. D) the audit time for accounts payable can be reduced if the client has effective system of internal controls and the auditor properly tests those controls. Answer: D Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 10) Which of the following is not a key control in the acquisition and payment cycle? A) authorization of purchases B) authorization of credit C) timely recording and independent review of transactions D) authorization of payments Answer: B Terms: Not a key control in acquisition and payment cycle Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 14 Copyright © 2023 Pearson Education, Inc.

11) A key system of internal control over the acquisition cycle is to ensure that the company requires recording transactions as soon as possible after the goods and services have been received. This satisfies the transaction-related audit objective of A) accuracy. B) completeness. C) timing. D) occurrence. Answer: C Terms: Controls over acquisition cycle; timing Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 12) When a client uses perpetual inventory records, the tests of details of balances for inventory can be significantly reduced if the auditor believes the records are accurate. The controls over the acquisitions included in the records are normally tested as a part of the A) tests of controls for acquisitions. B) tests of controls and substantive tests of transactions for acquisitions. C) tests of details of balances for acquisitions. D) analytical procedures and tests of controls for acquisitions. Answer: B Terms: Tests of details of balances for inventory Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 13) The auditor's system of internal control objective to determine that "recorded acquisitions are for goods and services received" satisfies the audit objective of A) accuracy. B) occurrence. C) authorization. D) completeness. Answer: B Terms: Internal control objective that recorded acquisitions are for goods and services received Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

14) Failure to record the acquisition of goods is a violation of which audit objective? A) accuracy B) occurrence C) authorization D) completeness Answer: D Terms: Failure to record acquisition is violation of which audit objective Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 15) The system of internal control that requires that "checks are prenumbered and accounted for" satisfies the objective of A) accuracy. B) existence. C) completeness. D) posting and summarization. Answer: C Terms: Internal control that requires that checks are prenumbered and accounted for Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 16) Because of the importance of tests of controls and substantive tests of transactions for acquisitions and cash disbursements, it is common in this audit area to use A) block sampling. B) variables sampling. C) attributes sampling. D) probability proportional to size sampling. Answer: C Terms: Tests of controls and substantive tests of transactions for acquisitions and cash disbursements Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 17) Which of the following tests of controls is least useful in assessing the transaction-related audit objective related to occurrence? A) Examine documents in voucher package for occurrence. B) Examine supporting documents for indication of approval. C) Account for sequence of vouchers. D) Attempt to input transactions with valid and invalid vendors. Answer: C Terms: Tests of controls for transaction-related audit objectives related to occurrence Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

18) You are performing the audit of Jenkins and Company. Your tests of controls and tests of transactions for accounts payable demonstrate that the controls are operating effectively. This would normally allow you to A) eliminate the need for substantive testing of balances for accounts payable. B) reduce the need for substantive testing of balances for accounts payable. C) reduce control tests in other transactions cycles. D) increase the need for substantive testing of balances for accounts payable. Answer: B Terms: Tests of controls and tests of transactions demonstrate controls are operating effectively Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 19) An auditor is using audit sampling to test transactions in the acquisition and payment cycle. She would normally set the tolerable exception rate at what level? A) Low B) Medium C) High D) Indeterminate Answer: A Terms: Test of transactions in the acquisition and payment cycle; Tolerable exception Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 20) Which of the following is the most effective control procedure to detect vouchers that were prepared for the payment of goods that were not received? A) Count goods upon receipt in storeroom. B) Match purchase order, receiving report, and vendor's invoice for each voucher in accounts payable department. C) Compare goods received with goods requisitioned in receiving department. D) Verify vouchers for accuracy and approval in internal audit department. Answer: B Terms: Most effective control procedure to detect vouchers that were prepared, and payment for goods not received Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

21) Which of the following should sign checks under conditions of effective system of internal control? A) treasurer B) purchasing agent C) accounts payable clerk D) person preparing the checks Answer: A Terms: Effective system of internal controls; Responsible for signing checks Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 22) Which of the following is a key system of internal control for the posting and summarization transaction-related audit objective? A) Batch totals are compared with computer summary reports. B) Documents are canceled. C) Dates are internally verified. D) The accounts payable database contents are internally verified. Answer: D Terms: Posting and summarization transaction-related audit objective Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 23) The test of transactions which requires one to "reconcile recorded cash disbursements with the cash disbursements on the bank statement" satisfies the objective of A) occurrence. B) completeness. C) accuracy. D) posting and summarization. Answer: B Terms: Test of transactions to reconcile recorded cash disbursement with those on bank statement Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking

24) For effective system of internal control purposes, the accounts payable department generally should A) approve the purchase order. B) have the authority to sign the checks. C) establish the agreement of the vendor's invoice with the receiving report and purchase order. D) supervise the preparation of the receiving report. Answer: C Terms: Effective system of internal control, vouchers payable department Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking 25) An auditor performs a test to determine whether all merchandise for which the client was billed was received. The population for this test consists of all A) merchandise received. B) vendors' invoices. C) canceled checks. D) receiving reports. Answer: B Terms: Auditor performs test to determine whether all merchandise for which client was billed was received Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking 26) Matching the supplier's invoice, the purchase order, and the receiving report prior to preparing the voucher would normally be the responsibility of the A) warehouse receiving function. B) purchasing function. C) general accounting function. D) treasury function. Answer: C Terms: Responsibility for matching supplier's invoice with the purchase order and receiving report Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking

27) A CPA learns that his client has paid a vendor twice for the same shipment, once based upon the original invoice and once based upon the monthly statement. A control procedure that should have prevented this duplicate payment is the A) attachment of the receiving report to the disbursement report. B) prenumbering of disbursement vouchers. C) use of a limit or reasonableness test. D) prenumbering of receiving reports. Answer: A Terms: Control procedure that prevents duplicate payment on invoice Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking 28) With respect to a small company's system of purchasing supplies, an auditor's primary concern should be to obtain satisfaction that supplies ordered and paid for have been A) requested by and approved by the same individual. B) used in the course of business and solely for business purposes during the year under audit. C) received, counted, and checked to quantities and amounts on purchase orders and invoices. D) properly recorded as assets and systematically amortized over the estimated useful life of the supplies. Answer: C Terms: Auditor's primary concern in system of purchasing supplies for supplies ordered and paid for Difficulty: Challenging Objective: LO 18-3 AACSB: Analytic thinking 29) System of internal controls that are likely to prevent the client from including as a business expense those transactions that primarily benefit management or other employees rather that the entity being audited satisfy the control objective that A) acquisitions are correctly valued. B) existing acquisitions are recorded. C) acquisitions are correctly classified. D) recorded acquisitions are for goods and services received. Answer: D Terms: Internal controls for asset acquisitions Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 30) Significant audit efficiencies can be achieved on many audits when controls are operating effectively. Answer: TRUE Terms: Audit efficiency and system of internal controls Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 20 Copyright © 2023 Pearson Education, Inc.

31) Failure to record the acquisition of goods and services received overstates both accounts payable and net income. Answer: FALSE Terms: Failure to record acquisition of goods Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 32) The controls over acquisitions included in the perpetual inventory records are normally tested as a part of the test of controls and substantive tests of transactions for the sales and collection cycle. Answer: FALSE Terms: Tests of controls and substantive tests of transactions Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 33) Because of the importance of tests of controls and substantive tests of transactions for acquisitions and cash disbursements, attributes sampling is commonly used when testing the acquisitions and cash disbursements cycle. Answer: TRUE Terms: Importance of tests of controls and substantive tests of transactions; Attributes sampling Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 34) A substantive test of transactions commonly used to test the completeness objective for acquisitions is "Trace from a file of receiving reports to the acquisitions journal." Answer: TRUE Terms: Substantive test of transactions to test completeness objective for acquisitions Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 35) The audit procedure "Test clerical accuracy by footing the journals and tracing postings to general ledger and to accounts payable and inventory databases" is used to test the posting and summarization objective for acquisitions. Answer: TRUE Terms: Audit procedure to test clerical accuracy to test posting and summarization objective Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

36) Auditors are normally more concerned about violations of the completeness objective for acquisitions than about violations of the occurrence objective for acquisitions. Answer: TRUE Terms: Auditor more concerned with violation of completeness objective than occurrence objective for acquisitions Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking 37) Checks should be prenumbered to make it easier to account for all checks. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 38) Since there are a large number of accounts involved in the acquisition and payment cycle, there is the potential for classification misstatements, some of which are likely to affect net income. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 39) The audit procedure "Examine canceled check for authorized signature, proper endorsement, and cancellation by the bank" is used to test the occurrence objective for cash disbursements. Answer: TRUE Terms: Audit procedure for occurrence objective for cash disbursements Difficulty: Challenging Objective: LO 18-3 AACSB: Reflective thinking 40) Auditors typically perform the acquisitions and cash disbursements tests at different times. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking

41) One of important internal controls over cash disbursements should include not only the physical signing of checks, but also the approval of electronic funds transfers by individuals with proper authority. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 42) A key system of internal control in the acquisition and payment cycle is someone matching the key information contained on the purchase requisition, the purchase order, the receiving report, and the vendor's invoice to the payment voucher. Answer: TRUE Terms: Key controls in acquisition and payment cycle Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 43) Auditors must also take into consideration the identification of material contracts, commitments, and related party transactions which require disclosure in the financial statements and/or the footnotes to the financial statements. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 18-3 AACSB: Reflective thinking 44) What are the three most important controls over cash disbursements? Answer: • signing of checks by an individual with proper authority. • separation of responsibilities for signing checks and performing the accounts payable function. • careful examination of supporting documents by the check signer at the time the check is signed. Terms: Important controls over cash disbursements Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

45) Discuss the key system of internal controls that should be present in the processing purchase orders function in the acquisitions and payment cycle. Answer: Proper authorization for acquisitions ensures that the goods and services acquired are for authorized company purposes, and it avoids the acquisition of excessive or unnecessary items. Most companies require different levels of authorization for different types of acquisitions or dollar amounts. For effective system of internal control, the purchasing department should be separate from those who authorize the acquisition or receive the goods. Purchase orders should be prenumbered to permit easier accounting for all outstanding purchase orders and should be designed to minimize the likelihood of unintentional omissions on the form when goods are ordered. Terms: Key system of internal controls for processing purchase orders in the acquisitions and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 46) Discuss the key system of internal controls that should be present in the receiving goods and services function in the acquisitions and payment cycle. Answer: For good system of internal control over the receiving goods and services function, most companies require that the receiving department initiate a receiving report as evidence of the receipt and examination of the goods. One copy of the report is sent to the raw materials storeroom and another to the accounts payable department for their information needs. To prevent theft and misuse, it is important that the goods be physically controlled from the time of their receipt until their disposal. The personnel in the receiving department should be independent of the storeroom personnel and the accounting department. In addition, the accounting records should transfer responsibility for the goods as they are transferred from receiving to storage and from storage to manufacturing. Terms: Key system of internal controls in receiving goods and services in the acquisitions and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking 47) How do auditors determine the extent of testing of system of internal controls in the acquisition and payment cycle? Answer: When auditors intend to rely on controls to support a preliminary control risk assessment below maximum, the auditor performs tests of controls to obtain evidence that controls are operating effectively. As the operating effectiveness of controls improves and is supported by additional tests of controls, the auditor is able to reduce substantive tests. If the company is an accelerated filer public company, then the auditor must document and test controls sufficiently to issue an opinion on system of internal control over financial reporting. Terms: Extent of testing of system of internal controls in the acquisitions and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

48) Listed below are some management assertions made for the acquisition and payment cycle. For each one, give an example of how the auditor, by using the documents normally found in the process, can apply an auditing procedure to test the assertion. - completeness - timing - accuracy Answer: (may vary based on student response) completeness: Trace from a file of receiving reports to the acquisitions journal. Trace from a file of vendors' invoices to the acquisition journal. timing: Compare dates of receiving reports and vendors' invoices with dates in the acquisitions journal. accuracy: Compare recorded transactions in the acquisitions journal with the vendor's invoice, receiving report, and other supporting documentation. Recompute the clerical accuracy on the vendor's invoice, including discounts and freight. Terms: Tests for management assertions for acquisition and payment cycle Difficulty: Moderate Objective: LO 18-3 AACSB: Reflective thinking

18.4 Learning Objective 18-4 1) A liability is properly accounted for as an account payable if A) the amount is known and owed as of the balance sheet date. B) the amount can be estimated and is owed at the balance sheet date. C) the amount is known at the balance sheet date and owed by the end of the next fiscal year. D) the amount is estimated and owed within 90 days of the balance sheet date. Answer: A Terms: Liability is properly accounted for as accounts payable Difficulty: Moderate Objective: LO 18-4 AACSB: Reflective thinking 2) When determining the methodology for designing tests of details of balances for accounts payable, A) the focus by many companies on improving their supply-chain management activities has led to numerous changes in the design of systems used to initiate and record acquisition and payment activities. B) it is relatively inexpensive to audit accounts payable. C) performance materiality for accounts payable is set relatively low. D) inherent risk is often set at low. Answer: A Terms: Risk and accounts payable Difficulty: Moderate Objective: LO 18-4 AACSB: Reflective thinking 3) Auditors are especially concerned about the ________ and ________ balance-related audit objectives in the acquisition and payment cycle because of the potential for understatements in the account balance. A) completeness; cutoff B) completeness; accuracy C) classification; realizable value D) classification; cutoff Answer: A Terms: Balance-related audit objectives for accounts payable Difficulty: Moderate Objective: LO 18-4 AACSB: Reflective thinking 4) The auditors' ultimate substantive tests depend on the relative effectiveness of system of internal controls related to accounts payable. Answer: TRUE Terms: Substantive tests for accounts payable Difficulty: Easy Objective: LO 18-4 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

5) Auditors typically set performance materiality for accounts payable relatively low. Answer: FALSE Terms: Performance materiality Difficulty: Easy Objective: LO 18-4 AACSB: Reflective thinking 6) Most accrued liabilities can be identified by the existence of vendors' invoices for the obligation. Answer: FALSE Terms: Accounts payable and accrued liabilities Difficulty: Easy Objective: LO 18-4 AACSB: Reflective thinking 7) Once the auditor concludes that system of internal controls are operating effectively in the acquisition and the payment cycle, the verification of accounts payable should require little audit effort. Answer: TRUE Terms: Audit of accounts payable Difficulty: Easy Objective: LO 18-4 AACSB: Reflective thinking 8) Examples of a client not using prenumbered receiving reports, a client not recording acquisitions until cash disbursements are actually made, and because of cash shortages paying bills several months after their due date generally force the auditor to perform more extensive substantive testing of the details of accounts payable. Answer: TRUE Terms: Accounts payable and accrued liabilities Difficulty: Easy Objective: LO 18-4 AACSB: Reflective thinking

9) Describe the methodology for designing tests of details of balances for accounts payable. Answer: The methodology for designing tests of accounts payable consists of: 1. Identify significant risks and assess risk of material misstatement for accounts payable. 2. Set performance materiality for accounts payable. 3. Assess control risk for the acquisition and payment cycle. 4. Design and perform tests of controls and substantive tests of transactions over transactions, balances, and disclosures for the acquisition and payment cycle. 5. Design and perform substantive analytical procedures for accounts payable. 6. Design tests of details of accounts payable and related disclosures to satisfy balance-related audit objectives. Decide audit procedures to perform, as well as the nature, timing, and extent of these procedures. Terms: Methodology for designing tests of details of balances for accounts payable Difficulty: Moderate Objective: LO 18-4 AACSB: Reflective thinking 18.5 Learning Objective 18-5 1) Which substantive analytical procedure would help determine if there are unrecorded or nonexistent accounts? A) Review the list of accounts payable for unusual items. B) Compare acquisition-related expense account balances with prior years. C) Calculate ratios, such as accounts payable divided by current liabilities. D) Calculate ratios, such as sales divided by gross profit. Answer: C Terms: Substantive analytical procedures Difficulty: Moderate Objective: LO 18-5 AACSB: Reflective thinking 2) Which substantive analytical procedure would help determine if there are unrecorded or nonexistent accounts? A) Review the list of accounts payable for unusual items. B) Compare acquisition-related expense account balances with prior years. C) Calculate ratios, such as purchases divided by accounts payable. D) Calculate ratios, such as sales divided by gross profit. Answer: C Terms: Substantive analytical procedures Difficulty: Moderate Objective: LO 18-5 AACSB: Reflective thinking

3) A misstatement of an expense account usually also results in an equal misstatement of accounts receivable. Answer: FALSE Terms: Substantive analytical procedures Difficulty: Easy Objective: LO 18-5 AACSB: Reflective thinking 4) Because of double-entry accounting, misstatement of an expense account usually also results in an equal misstatement of accounts payable. Answer: TRUE Terms: Substantive analytical procedures Difficulty: Moderate Objective: LO 18-5 AACSB: Reflective thinking 5) Explain why auditors should compare current year expense totals with prior year expense totals as an analytical procedure for accounts payable. Answer: Auditors should compare current year expense totals with prior years to uncover misstatements in accounts payable as well as in the expense accounts. Because of double-entry accounting, a misstatement of an expense account usually also results in an equal misstatement of accounts payable. Therefore, comparing current expenses such as rent, utilities, and other regularly scheduled bills with prior years is an effective procedure for analyzing accounts payable when expenses from year to year are expected to be relatively stable. Terms: Substantive analytical procedures Difficulty: Moderate Objective: LO 18-5 AACSB: Reflective thinking

18.6 Learning Objective 18-6 1) At what point do most companies recognize liabilities in the acquisition and payment cycle when the goods are shipped FOB destination? A) when the purchase order is issued B) when the vendor acknowledges receipt of the order C) when the goods or services are received D) when the vendor invoice is received Answer: C Terms: Companies recognize liabilities in acquisition and payment cycle; FOB destination Difficulty: Easy Objective: LO 18-6 AACSB: Reflective thinking 2) Cutoff procedures for inventory purchased should be designed by companies to assure that A) inventory owned by the company has been received. B) inventory included in the year-end inventory count has been paid. C) inventory received before year-end was recorded before year-end. D) inventory was correctly valued at year-end. Answer: C Terms: Cutoff procedures for inventory purchased Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 3) You are the in-charge auditor and are designing audit procedures for accounts payable. Which of the following management assertions would you normally be most concerned about? A) occurrence B) accuracy C) completeness D) existence Answer: C Terms: Audit procedures for accounts payable; Management assertions Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking

4) The main focus taken by the auditor in verifying liability balances is on the discovery of I. understated liabilities. II. omitted liabilities. A) I only B) II only C) both I and II D) neither I nor II Answer: C Terms: Main focus in verifying liability balances Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 5) By tracing receiving reports issued at and before year-end to vendors' invoices and making sure they are included in accounts payable, the auditor is testing for A) theft of merchandise by employees. B) unrecorded obligations. C) lapping. D) kiting. Answer: B Terms: Tracing receiving reports issued at and before year-end to vendors' invoices Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 6) The extent of a search for unrecorded liabilities largely depends on A) materiality and inherent risk. B) materiality and control risk. C) materiality only. D) inherent risk only. Answer: B Terms: Unrecorded liabilities Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 7) A document review of which of the following is most likely to yield evidence of any unrecorded liabilities? A) debit memos B) vendor memos C) unpaid accounts payable D) sales invoices out of sequence Answer: C Terms: Document review for unrecorded liabilities Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 31 Copyright © 2023 Pearson Education, Inc.

8) When the client's physical inventory occurs before the last day of the year, it is still necessary to perform an accounts payable cutoff at the time of the count. In addition, the auditor must verify whether all acquisitions taking place between the count and the end of the year were added to A) the physical inventory. B) accounts payable. C) accounts payable and cost of goods sold. D) the physical inventory and accounts payable. Answer: D Terms: Accounts payable cutoff; Physical inventory before last day of year Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 9) Peprah Company pays its accounts payable 45 days after receipt of the goods or services. In this case, which audit procedure should be used to detect any unrecorded liabilities? A) Examine cash disbursements for several weeks after the balance sheet date. B) Reconcile purchase orders to requisition orders. C) Reconcile purchase orders to receiving reports. D) Reconcile purchase orders to vendor invoices. Answer: A Terms: Audit procedure for unrecorded liabilities Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 10) Cutoff information for inventory acquisitions should be obtained during A) the interim period prior to year-end. B) the interim period immediately following year-end. C) the physical observation of inventory. D) either the interim period prior to or immediately following year-end. Answer: C Terms: Cutoff information for inventory acquisitions Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking

11) Which of the following is not a typical audit procedure performed as part of the out-ofperiod liability tests? A) Examine underlying documentation for cash disbursements made during the last month of the year. B) Examine underlying documentation for bills not paid several weeks after the year-end. C) Trace receiving reports issued before year-end to related vendors' invoices. D) All of the above are correct. Answer: A Terms: Out-of-period liability tests Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 12) In searching for unrecorded liabilities, the purpose of the audit procedure to "examine underlying documentation for subsequent cash disbursements" is to A) uncover liabilities on the balance sheet which should not have been recorded until a subsequent period. B) find the documentation relating to a cash disbursement. C) uncover payments made in a subsequent accounting period for liabilities that existed at the balance sheet date. D) uncover cash disbursements recorded in a subsequent accounting period which should be recorded in this period. Answer: C Terms: Unrecorded liabilities Difficulty: Challenging Objective: LO 18-6 AACSB: Reflective thinking 13) To test for cutoff errors which overstate liabilities, the auditor should trace the receiving reports issued ________ to vendors' invoices. A) after year-end B) before year-end C) the last day of the fiscal year D) both before and after year-end Answer: A Terms: Test for cutoff errors which overstate liabilities Difficulty: Challenging Objective: LO 18-6 AACSB: Reflective thinking

14) In determining that the accounts payable cutoff is correct, it is essential that the cutoff tests be coordinated with the A) confirmation of payables. B) tests of long-term liabilities. C) observation of inventory. D) cash count. Answer: C Terms: Accounts payable cutoff test coordinated with Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 15) An inventory acquisition is received late in the afternoon of December 31 after the physical inventory is completed. If the acquisition is included in accounts payable and purchases, but excluded from inventory, the result A) is an understatement of net earnings. B) is an overstatement of net earnings. C) is an overstatement of working capital. D) is an overstatement of owner's equity. Answer: A Terms: Inventory acquisition received after year-end, but included in accounts payable and purchases Difficulty: Challenging Objective: LO 18-6 AACSB: Analytic thinking 16) When an acquisition is on an FOB origin basis, the inventory and related accounts payable must be recorded in the current period if the goods were A) received prior to the balance sheet date. B) shipped on or before the balance sheet date. C) both shipped and received prior to the balance sheet date. D) paid for in advance. Answer: B Terms: Acquisition of inventory on FOB basis Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking

17) When assets are being verified, auditors focus much of their attention on making sure that the accounts are not overstated. Alternatively, auditors focus their efforts on understatements when auditing liabilities. What is the primary reason for this difference in focus? A) auditors' legal liability B) GAAP C) GAAS requirements D) all of the above Answer: A Terms: Basis for testing of asset accounts for overstatement and testing of liabilities for understatement Difficulty: Challenging Objective: LO 18-3 and LO 18-6 AACSB: Reflective thinking 18) A company recorded an acquisition of merchandise and its related liability, but failed to include the merchandise in ending inventory. The effect on the financial statements was to A) understate liabilities. B) understate net income. C) overstate net income. D) have no impact on the financial statements since the errors cancel each other out. Answer: B Terms: Effect on financial statements of inventory cutoff Difficulty: Challenging Objective: LO 18-6 AACSB: Analytic thinking 19) The overall objective in the audit of accounts payable is to determine whether accounts payable A) are fairly stated and properly disclosed. B) are overstated. C) are understated. D) are accurately stated. Answer: A Terms: Liabilities and balance-related audit objectives Difficulty: Easy Objective: LO 18-6 AACSB: Reflective thinking

20) ________ is a balance-related audit objective that is not applicable to liabilities. A) Existence B) Accuracy C) Detail tie-in D) Realizable value Answer: D Terms: Liabilities and balance-related audit objectives Difficulty: Easy Objective: LO 18-6 AACSB: Reflective thinking 21) The balance-related audit objective realizable value is not applicable when auditing accounts payable. Answer: TRUE Terms: Balance-related audit objective of realizable value Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 22) When auditing accounts payable, the auditor is more concerned about the possibility of understatements than overstatements. Answer: TRUE Terms: Auditing accounts payable, auditor concerned with understatement Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 23) To test for overstatement cutoff amounts when auditing accounts payable, the auditor should trace receiving reports issued before year-end to related vendors' invoices to make sure they are not recorded as accounts payable. Answer: FALSE Terms: Test for overstatement cutoff amounts in Accounts Payable Difficulty: Challenging Objective: LO 18-6 AACSB: Reflective thinking 24) The "rights "aspect of the "rights and obligations" objective is not applicable to liabilities. Answer: TRUE Terms: Rights and obligations; accounts payable Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking

25) Auditors primarily emphasize the understatement of liabilities in the audit of accounts payable because they are concerned about potential legal liability. Answer: TRUE Terms: Auditors emphasize understatement of liabilities because of potential legal liability Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking 26) Auditors examine supporting documentation for cash disbursements subsequent to the balance sheet date in order to determine whether the cash disbursement was for a current period liability. Describe at least two audit procedures the auditor would perform to provide evidence that the cash disbursement was made for a current period liability. Answer: 1. Trace vendor invoice to accounts payable subsidiary ledger and to the trial balance. 2. Trace receiving report to vendor invoice and to accounts payable subsidiary ledger. 3. Examine vendor invoices for inclusion in the proper period. 4. Examine cash disbursements for several weeks after the company's year-end. Terms: Audit procedures for cash disbursements Difficulty: Challenging Objective: LO 18-6 AACSB: Reflective thinking 27) Describe the audit procedures typically used to test for out-of-period liabilities (also referred to as the search for unrecorded accounts payable). Answer: The audit procedures typically used to test for out-of-period liabilities are: • Examine underlying documentation for subsequent cash disbursements. • Examine underlying documentation for bills not paid several weeks after the year-end. • Trace receiving reports issued before year-end to related vendors' invoices. • Trace vendors' statements that show a balance due to the accounts payable trial balance. • Send confirmations to vendors with which the client does business, including zero balance confirmations. Terms: Audit procedures for out-of-period liabilities Difficulty: Challenging Objective: LO 18-6 AACSB: Reflective thinking 28) Sampling is more commonly used for the audit of accounts payable than for accounts receivable. Answer: FALSE Terms: Test for overstatement cutoff amounts in Accounts Payable Difficulty: Moderate Objective: LO 18-6 AACSB: Reflective thinking; Analytic thinking

18.7 Learning Objective 18-7 1) The documents typically used to reconcile the balance on the accounts payable list with the confirmation or vendors' statements include all of the following except for A) receiving reports. B) vendors' invoices. C) sales invoices. D) cancelled checks. Answer: C Terms: Account payable reconciliation Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 2) Which of the following is most reliable for verifying the correct balance of accounts payable? A) vendors' invoices B) vendors' statements C) confirmations D) bills of lading Answer: B Terms: Most reliable for verifying correct balance of accounts payable Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 3) Vendors' statements and vendors' invoices are both relatively reliable evidence because they A) come directly to the auditor without being in client's possession. B) originate from a third party. C) validate the effectiveness of the control system. D) are compared to and reconciled with sales invoices. Answer: B Terms: Reliable evidence; Vendors' statements and vendors' invoices Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking

4) The auditor is performing tests of transactions for individual accounts payable transactions with vendors. Which document provides more reliable information about individual transactions with vendors? A) receiving report B) vendors' invoices C) vendors' statements D) purchase orders Answer: B Terms: Tests of transactions for accounts payable; Reliable evidence Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 5) Auditor confirmation of accounts payable balances at the balance sheet date may not need to be performed by the auditor because A) this is a duplication of cutoff tests. B) there is likely to be other reliable external evidence available to support the balances. C) accounts payable balances at the balance sheet date may not be paid before the audit is completed. D) correspondence with the audit client's attorney will reveal all legal action by vendors for nonpayment. Answer: B Terms: Confirmation of accounts payable Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 6) Under which of the following circumstances would it be advisable for the auditor to confirm accounts payable with creditors? A) The internal accounting control over accounts payable is effective, and there is sufficient evidence on hand to minimize the risk of a material misstatement. B) The confirmation response is expected to be favorable, and accounts payable balances are of immaterial amounts. C) The creditor statements are not available and system of internal control over payables is deficient. D) The majority of accounts payable balances are with associated companies. Answer: C Terms: Confirm accounts payable with creditors Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking

7) The auditor is performing substantive tests of balances for accounts payable. What documentation would provide the best evidence for the ending balance? A) vendors' invoices B) vendors' statements C) receiving reports D) purchase orders Answer: B Terms: Best evidence for substantive tests of balances for accounts payable Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 8) The auditor gets highly reliable evidence about individual transactions by examining A) vendors' invoices. B) vendors' statements. C) confirmations of accounts payable balances. D) detailed inventory counting instructions. Answer: A Terms: Auditor gets highly reliable evidence about individual transactions Difficulty: Challenging Objective: LO 18-7 AACSB: Reflective thinking 9) When determining sample sizes for accounts payable tests, A) sample sizes rarely vary from audit to audit. B) auditors must try to ensure that the population includes all potential payables. C) defining the population is a simple procedure. D) all of the above are correct. Answer: B Terms: Sample size and accounts payable tests Difficulty: Challenging Objective: LO 18-7 AACSB: Reflective thinking 10) When auditors examine vendors' statements or receive confirmations, there must be a reconciliation of the statement or confirmation with the A) accounts payable list. B) vendors' invoices. C) purchase orders. D) receiving reports. Answer: A Terms: Substantive tests of balances with vendor statements or vendor confirmations Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking

11) You are performing an audit of Hawk Company. In evaluating the accounts payable balance you are concerned with the completeness assertion. Which of the following audit procedures best satisfies your concern? A) Send confirmations to only vendors with large balances. B) Send confirmations to vendors with large, active, zero balance accounts and a representative sample of all others. C) Send confirmations to vendors chosen from sample stratified by the dollar balance. D) Send confirmations to all vendors. Answer: B Terms: Accounts payable and completeness assertion Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 12) A vendor's statement is unreliable and auditors rarely use it. Answer: FALSE Terms: Vendor's statement reliability Difficulty: Easy Objective: LO 18-7 AACSB: Reflective thinking 13) When verifying the correct balance in accounts payable, vendors' invoices are more useful than vendors' statements. Answer: FALSE Terms: Vendors' invoices more useful than vendors' statements Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 14) A company purchasing goods from a vendor on a FOB origin basis must record the liability when the goods are received at the company's receiving dock. Answer: FALSE Terms: Vendors' invoices more useful than vendors' statements Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 15) Typically, a company can determine whether inventory has been acquired FOB destination or origin by examining the vendor's invoice. Answer: TRUE Terms: Vendors' invoices more useful than vendors' statements Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking

16) If the client counts inventory at year end, it is essential that cutoff tests be coordinated with the physical observation of inventory. Answer: TRUE Terms: Relationship of cutoff to physical observation of inventory Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 17) Knowledge of the client's business is essential for tests related to reviewing the accounts payable listing and database for related parties and debit balances. Answer: TRUE Terms: Accounts payable are correctly classified and disclosed in the financial statements Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 18) In an audit with a December 31 year-end, the audit needs to only examine supporting documentation for disbursements paid through January 31 of the following month. Answer: FALSE Terms: Examining documentation for invoices not paid several weeks after the year-end Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking 19) Discuss the circumstances in which it is desirable to send confirmation requests to the client's vendors. Answer: It is desirable to send confirmation requests to the client's vendors when the client's system of internal controls are deficient, when vendors' statements are not available, or when the auditor questions the client's integrity. Terms: Confirmations Difficulty: Moderate Objective: LO 18-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 19 Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts 19.1 Learning Objective 19-1 1) Which of the following accounts is not associated with the acquisition and payment cycle? A) common stock B) property, plant and equipment C) accrued property taxes D) income tax expense Answer: A Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-1 AACSB: Reflective thinking 2) Which of the following expenses is not typically evaluated as part of the audit of the acquisition and payment cycle? A) retirement benefits B) insurance expense C) bad debt expense D) property tax expense Answer: C Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-1 AACSB: Reflective thinking 3) Other accrued expenses are normally considered to be associated with the acquisition and payment cycle. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-1 AACSB: Reflective thinking 4) The types of assets, expenses, and liabilities associated with the acquisition and payment cycle will differ by company. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-1 AACSB: Reflective thinking

5) The billing of customers and collection of the related accounts receivable are normally considered to be associated with the acquisition and payment cycle. Answer: FALSE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-1 AACSB: Reflective thinking 19.2 Learning Objective 19-2 1) You are auditing the acquisition and payment cycle and note the presence of excessive recurring losses on retired assets. You may conclude that A) insured values are greater than book values. B) there are a large number of fully depreciated assets. C) depreciation charges may by insufficient. D) the company has a policy of selling relatively new assets. Answer: C Terms: Acquisition and payment cycle; Excessive recurring losses on retired assets Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 2) Which of the following would generally not be a component of the audit of the acquisition and payment cycle? A) adequacy of controls over acquisitions of long-lived assets B) tracing disposals of long-lived assets to the fixed asset database C) determining the adequacy of the funds available for capital expenditures D) reperformance of recorded depreciation expense Answer: C Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 3) Normally it may be unnecessary to examine supporting documentation for each addition to property, plant, and equipment, but it would be customary to verify A) all large transactions. B) all unusual transactions. C) a representative sample of typical additions. D) all of the above. Answer: D Terms: Property, plant, and equipment documentation Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

4) The auditor must know the client's capitalization policies to determine whether acquisitions are A) Recorded at historical Treated consistently with Necessary cost those of the preceding year Yes Yes Yes B) Recorded at historical cost Yes C) Recorded at historical cost No D) Recorded at historical cost No

Treated consistently with those of the preceding year No

Necessary

Treated consistently with those of the preceding year No

Necessary

Treated consistently with those of the preceding year Yes

Necessary

Answer: D Terms: Acquisitions; Capitalization policy Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 5) Which is not one of the tests that would be used in the audit of equipment, depreciation expense, and accumulated depreciation? A) Verify the ending balance in the asset account. B) Send confirmations to the sales personnel who sold the equipment to the company. C) Perform substantive analytical procedures. D) Verify current year acquisitions. Answer: B Terms: Property, plant, and equipment; Capitalized Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

6) The primary accounting record for manufacturing equipment and other fixed assets is the A) depreciation ledger. B) fixed asset database. C) asset inventory. D) equipment roster. Answer: B Terms: Primary accounting record for equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 7) Which of the following statements about the audit of fixed assets is the least correct? A) The primary accounting record for manufacturing equipment and other property, plant and equipment is generally a fixed asset database. B) Manufacturing equipment and current assets are normally audited in the same fashion regardless of the activity within a particular account. C) The emphasis on auditing fixed assets is on verification of current-period acquisitions. D) Failure to record the acquisition of a fixed asset affects the income statement until the assets are fully depreciated. Answer: B Terms: Audit of fixed assets Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 8) You are the in-charge auditor for a company who has been an audit client for several years. Which of the following is not a category of tests commonly associated with the audit of manufacturing equipment? A) verification of depreciation expense B) analytical procedures C) verification of current-period disposals D) verification of the beginning balance in the equipment account Answer: D Terms: Audit of manufacturing equipment; Category of tests Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

9) The audit procedure that requires an auditor to "foot the acquisition schedule" relates to which balance-related audit objective? A) classification B) detail tie-in C) existence D) cutoff Answer: B Terms: Audit procedure; Balance-related audit objective; Foot acquisition schedule Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 10) You are auditing Manufacturing Company and testing the audit-related objective of completeness for the equipment accounts. Which of the following audit procedures is most likely to achieve your objective? A) Examine vendor invoices and receiving reports. B) Physically examine assets. C) Examine vendor invoices of closely related accounts such as repairs and maintenance. D) Trace individual acquisitions to the fixed asset database. Answer: C Terms: Testing audit related objective of completeness for equipment accounts Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 11) Which of the following audit procedures would be the most correct in determining the audit objective of existence for the equipment account in the fixed asset database? A) Examine vendor invoices and receiving reports. B) Review transactions near the balance sheet date. C) Recalculate vendor invoices. D) Examine vendor invoices for correct accounting treatment. Answer: A Terms: Audit objective of existence for equipment account Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 12) The source of debits in the equipment account is the A) sales schedule. B) cash disbursements journal. C) cash receipts journal. D) acquisitions schedule. Answer: D Terms: Acquisitions schedule and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

13) Failure to capitalize a fixed asset at the correct amount would impact which financial statements? A) the balance sheet B) the income statement C) the cash flow statement only D) both the income statement and the balance sheet Answer: D Terms: Failure to capitalize a fixed asset; Financial statements Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 14) Which of the following tests are typically not necessary when auditing a client's schedule of recorded disposals? A) footing the schedule B) tracing the totals on the schedule to the recorded disposals in the general ledger C) tracing cost and accumulated depreciation of the disposals to the fixed assets database D) All of the above are necessary. Answer: D Terms: Tests when auditing schedule of recorded disposals Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 15) Which of the following is a substantive analytical procedure to determine if there is idle equipment or equipment that was disposed of but not written off? A) Compare depreciation expense divided by gross equipment cost with previous years. B) Compare gross manufacturing cost divided by some measure of production with previous years. C) Compare accumulated depreciation divided by gross equipment cost with previous years. D) Compare annual repairs and maintenance accounts with previous years. Answer: B Terms: Equipment; analytical procedures Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

16) A set of records for each piece of equipment that includes descriptive information, date of acquisition, original cost, current year depreciation, and accumulated depreciation is the A) acquisitions schedule. B) depreciation schedule. C) fixed asset database. D) file of purchase requisitions. Answer: C Terms: Set of records for each piece of equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 17) In testing acquisitions the auditor needs to understand the appropriate accounting guidance related to acquisition accounting. Which of the following is not an accounting consideration for the auditor with regards to acquisition cost? A) inclusion of material transportation and installation costs B) recording of trade-in costs C) allocating costs when building and equipment are purchased at one price D) verifying that purchased equipment amounts correspond to the budgeted amount Answer: D Terms: Appropriate accounting guidance related to acquisition accounting Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 18) Methods used to determine if there are legal encumbrances related to fixed assets include all but which of the following? A) Read the terms of loan and credit agreements. B) Send loan confirmation requests to banks and other lending institutions. C) Have discussions with the client or send letters to legal counsel. D) All of the above may be used to identify legal encumbrances. Answer: D Terms: Methods to determine legal encumbrances related to fixed assets Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

19) When performing the test of details of balances, the balance-related audit objective of classifications is closely related to the objective of A) accuracy. B) detail tie-in. C) existence. D) completeness. Answer: D Terms: Tests of details of balances Difficulty: Moderate Objective: LO 19-2 AACSB: Analytic thinking 20) The test of details of balances procedure to "examine vendors' invoices of closely related accounts such as repairs to uncover items that should be property, plant, and equipment" satisfies the audit objective of A) completeness. B) detail tie-in. C) cutoff. D) existence. Answer: A Terms: Test of details of balances; Audit objective Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 21) The auditor's starting point for verifying disposals of property, plant, and equipment is the A) equipment account in the general ledger. B) file of shipping documents. C) client's schedule of recorded disposals. D) equipment subsidiary ledger. Answer: C Terms: Disposals of property, plant, and equipment Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

22) Improperly classifying a fixed asset by recording the amount in the repairs and maintenance expense account will have an effect on which of the following financial statements until the asset would normally have been depreciated? A) the balance sheet B) the income statement C) the cash flow statement D) both the income statement and the balance sheet Answer: D Terms: Failure to capitalize a fixed asset Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 23) Because the failure to record disposals of property, plant, and equipment can significantly affect the financial statements, the search for unrecorded disposals is essential. Which of the following is not a procedure used to verify disposals? A) Make inquiries of management and production personnel about the possibility of the disposal of assets. B) Review whether newly acquired assets replace existing assets. C) Test the valuation of fixed assets recorded in prior periods. D) Review plant modifications and changes in product line, property taxes, or insurance coverage. Answer: C Terms: Unrecorded disposals of property, plant, and equipment Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 24) When the auditor is determining whether the client followed a consistent depreciation policy from period to period, and the client's depreciation calculations are correct, the balance-related audit objective of ________ is being determined for depreciation expense. A) completeness B) existence C) classification D) accuracy Answer: D Terms: Determining appropriate depreciation calculations; Testing audit objective Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

25) A major consideration in verifying the ending balance in fixed assets is the possibility of existing legal encumbrances. Tests to identify possible legal encumbrances would satisfy the audit objective of A) existence. B) presentation and disclosure. C) detail tie-in. D) classification. Answer: B Terms: Tests to identify legal encumbrances Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 26) When auditing depreciation expense, the two major concerns related to the accuracy audit objective are A) consistent application of depreciation method and useful lives. B) consistent application of depreciation method and classification of assets. C) correctness of calculations and consistent application of depreciation policies. D) cost of the fixed asset and useful lives. Answer: C Terms: Auditing depreciation expense Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 27) The auditor needs to gain reasonable assurance that the equipment accounts in the fixed asset database are not understated. Which of the following accounts would most likely be reviewed in making that determination? A) depreciation expense B) repairs and maintenance expense C) gains/losses on sales and retirements D) cash Answer: B Terms: Reasonable assurance that equipment accounts in the fixed asset database are not understated Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

28) Changing circumstances may require a change in the useful life of an asset. When this occurs, it involves a change in A) accounting estimate rather than a change in accounting principle. B) accounting principle rather than a change in accounting estimate. C) both accounting principle and accounting estimate. D) neither accounting principle nor accounting estimate. Answer: A Terms: Change in useful life of an asset Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 29) The auditor normally does not need to test the accuracy or classification of fixed assets recorded in prior periods if they are the continuing auditor because A) they are rarely material to the audit. B) they rarely contain misstatements. C) they are verified in previous audits. D) they don't affect the balance sheet. Answer: C Terms: Test accuracy or classification of fixed assets recorded in prior periods Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 30) The auditor is examining the accounting entries made to the accumulated depreciation account during the year and notices a significant number and amounts of debits to the account. Which of the following provides the most logical explanation? A) large number of asset retirements B) salvage values were revised downward C) useful lives were revised downward D) allocation of fixed overhead was revised Answer: A Terms: Accounting entries (debits) made to accumulated depreciation account Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

31) In determining the reasonableness of the client's amount for depreciation expense, the auditor is primarily concerned that the client has followed a consistent policy and the calculations are correct. Which of the following audit objectives best addresses the above concerns? A) existence B) accuracy C) valuation D) allocation Answer: B Terms: Depreciation expense; Consistency policy and calculations are correct Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 32) Which of the following audit procedures would be least likely to lead the auditor to find an unrecorded fixed asset disposal? A) examination of insurance policies B) review of repairs and maintenance expense C) review of property tax files D) scanning of invoices for fixed asset additions Answer: B Terms: Unrecorded fixed asset disposal Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 33) The most common audit test to verify equipment additions is to A) examine vendors' invoices. B) perform an inventory of the fixed assets. C) confirm the additions with the vendors. D) trace the vendor invoices to the cash disbursements journal. Answer: A Terms: Equipment additions; audit procedures Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 34) The auditor is testing for unrecorded retirements/disposals of equipment. Which of the following audit procedures would the auditor most likely use? A) Select items from the fixed asset database and then physically locate them. B) Examine the repairs and maintenance amount for large debits. C) Compare current year's depreciation expense with the previous year's depreciation expense. D) Trace acquisition documents to the fixed asset database. Answer: A Terms: Testing for unrecorded retirements/disposals of equipment Difficulty: Challenging Objective: LO 19-2 AACSB: Analytic thinking 12 Copyright © 2023 Pearson Education, Inc.

35) The failure to capitalize a permanent asset, or the recording of an asset acquisition at the improper amount, affects the balance sheet A) forever. B) for the current period. C) for the depreciable life of the asset. D) until the firm disposes of the asset. Answer: D Terms: Failure to capitalize a permanent asset; Recording of an asset acquisition at improper amount Difficulty: Moderate Objective: LO 19-2 AACSB: Analytic thinking 36) One of the primary objectives in examining the repairs and maintenance accounts is to obtain evidence that A) expenditures of equipment have not been charged to expense. B) the actual amount recorded is the same as the budgeted amount. C) expenditures for equipment have been recorded in the proper period. D) revenue expenditures made on behalf of equipment have been recorded in the proper period. Answer: A Terms: Primary objective in examining repairs and maintenance accounts Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 37) The auditor's main objectives in the verification of the sale, trade-in, or abandonment of equipment are to gather sufficient appropriate evidence that all disposals are ________ and at the ________. A) verified; historical cost B) recorded; correct amounts C) accurate; proper gain or loss amount D) classified properly; net realizable value Answer: B Terms: Equipment disposals; audit procedures Difficulty: Moderate Objective: LO 19-2 AACSB: Analytic thinking

38) Which of the following explanations might satisfy an auditor who discovers significant debits to an accumulated depreciation account? A) Significant retirements occurred during the year. B) Prior years' depreciation charges were erroneously understated. C) A reserve for possible loss on retirement has been recorded. D) An asset has been recorded at its fair value. Answer: A Terms: Significant debits to accumulated depreciation account Difficulty: Challenging Objective: LO 19-2 AACSB: Analytic thinking 39) Which of the following is not one of the reasons auditors verify equipment differently from current asset accounts? A) There are usually fewer current period acquisitions of equipment. B) The amount of any given acquisition is often material. C) The equipment is likely to be kept and maintained in the accounting records for several years. D) Current assets are subject to liens and encumbrances while equipment is not. Answer: D Terms: Acquisition and payment cycle; Current assets and equipment Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 40) Which of the following information would not be included, generally, in a fixed asset database for a piece of equipment? A) disposal of the equipment during the year B) copy of the supplier's sales proposal for the equipment C) date of acquisition of the equipment D) accumulated depreciation for the equipment Answer: B Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

41) Auditors verify and emphasize current additions of equipment. Which of the following is not a reason for this verification and emphasis? A) The amount of any given acquisition is often material. B) The equipment is likely to be kept and maintained in the accounting records for several years. C) There are usually fewer current period acquisitions of equipment, especially large equipment used in manufacturing. D) The balance carried forward in the equipment account from the previous year is important. Answer: D Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 42) One of the auditor's primary objectives when auditing manufacturing equipment is completeness. Answer: TRUE Terms: Primary objective in auditing equipment; Completeness Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 43) Completeness and existence are the auditor's primary objectives in auditing manufacturing equipment. Answer: TRUE Terms: Completeness and existence; Primary objectives in auditing equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 44) The primary characteristic that distinguishes property, plant, and equipment from inventory, prepaid expenses, and investments is the intention to use property, plant, and equipment as a part of the operations of the client's business over their expected life. Answer: TRUE Terms: Primary characteristic of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 45) The emphasis in auditing manufacturing equipment is on the verification of current-period disposals and acquisitions. Answer: TRUE Terms: Auditing equipment; Current-period disposals and acquisitions Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

46) The starting point for the verification of current-year acquisitions of property, plant, and equipment is normally a client-prepared schedule of all acquisitions recorded in the general ledger during the year. Answer: TRUE Terms: Verification of acquisitions; Client-prepared schedule of acquisitions Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 47) Depreciation amounts are determined by exchange transactions with outside parties. Answer: FALSE Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests of transactions Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 48) Depreciation expense is normally verified as a part of tests of details of balances rather than as part of tests of controls or substantive tests of transactions. Answer: TRUE Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests of transactions Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 49) The most important audit objective for depreciation expense is detail tie-in. Answer: FALSE Terms: Audit objective for depreciation expense Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 50) One of the reasons that auditors verify equipment differently from current assets is the amount of any given equipment acquisition is often material. Answer: TRUE Terms: Auditing current year acquisitions Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

51) The transportation and installation costs for a piece of equipment should be charged to an expense account. Answer: FALSE Terms: Equipment additions; audit procedures Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 52) The auditor's tests for proper cutoff of current year acquisitions of property, plant, and equipment are usually done as part of accounts payable cutoff tests. Answer: TRUE Terms: Cutoff of acquisitions; Accounts payable cutoff tests Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 53) The company's choices for determining the fixed asset's useful life and residual value impact the amount of depreciation recorded. Answer: TRUE Terms: Asset's useful life and residual value; Impact depreciation recorded Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 54) The audit procedure "foot the schedule of fixed assets acquisitions and trace the total to the general ledger" relates most closely to the completeness objective for fixed assets acquisitions. Answer: FALSE Terms: Audit procedure for completeness objective Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 55) Confirmations are commonly used to verify additions of property, plant, and equipment. Answer: FALSE Terms: Confirmations to verify additions Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 56) One very useful method of auditing depreciation is to use an analytical procedure to test for reasonableness. Answer: TRUE Terms: Auditing depreciation; Analytical procedures to test for reasonableness Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 17 Copyright © 2023 Pearson Education, Inc.

57) The approach to auditing patents and copyrights is similar to that used for property, plant, and equipment accounts. Answer: TRUE Terms: Auditing patents and copyrights Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 58) Recording an acquisition of a fixed asset at an improper amount affects the balance sheet until the company disposes of the asset, but the income statement is not affected. Answer: FALSE Terms: Recording acquisition at improper amount Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 59) Ordinarily, if you are auditing a continuing client, it is unnecessary to test the accuracy objective or the classification objective for fixed assets acquired in prior years. Answer: TRUE Terms: Accuracy objective; Classification objective; Fixed assets in prior years Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 60) When auditing acquisitions of property, plant, and equipment, the auditor's review of lease and rental agreements most closely relate to the cutoff objective. Answer: FALSE Terms: Auditing acquisitions; Lease and rental agreements; Cutoff objective Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 61) Performance materiality is important for verifying current year additions because these transactions have consistent dollar amounts from year to year. Answer: FALSE Terms: Performance materiality Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 62) Property, plant, and equipment are assets that have expected lives of less than one year, are used in the business, and are not acquired for resale. Answer: FALSE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

63) The intent to use property, plant, and equipment as part of the operations of a client's business is a significant characteristic that differentiates these assets from other assets like inventory and prepaid expenses. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 64) Generally, in most situations, the audits of property, plant, and equipment accounts are similar. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 65) Equipment additions which are infrequent in occurrence and large in dollar amounts, which were included as part of the tests of the acquisition and payment cycle, allow the auditor to rely heavily on the results of such tests. Answer: FALSE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 66) In the audit of equipment and related accounts, verifying that the ending balances are properly classified and are adequately disclosed in the financial statements is one of the tests the auditor must perform. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 67) A balance-related audit objective in property, plant, and equipment includes the proper classification of these assets on the balance sheets. The auditor should therefore examine vendors' invoices in various property, plant, and equipment accounts to ensure that such invoices are classified, properly, as building, manufacturing, office equipment, or repairs. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

68) In the audit of property, plant, and equipment, auditors need to examine if the client has the right to record these assets as assets on the balance sheet. The auditor needs to examine any lease agreements associated with these assets to determine if the lease qualifies as a finance or an operating lease. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 69) Auditors needs to examine purchase and/or lease contracts entered into related to property, plant, and equipment, to determine if capitalization of the property, plant, and equipment is appropriate or not. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 70) Using audit software to foot the equipment database and agreeing the database total to the general ledger is generally sufficient when verifying the ending balance of the equipment account. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 71) Equipment on hand which is no longer used in operations but which the auditor has physically verified as being in existence does not need to be evaluated for potential impairment. Answer: FALSE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 72) A long-lived asset that is classified as held for sale is measured at the lower of the carrying value or fair value less the cost to sell, and should be presented, separately, in the financial statements if material. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

73) The auditor's knowledge of the client's business is important when auditing management's judgements in evaluating whether a long-lived asset is impaired or not, including estimating fair value of these assets. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 74) If management hires a specialist to estimate the fair value of a long-lived asset, the auditor should take appropriate steps as required by auditing standards in evaluating the work of the specialist. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 75) The auditor can rely on the combination of management's estimates of fair value estimates and any associated impairment write downs that result to long-lived assets, when required, combined with the opinion of the specialist hired by management in auditing management's estimates and write downs. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 76) It is important that the auditor use various data analytics techniques in testing the entire population of fixed assets and related depreciation. Answer: TRUE Terms: Audit of property, plant, and equipment Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

77) The primary accounting record for property, plant, and equipment accounts is the fixed asset database. What is included for each fixed asset in the database? Answer: • description of the asset • date of acquisition • original cost • current year depreciation • accumulated depreciation for the asset Terms: Included for each fixed asset in the database Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 78) The auditor receives the client's schedule of recorded disposals and then performs detail tiein tests of the recorded disposals schedule. What procedures does the auditor perform on the client's schedule of recorded disposals? Answer: • footing the schedule • tracing the totals on the schedule to the recorded disposals in the general ledger • tracing the cost and accumulated depreciation of the disposals to the property database Terms: Procedures performed on client's schedule of recorded disposals Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 79) In auditing depreciation expense, one of the auditor's concerns is determining that the client's calculations are correct. In making this determination, the auditor must weigh four considerations. List these four considerations. Answer: 1. the useful life of current period acquisitions 2. the method of depreciation 3. the estimated salvage value 4. the policy of depreciating assets in the year of acquisition and disposition Terms: Auditing depreciation expense; Determining client calculations are correct Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking

80) In testing acquisitions, the auditor must understand the relevant accounting standards to insure the client adheres to accepted accounting practices for property, plant, and equipment. Describe three of the auditor's concerns in this area. Answer: (Answers may vary.) • inclusion of material transportation and installation costs as part of the asset's acquisition cost • failure to properly record the trade-in of existing equipment • client's capitalization policy to determine whether acquisitions are treated consistently with those of the preceding year • examine whether the client has the right to record the equipment as an asset (capitalization of leased equipment or classification of the equipment as an operating lease) • correct classification among various equipment accounts • improper inclusion of transactions that should be recorded as assets in repairs and maintenance expense, lease expense, supplies, small tools, and similar accounts Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking 81) Property, plant, and equipment is normally audited in a different manner than current asset accounts. State three reasons why this is so, and discuss the differences in how property, plant, and equipment is audited compared to current assets. Answer: • There are usually fewer current period acquisitions of property, plant, and equipment than current assets. • The amount of any given acquisition is often material. • The equipment is likely to be kept and maintained in the accounting records for several years. Because of these three differences, the emphasis in auditing property, plant, and equipment is on the verification of current period acquisitions rather than on the balance in the account carried forward from the preceding year. In addition, the expected life of assets over one year requires depreciation expense and accumulated depreciation accounts, which are verified as a part of the audit of the assets. Terms: Audit of property, plant, and equipment Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

82) State four of the seven specific balance-related audit objectives for property, plant, and equipment additions and, for each objective, describe one common test of details of balances. Answer: • Current-year acquisitions in the acquisitions schedule agree with related database amounts, and the total agrees with the general ledger (detail tie-in). (1) Foot the acquisitions schedule, (2) trace the individual acquisitions to the database for amounts and descriptions, and (3) trace the total to the general ledger. • Current-year acquisitions as listed exist (existence). (1) Examine vendors' invoices and receiving reports and (2) physically examine assets. • Existing acquisitions are recorded (completeness). (1) Examine vendors' invoices of closely related accounts such as repairs and maintenance to uncover items that should be recorded as equipment, and (2) review lease and rental agreements. • Current-year acquisitions as listed are accurate (accuracy). Examine vendors' invoices. • Current-year acquisitions as listed are correctly classified (classification). (1) Examine vendors' invoices in various equipment accounts to uncover items that should be classified as manufacturing or office equipment, part of buildings, or repairs, (2) examine vendors' invoices of closely related accounts such as repairs to uncover items that should be recorded as equipment, and (3) examine rent and lease expense for capitalizable leases. • Current-year acquisitions are recorded in the correct period (cutoff). Review transactions near the balance sheet date for correct period. • The client has rights to current-year acquisitions (rights). Examine vendors' invoices. Terms: Balance-related audit objectives for property, plant, and equipment; Test of details of balances Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking 83) When auditing disposals of property, plant, and equipment, the search for unrecorded disposals is essential. State the four audit procedures frequently used for verifying disposals. Answer: • Review whether newly acquired assets replace existing assets. • Analyze gains and losses on the disposal of assets and miscellaneous income for receipts from the disposal of assets. • Review plant modifications and changes in product lines, changes in major costly computerrelated equipment, property taxes, or insurance coverage for indications of deletions of equipment. • Make inquiries of management and production personnel about the possibility of the disposal of assets. Terms: Audit procedures for verifying disposals Difficulty: Challenging Objective: LO 19-2 AACSB: Reflective thinking

84) Discuss the key system of internal controls related to the disposal of property, plant, and equipment. Answer: The most important system of internal control over the disposal of property, plant, and equipment is the existence of a formal method to inform management of the sale, trade-in, abandonment, or theft of recorded machinery and equipment. Formal methods of tracking disposals and provisions for proper authorization of the sale or other disposal of equipment help reduce the risk of misstatement. There should also be adequate internal verification of recorded disposals to make sure that assets are correctly removed from the accounting records. The client should periodically take an inventory of fixed assets to identify assets that have been lost or stolen. Terms: Equipment disposals; audit procedures Difficulty: Easy Objective: LO 19-2 AACSB: Reflective thinking 85) State four of the seven specific balance-related audit objectives which the auditor should use as a frame of reference for tests of property, plant, and equipment acquisitions. Answer: Existence; Completeness; Accuracy; Cutoff; Detail Tie-In; Rights and Obligations; and Classification Terms: Audit of property, plant, and equipment Difficulty: Moderate Objective: LO 19-2 AACSB: Reflective thinking

19.3 Learning Objective 19-3 1) Which of the following accounts would normally not be a part of the acquisition and payment cycle of prepaid insurance? A) cash B) insurance payable C) insurance expense D) prepaid insurance Answer: B Terms: Acquisition and payment cycle; Current assets and equipment Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 2) Which type of audit procedure would normally be sufficient for purposes of auditing prepaid expenses and deferred charges? A) tests of controls B) tests of transactions C) tests of details of balances D) substantive analytical procedures Answer: D Terms: Audit procedure for auditing prepaid expenses and deferred charges Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 3) When an auditor recomputes the unexpired portion of prepaid insurance, they are satisfying which audit objective? A) completeness B) existence C) accuracy and detail tie-in D) rights Answer: C Terms: Audit objective; Recompute unexpired portion of prepaid insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking

4) A record of insurance policies in force and the due date of each policy is contained in the A) voucher register. B) insurance register. C) insurance expense account. D) prepaid insurance account. Answer: B Terms: Record of insurance policies Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 5) Insurance expense for the period is a function of which of the following? A) the beginning prepaid balance, current premium payments and the ending prepaid balance B) the beginning prepaid balance and the current period premium payments C) the current period premium payments D) the current period premium payments and the ending prepaid balance Answer: A Terms: Insurance expense if a function of Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 6) In connection with a review of the prepaid insurance account, which of the following audit procedures would you be least likely to use? A) Recompute the portion of the premium that expired during the year. B) Prepare excerpts of insurance policies for audit working papers. C) Confirm premium rates with an independent insurance broker. D) Examine support for premium payments. Answer: C Terms: Prepaid insurance; Audit procedures Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 7) Controls over the acquisition and recording of insurance are a part of which of the following transaction cycles? A) inventory and warehousing cycle B) capitalization cycle C) treasury cycle D) acquisition and payment cycle Answer: D Terms: Acquisition and recording of insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking

8) Which balance-related audit objective is not relevant to an audit of prepaid expenses? A) rights B) accuracy C) detail tie-in D) realizable value Answer: D Terms: Balance-related audit objective for audit of prepaid expenses Difficulty: Challenging Objective: LO 19-3 AACSB: Reflective thinking 9) When auditing prepaid insurance, A) for many audits, significant substantive procedures are needed if the control risk is low. B) companies often have a standard monthly journal entry to reclassify prepaid insurance as insurance expense. C) the emphasis in the tests of details of balances is on insurance expense. D) the auditor must prepare the insurance register. Answer: B Terms: Audit of prepaid insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 10) The realizable value audit objective is not applicable when auditing prepaid insurance or insurance expense. Answer: TRUE Terms: Auditing prepaid insurance and insurance expense; Realizable value Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 11) Problems commonly encountered in the audit of prepaid insurance are not typical of the problems found in other prepaid assets. Answer: FALSE Terms: Audit of prepaid insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 12) Cutoff for acquisitions of insurance is normally not a significant problem for the auditors. Answer: TRUE Terms: Tests of cutoff objective for prepaid insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking

13) When auditing insurance expense, auditors normally rely on analytical procedures and limited testing of the debits to ensure that they arose from credits to prepaid insurance. Answer: TRUE Terms: Auditing insurance expense; Analytical procedures Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 14) The auditor should keep in mind that the amount in insurance expense is a residual amount. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 15) In determining whether goodwill should be tested for impairment, companies and their management consider qualitative factors second, after performing a quantitative test for impairment. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 16) Goodwill is often identified as a significant audit risk area by auditors and is likely to be a critical audit matter disclosed in audit reports for companies with goodwill impairment(s). Answer: TRUE Terms: Goodwill impairment testing Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 17) The accounting rules related to goodwill impairment testing were recently changed by the Financial Accounting Standards Board (FASB) simplifying, for auditor's, the process of auditing management's estimates related to potential goodwill impairment. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking

18) For auditors, there is a significant amount of objectivity management must follow under generally accepted accounting principles in preparing the analysis required for goodwill impairment testing. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking 19) Subsequent to the initial measurement of goodwill in a business combination, goodwill is evaluated at least quarterly. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 20) Subsequent to the initial measurement of goodwill in a business combination, goodwill is evaluated for impairment using only qualitative factors. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 21) Subsequent to the initial measurement of goodwill in a business combination, goodwill is evaluated for impairment. If it is determined that it is "more likely than not" that the goodwill is impaired, the auditor should proceed to performing the qualitative test for impairment. Answer: FALSE Terms: Goodwill impairment testing Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 22) Describe the two tests auditors can perform to test for the existence and completeness of insurance policies in force. Answer: The verification of existence and tests for completeness of the insurance policies can be tested in one of two ways: by examining a sample of insurance invoices and policies in force for comparison to the schedule, or by obtaining a confirmation of insurance information from the company's insurance agent. Terms: Verification of existence and tests for omissions of insurance policies Difficulty: Easy Objective: LO 19-3 AACSB: Reflective thinking

23) What are several substantive analytical procedures used in the audit of prepaid insurance and insurance expense? Answer: 1. Compare total prepaid insurance and insurance expense with previous years. 2. Compute the ratio of prepaid insurance to insurance expense and compare it with previous years. 3. Compare the individual insurance policy coverage on the schedule of insurance obtained from the client with the preceding year's schedule as a test of elimination of certain policies or a change in insurance coverage. 4. Compare the computed prepaid insurance balance for the current year on a policy-by-policy basis with that of the preceding year as a test of an error in the calculation. 5. Review the insurance coverage listed on the prepaid insurance schedule with an appropriate client official or insurance broker for adequacy of coverage. Terms: Analytical procedures in the audit of prepaid insurance and insurance expense Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking 24) Describe the audit procedures used to verify the accuracy and detail tie-in objectives for prepaid insurance. Answer: The accuracy objective is tested by verifying the amount of the insurance premium, the length of the policy period, and the allocation of the premium to unexpired insurance. The amount of the premium for a given policy and its time period can be verified at the same time by examining the premium invoice or the confirmation from an insurance agent. After these two have been verified, the client's calculations of unexpired insurance can be tested by recalculation. The schedule of prepaid insurance can then be footed and the totals traced to the general ledger to complete the detail tie-in tests. Terms: Audit procedures to verify accuracy and detail tie-in objectives for prepaid insurance Difficulty: Moderate Objective: LO 19-3 AACSB: Reflective thinking

25) Discuss the key system of internal controls for prepaid insurance that affect the auditor's extent of testing of the prepaid insurance account. Answer: Internal controls for prepaid insurance and insurance expense can be conveniently divided into three categories: controls over the acquisition and recording of insurance, controls over the insurance register, and controls over the charge-off of insurance expense. Controls over the acquisition and recording of insurance are a part of the acquisition and payment cycle and include proper authorization for new insurance policies and payment of insurance premiums. An insurance register, which is a record of insurance policies in force and the expiration date of each policy, is an essential control which auditors use to identify policies in force related to prepaid insurance accounts. Because the terms and amounts contained in the register provide the basis for determining prepaid insurance amounts, the auditor independently verifies these terms and amounts to the underlying insurance policies or contracts. Companies often have a closely related control which is to have a standard monthly journal entry to reclassify prepaid insurance as insurance expense. Terms: Key system of internal controls for prepaid insurance Difficulty: Challenging Objective: LO 19-3 AACSB: Reflective thinking 19.4 Learning Objective 19-4 1) When auditing accrued property taxes, A) the source for the debits to the liability account is the acquisitions journal. B) realizable value is an important balance-related audit objective. C) the ending balance in the account should be confirmed with the applicable taxing authority. D) the most important consideration for the auditor is that the same portion of each tax payment for the accrual that was used in the preceding year is used in the current year. Answer: D Terms: Audit of accrued liabilities Difficulty: Moderate Objective: LO 19-4 AACSB: Reflective thinking 2) The estimated unpaid obligations for services or benefits that have been received before the balance sheet date are A) accounts payable. B) accounts receivable. C) unearned liabilities. D) accrued liabilities. Answer: D Terms: Audit of accrued liabilities Difficulty: Moderate Objective: LO 19-4 AACSB: Reflective thinking 32 Copyright © 2023 Pearson Education, Inc.

3) When auditors verify accrued property taxes, two audit objectives are especially significant. These are A) completeness and accuracy. B) completeness and net realizable value. C) detail tie-in and completeness. D) accuracy and classification. Answer: A Terms: Accrued property taxes; Audit objectives Difficulty: Moderate Objective: LO 19-4 AACSB: Reflective thinking 4) When auditing accrued property taxes, A) the auditors will generally only verify the larger payments since there are usually many property tax payments. B) property taxes should only be charged to one expense account. C) the auditor begins by obtaining a schedule of property tax payments from the client. D) the auditor must generally spend a considerable amount of time in this area. Answer: C Terms: Property tax expense Difficulty: Moderate Objective: LO 19-4 AACSB: Reflective thinking 5) Auditors verify the accruals before they verify the current year property tax payments. Answer: FALSE Terms: Audit of accrued property taxes Difficulty: Easy Objective: LO 19-4 AACSB: Reflective thinking 6) After the accrual and property tax expense for each piece of property has been recalculated, the totals are added and compared with the general ledger. Answer: TRUE Terms: Audit of accrued property taxes Difficulty: Moderate Objective: LO 19-4 AACSB: Reflective thinking 7) In the audit of accrued property taxes, the two most important balance-related audit objectives are completeness and accuracy. Answer: TRUE Terms: Audit of accrued property taxes Difficulty: Challenging Objective: LO 19-4 AACSB: Reflective thinking 33 Copyright © 2023 Pearson Education, Inc.

19.5 Learning Objective 19-5 1) Which of the following audit tests both have the effect of simultaneously verifying balance sheet and income statement accounts? A) analytical procedures and substantive tests of transactions B) tests of controls and substantive tests of transactions C) tests of details of balances and substantive tests of transactions D) tests of controls and analytical procedures Answer: B Terms: Audit tests that have effect simultaneously verifying balance sheet and income statement accounts Difficulty: Challenging Objective: LO 19-5 AACSB: Analytic thinking 2) The most effective and efficient audit approach in the examination of the income statement would be which of the following? A) Examine income statement accounts concurrently with the related balance sheet accounts. B) Compare company's components of net income to other businesses in the same industry. C) Compare company's components of net income to the previous two years. D) Examine changes in all balance sheet accounts. Answer: A Terms: Effective and efficient audit approach in examination of the income statement Difficulty: Challenging Objective: LO 19-5 AACSB: Reflective thinking 3) The auditor needs to be aware that most users of financial statements rely most heavily on the ________ for making decisions. A) balance sheet B) income statement C) statement of cash flows D) statement of stockholders' equity Answer: B Terms: Audit of income and expense accounts Difficulty: Moderate Objective: LO 19-5 AACSB: Analytic thinking

4) ________ expense is rarely analyzed unless analytical procedures indicate high potential for material misstatement. A) Repairs and maintenance B) Legal C) Utilities D) Rent and lease Answer: C Terms: Audit of income and expense accounts Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking 5) In the analysis of expense accounts, the auditor verifies transactions in specific accounts to determine whether the transactions are properly classified and accurately recorded. Answer: TRUE Terms: Audit of income and expense accounts Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking 6) In auditing allocations, which of the following statements is not true? A) Allocations between inventory and cost of goods sold are not important. B) Allocations must adhere to accounting standards. C) Allocations must be treated consistently with the preceding accounting period. D) Allocation audit procedures include tests for overall reasonableness. Answer: A Terms: Audit of income and expense accounts Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking 7) Depreciation expense results from the allocation of accounting data rather than discrete transactions. Answer: TRUE Terms: Tests of details of balances; allocation Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking 8) Tests of controls provide an indication of the likelihood of misstatements in both the income statement and the balance sheet, simultaneously. Answer: TRUE Terms: Tests of controls; Misstatements in income statement and balance sheet Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking 35 Copyright © 2023 Pearson Education, Inc.

9) Typically, analytical procedures are the primary means of verifying income statement accounts resulting from allocations. Answer: TRUE Terms: Analytical procedures; Verifying income statement accounts resulting from allocations Difficulty: Challenging Objective: LO 19-5 AACSB: Reflective thinking 10) Explain the audit objective allocation and why it is important to have accurate allocation within the financial statements, particularly for property, plant, and equipment. Answer: Several expense accounts result from the allocation of accounting data rather than discrete transactions. Such expenses include depreciation, depletion, and the amortization of copyrights and trademark costs. The allocation of manufacturing overhead between inventory and cost of goods sold is an example of another type of allocation that affects expenses. Allocations are important because they determine whether an expenditure is an asset or current period expense. If the client fails to follow accounting standards or fails to calculate the allocation correctly, then financial statements can be materially misstated. Terms: Allocation within financial statements Difficulty: Moderate Objective: LO 19-5 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 20 Audit of the Payroll and Personnel Cycle 20.1 Learning Objective 20-1 1) Which of the following statements about the payroll and personnel cycle is correct? A) There are three classes of Transactions are Internal controls transactions within the payroll more significant over payroll are cycle – salaried employees, than related effective for almost hourly employees, and balance sheet all companies, even commissioned employees. accounts. small ones. No No Yes B) There are three classes of transactions within the payroll cycle – salaried employees, hourly employees, and commissioned employees. Yes

Transactions are more significant than related balance sheet accounts. No

Internal controls over payroll are effective for almost all companies, even small ones. Yes

Transactions are more significant than related balance sheet accounts. Yes

Internal controls over payroll are effective for almost all companies, even small ones. Yes

Transactions are more significant than related balance sheet accounts. Yes

Internal controls over payroll are effective for almost all companies, even small ones. No

C) There are three classes of transactions within the payroll cycle – salaried employees, hourly employees, and commissioned employees. No D) There are three classes of transactions within the payroll cycle – salaried employees, hourly employees, and commissioned employees. No Answer: C Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-1 AACSB: Reflective thinking

2) Most companies, with the exception of small ones, have effective controls over the payroll cycle. Answer: FALSE Terms: Effective controls over payroll cycle Difficulty: Easy Objective: LO 20-1 AACSB: Reflective thinking 3) While most cycles include at least two classes of transactions, the payroll and personnel cycle includes only one class of transactions. Answer: TRUE Terms: Payroll and personnel cycle includes one class of transactions Difficulty: Easy Objective: LO 20-1 AACSB: Reflective thinking 4) Auditors typically test details of account balances in the audit of payroll. Answer: FALSE Terms: Audit tests of payroll cycle Difficulty: Moderate Objective: LO 20-1 AACSB: Reflective thinking 5) The overall audit objective in the audit of the payroll and the personnel cycle is to evaluate whether the account balances affected by the cycle are fairly stated according to the applicable accounting standards. Answer: TRUE Terms: Audit tests of payroll cycle Difficulty: Easy Objective: LO 20-1 AACSB: Reflective thinking 6) In most accounting systems, the accrued wages and salaries account is used only at the beginning of an accounting period. Answer: FALSE Terms: Audit tests of payroll cycle Difficulty: Moderate Objective: LO 20-1 AACSB: Reflective thinking 7) In most accounting systems, payroll expenses are charged when the employees are actually paid rather than when the labor costs are actually incurred. Answer: TRUE Terms: Audit tests of payroll cycle Difficulty: Moderate Objective: LO 20-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

8) In most accounting systems, accruals for salaries and wages are recorded by adjusting entries at the end of the period for any earned-but-unpaid labor-related costs. Answer: TRUE Terms: Audit tests of payroll cycle Difficulty: Moderate Objective: LO 20-1 AACSB: Reflective thinking 9) Discuss three important differences between the payroll and personnel cycle and other cycles in a typical audit. Answer: Three important differences between the payroll and personnel cycle and other cycles in a typical audit are: • There is only one class of transactions for payroll, whereas most cycles include at least two classes of transactions. Payroll-related accounts such as accrued payroll and withheld taxes are usually small compared to the total amount of transactions for the year. • In the payroll cycle, transactions are far more significant than related balance sheet accounts. • Internal controls over payroll are effective for almost all companies, even small ones. This is primarily due to severe federal and state penalties for errors in withholding and paying payroll taxes, and employee morale problems if employees are not paid or are underpaid. Terms: Important differences between payroll and personnel cycle and other cycles in audit Difficulty: Moderate Objective: LO 20-1 AACSB: Reflective thinking

20.2 Learning Objective 20-2 1) Which of the following departments is most likely responsible for pay rate changes and changes in deductible amounts for employees? A) general accounting department B) human resources department C) treasurer D) controller Answer: B Terms: Department responsible for pay rate changed Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 2) The payroll and personnel cycle ends with which of the following events? A) interviewing job candidates B) hiring a new employee C) existing employees submitting requests for payment for work performed D) issuance of paychecks Answer: D Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 3) Which of the following includes all payroll transactions processed by the accounting system for a given period of time? A) payroll journal B) payroll transaction file C) time report D) payroll summary Answer: B Terms: Includes all payroll transactions processed by the accounting system Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 4) An imprest payroll account that has a significant balance may indicate the presence of A) employees not cashing their payroll checks. B) fraudulent transfer of funds by the company. C) lack of controls over payroll distribution. D) the company overpaying its employees. Answer: A Terms: Imprest payroll account has significant balance Difficulty: Challenging Objective: LO 20-2 AACSB: Analytic thinking 4 Copyright © 2023 Pearson Education, Inc.

5) Records that include data about employees such as employment date, performance ratings, and pay rates are the A) human resource records. B) employee screening forms. C) summary payroll reports. D) employee folders. Answer: A Terms: Records that include data about employees Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 6) The computer file used for recording payroll transactions for each employee and maintaining total wages paid for the year to date is the A) payroll transaction file. B) payroll database. C) payroll bank account reconciliation. D) payroll tax returns. Answer: B Terms: Computer file used for recording payroll transactions Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking 7) Which of the following is not one of the business functions for the payroll and personnel cycle? A) payment of payroll B) timekeeping and payroll preparation C) reconciliation of payroll account D) human resources and employment Answer: C Terms: Payroll and personnel cycle Difficulty: Challenging Objective: LO 20-2 AACSB: Reflective thinking 8) The total of the individual employee earnings in the payroll database should equal the total A) balance of gross payroll in the general ledger accounts. B) of the checks drawn to employees for payroll. C) gross payroll plus the total contributed by the employer for payroll taxes. D) gross pay for the current week's payroll. Answer: A Terms: Total of individual employee earnings in payroll database equals Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

9) Which department should be authorized to add and delete employees from the payroll or change pay rates and deductions? A) the supervising department B) the accounting department C) the human resources department D) the treasurer's department Answer: C Terms: Department authorized to add and delete employees from payroll Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking 10) Hiring personnel initiates the payroll and personnel cycle. Answer: TRUE Terms: Initiates payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 11) Firing personnel terminates the payroll and personnel cycle. Answer: FALSE Terms: Terminates payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 12) Paying employees for their services ends the payroll and personnel cycle. Answer: TRUE Terms: Terminates payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 13) The deduction authorization form authorizes the rate of pay and the deductions for taxes, dues, etc. Answer: FALSE Terms: Deduction authorization form Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking

14) The job time ticket indicates the starting and stopping times of work during the pay period. Answer: FALSE Terms: Job time ticket Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 15) An imprest payroll account limits the client's exposure to payroll fraud. Answer: TRUE Terms: Imprest payroll account Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 16) Imprest accounts usually carry a significant balance. Answer: FALSE Terms: Imprest accounts Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 17) Auditors must understand the business functions and documents and record for the payroll and personnel cycle before they can assess control risk and design test of controls and substantive tests of transactions. Answer: TRUE Terms: Assessing control risk in the payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 18) The human resources department is considered to be an independent source for interviewing and hiring qualified personnel to work for a company. Answer: TRUE Terms: Human resources independent role in the payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 19) The human resources department is not considered to be an independent source for the internal verification of wage information. Answer: FALSE Terms: Human resources independent role in the payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking

20) Although some time records may be in paper form, most are electronically generated — for example, employees may enter time worked into online systems, apps and other IT-based payroll systems. Answer: TRUE Terms: Electronically generated time records Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 21) An impress payroll account is a separate payroll bank account in which a large cash balance is maintained. Answer: FALSE Terms: Impress payroll account Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 22) What events initiate and terminate the payroll and personnel cycle? Answer: The hiring of an employee initiates the cycle and the payments to employees; the cycle ends with paying governments and other institutions for withheld and accrued payroll taxes and benefits. Terms: Events that initiate and terminate the payroll and personnel cycle Difficulty: Easy Objective: LO 20-2 AACSB: Reflective thinking 23) Discuss each of the following primary documents and records used in the personnel and employment function in the payroll and personnel cycle: human resource records, deduction authorization form, and the rate authorization form. Answer: • Human resource records. These records include employees' date of employment, personnel investigations, rates of pay, authorized deductions, performance evaluations, and termination of employment. • Deduction authorization form. This form authorizes payroll deductions, including the number of exemptions for withholding of income taxes, 401(k) and other retirement savings plans, health insurance, and union dues. • Rate authorization form. This form authorizes employees' rate of pay. Terms: Primary documents and records used in personnel and employment function in payroll and personnel cycle Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking

24) Discuss each of the following documents and records used in the timekeeping and payroll preparation function in the payroll and personnel cycle: time record, job time ticket, payroll transaction file, payroll journal and payroll database. Answer: The primary documents and records used in the timekeeping and payroll preparation function are: • Time record. The time record is a document used to indicate the time the employee started and stopped working each day and the number of hours the employee worked. • Job time ticket. This document indicates jobs on which an employee worked during a given time period. This form is used only when an employee works on different jobs or in different departments. • Payroll transaction file. This computer-generated file includes all payroll transactions processed by the accounting system for a period of time. • Payroll journal. This report is generated from the payroll transaction file and typically includes the employee name, date, gross and net payroll amounts, withholding amounts, and account classifications for each transaction. • Payroll database. This computer file is used for recording payroll transactions for each employee and maintaining total employee wages paid for the year to date. Terms: Primary documents and records used in timekeeping and payroll preparation function in payroll and personnel cycle Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking 25) State the purpose and the information contained on the W-2 Form and on the payroll tax returns. Answer: The primary documents and records used in the payment of payroll function and the preparation of payroll tax returns and payment of taxes function are: • W-2 form. This is a form sent to each employee that summarizes the employees' earnings for the calendar year, including gross pay, income taxes withheld, and FICA withheld. This same information is also submitted to the IRS and state and local tax commissions when applicable. • Payroll tax returns. These are tax forms submitted to local, state, and federal units of government for the payment of withheld taxes and the employer's tax. The nature and due dates of the forms vary depending on the type of taxes. Terms: Primary documents and records used in payment of payroll function in payroll and personnel cycle Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking

26) Match seven of the terms for documents and records (a-k) used in the payroll and personnel cycle with the descriptions provided below (1-7). a. b. c. d. e. f. g. h. i. j. k.

human resource records deduction authorization form rate authorization form time record job time ticket summary payroll report payroll check W-2 form payroll tax returns payroll journal payroll database

________ 1. a file used for recording payroll transactions for each employee and maintaining total employee wages paid for the year to date ________ 2. a document indicating the time the hourly employee started and stopped working ________ 3. a form indicating which jobs an employee worked on during a given time period ________ 4. forms submitted to local, state, and federal units of government for the payment of withheld taxes and the employer's tax ________ 5. a form authorizing payroll deductions, including the number of exemptions for withholding of income taxes, retirement savings plans, and union dues ________ 6. a form used to authorize the amount of pay ________ 7. records including date of employment, personnel investigations, rates of pay, etc. Answer: 1. k, 2. d, 3. e, 4. i, 5. b, 6. c, 7. a Terms: Human resource records; Deduction authorization form; Rate authorization form; Time card; Job time ticket; Payroll tax returns; Payroll database Difficulty: Moderate Objective: LO 20-2 AACSB: Reflective thinking

20.3 Learning Objective 20-3 1) Which of the following statements is false? A) The payroll cycle consists of one class of transactions. B) Balance sheet accounts related to payroll are generally more significant than related transactions. C) Internal controls over payroll are effective for most companies. D) Small companies usually have effective controls over payroll. Answer: B Terms: Payroll cycle Difficulty: Easy Objective: LO 20-1 and LO 20-3 AACSB: Reflective thinking 2) Which of the following would have the least amount of importance regarding controls over the processing of payroll? A) The person authorized to sign paychecks should not be otherwise involved in the preparation of the payroll. B) A check-signing machine should not be used to replace a manual signature. C) Distribution of paychecks should be performed by someone who is not involved in the other payroll functions. D) Unclaimed paychecks should be immediately returned for redeposit. Answer: B Terms: Least important regarding controls over processing payroll Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 3) An auditor is vouching a sample of hourly employees from the payroll database to approved time clock or time sheet data in order to provide evidence that A) employees work the number of hours for which they are paid. B) payments are made at the contractual rate. C) product cost information is accurate. D) segregation of duties is present between the payroll function and the payment function for cash disbursements. Answer: A Terms: Vouch from payroll database to approved time sheets Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking

4) When the auditor compares the cancelled check or direct deposit with the payroll journal for amount, they are concerned with the transaction-related audit objective of A) occurrence. B) accuracy. C) classification. D) timing. Answer: B Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 5) Which of the following best describes the systems of internal control for payroll for large companies? A) loosely structured but well controlled B) loosely structured and loosely controlled C) highly structured and well controlled D) highly structured but loosely controlled Answer: C Terms: Systems of internal control for payroll for large companies Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 6) When testing for fraudulent hours or fraudulent expense reports A) it is easy for the auditor to discover fraudulent hours because of the abundance of available evidence. B) it is difficult to prevent fraud in these two areas with adequate system of internal controls. C) management falsification of expense reports can be an indicator of disregard for system of internal controls and the potential for fraud in other areas. D) examining payroll records for approval is an important substantive test of transactions to uncover fraudulent hours. Answer: C Terms: Fraudulent payroll hours and fraudulent expense reports Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking

7) In audits of companies in which payroll is a significant portion of inventory, the improper account classification of payroll can A) Increase inventory asset valuations. Decrease inventory asset valuations. Yes Yes B) Increase inventory asset valuations. Decrease inventory asset valuations. No No C) Increase inventory asset valuations. Decrease inventory asset valuations. Yes No D) Increase inventory asset valuations. Decrease inventory asset valuations. No Yes Answer: A Terms: Audits of payroll in which payroll is a significant portion of inventory Difficulty: Easy Objective: LO 20-2 and LO 20-3 AACSB: Reflective thinking 8) To minimize the opportunity for fraud, unclaimed salary checks should be A) redeposited. B) kept in the payroll department. C) left with the employee's supervisor. D) held for the employee in the personnel department. Answer: A Terms: Minimize opportunity for fraud, unclaimed salary checks Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 9) When examining payroll transactions, an auditor is primarily concerned with the possibility of A) incorrect summaries of employee time records. B) overpayments and unauthorized payments. C) under withholding of amounts required to be withheld. D) posting of gross payroll amounts to incorrect salary expense accounts. Answer: B Terms: Examining payroll transactions, auditor primarily concerned with Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

10) The ________ has the responsibility for approving the number of hours worked for each employee. A) employee's supervisor B) human resources department C) chief financial officer D) budgeting supervisor Answer: A Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 11) Which of the following audit procedures would be the most effective in testing for nonexistent employees? A) Trace transactions recorded in the payroll journal to the human resources department to determine employment status. B) Examine cancelled checks for proper endorsement. C) Recalculate net pay. D) Reconcile the disbursements in the payroll journal with the disbursements on the payroll bank statement. Answer: A Terms: Audit procedures most effective in testing for nonexistent employees Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 12) No individual with access to time cards, payroll records, or checks should also be permitted access to A) the computer. B) job time tickets. C) personnel records. D) the canceled check files. Answer: C Terms: Individual with access to time cards, payroll records, or checks should not have access to Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

13) The auditor ________ rely on the system of internal controls of the payroll service organization if the service organization's auditor issues a report on the service organization's system of internal control. A) must B) cannot C) can rarely D) can often Answer: D Terms: Use of outside payroll services and responsibility regarding reliance on system of internal control Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 14) Many audits have a ________ risk of misstatement for the payroll cycle. A) high B) low C) moderate D) zero Answer: B Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 15) The careful and timely preparation of all payroll tax returns is necessary to avoid penalties and criminal charges. The most important control in the timely preparation of these returns is A) computerized preparation of tax returns. B) a well-defined set of policies that indicate when each form must be filed. C) independent verification of computer output by a competent individual. D) the use of an outside payroll service. Answer: B Terms: Control for careful and timely preparation of payroll tax returns Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

16) Which of the following types of audit tests is usually emphasized due to a lack of independent third-party evidence related to payroll transactions? A) analytical procedures B) tests of details of balances C) tests of controls D) Each of the above is emphasized. Answer: C Terms: Audit test emphasized due to lack of independent third-party evidence related to payroll transactions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 17) The most important means of verifying account balances in the payroll and personnel cycle are A) tests of controls and substantive tests of transactions. B) analytical procedures and tests of controls. C) analytical procedures and substantive tests of transactions. D) tests of controls and tests of details of balances. Answer: A Terms: Most important means of verifying account balances in payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

18) Audit tests of payroll are usually not extensive because A) Employees will Payroll Payroll transactions are likely complain transactions are typically subject to audit by federal if underpaid. uniform and and state governments. uncomplicated. Yes Yes Yes B) Employees will likely complain if underpaid. No

Payroll transactions are typically uniform and uncomplicated. Yes

Payroll transactions are subject to audit by federal and state governments.

Payroll transactions are typically uniform and uncomplicated. No

Payroll transactions are subject to audit by federal and state governments.

Payroll transactions are typically uniform and uncomplicated. No

Payroll transactions are subject to audit by federal and state governments.

C) Employees will likely complain if underpaid. No

Yes

D) Employees will likely complain if underpaid. Yes

Answer: A Terms: Audit tests of payroll are usually not extensive because Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 19) If an auditor wishes to test the completeness transaction-related audit objective in the payroll and personnel cycle, which of the following would be a reasonable test of control? A) Account for a sequence of payroll checks. B) Examine the procedures manual and observe the recording of transactions. C) Examine the payroll records for indication of pay rate approval. D) Reconcile the payroll bank account. Answer: A Terms: Auditor tests completeness transaction-related audit objective in payroll and personnel cycle, a test of control Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 17 Copyright © 2023 Pearson Education, Inc.

20) Which of the following is a substantive test of transactions? A) Review personnel policies. B) Account for a sequence of payroll checks. C) Reconcile the disbursements in the payroll journal with the disbursements on the payroll bank statement. D) Examine printouts of transactions rejected by the computer as having invalid employee IDs. Answer: C Terms: Substantive test of transactions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 21) As a part of the auditor's responsibility for ________, the auditor should review the preparation of at least one of each type of payroll tax form the client is responsible for filing. A) fraud awareness B) doing tests of balances C) doing tests of transactions D) understanding the client's system of internal controls Answer: D Terms: Auditor's responsibility and review of preparation of at least one type of payroll tax form Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 22) Verifying that an adequate chart of accounts is used is a key system of internal control for the transaction-related objective of A) classification. B) accuracy. C) existence. D) occurrence. Answer: A Terms: Assertion related to the classes of transactions underlying the payroll cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

23) When labor is a material factor in inventory valuation, the auditor should place special emphasis on testing the system of internal controls concerning A) fictitious employees. B) authorization of wage rates. C) proper classification of payroll transactions. D) completeness of recorded transactions. Answer: C Terms: Labor material part of inventory Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 24) What potential problems may arise when an auditor considers the relationship between payroll and inventory valuation? A) Improper Improper The overpayment or account allocation to jobs underpayment of factory classification or processes employees Yes Yes Yes B) Improper account classification No

Improper allocation to jobs or processes Yes

The overpayment or underpayment of factory employees No

Improper account classification No

Improper allocation to jobs or processes No

The overpayment or underpayment of factory employees Yes

Improper account classification Yes

Improper allocation to jobs or processes Yes

The overpayment or underpayment of factory employees No

Answer: D Terms: Potential problems considering relationship between payroll and inventory valuation Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

25) Which of the following errors gives the auditor concern in auditing payroll transactions? A) an error that indicates possible fraud B) computational errors in formulas when a computerized system is used C) classification errors in charging labor to inventory and job cost accounts D) Each of the above gives the auditor significant concern. Answer: D Terms: Error that gives least concern in auditing payroll transactions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 26) Auditors may extend their tests of payroll in which of the following circumstances? A) Payroll materially affects The auditor is concerned there the valuation of inventory. may be nonexistent employees on the payroll. Yes Yes B) Payroll materially affects the valuation of inventory. No C) Payroll materially affects the valuation of inventory. Yes D) Payroll materially affects the valuation of inventory. No

The auditor is concerned there may be nonexistent employees on the payroll. No

The auditor is concerned there may be nonexistent employees on the payroll. Yes

Answer: A Terms: Auditors may extend tests of payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

27) ________ is not a transaction-related audit objective for the classes of transactions underlying the payroll cycle. A) Classification B) Existence C) Timing D) Completeness Answer: B Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 28) A surprise payroll payoff in which employees must pick-up and sign for their paychecks is one means of A) identifying employees who do not have proper work credentials. B) establishing a tightly controlled, fraud-free work environment. C) testing for nonexistent employees. D) identifying employees who have not submitted proper W-2 forms. Answer: C Terms: Surprise payroll payoff means to check Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 29) Which of the following is the best way for an auditor to determine that every name on a company's payroll for the Rodgers factory is that of a bona fide employee presently on the job? A) Examine personnel records for accuracy and completeness. B) Examine employees' names listed on payroll tax returns for agreement with payroll accounting records. C) Make a surprise observation of the company's regular distribution of paychecks. D) Visit the working areas and confirm with employees their badge or identification numbers. Answer: C Terms: Audit procedure to verify bona fide employee name on payroll check Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

30) Which of the following best describes inherent risk for balance-related audit objectives as they relate to payroll? A) not considered B) low C) moderate D) high Answer: B Terms: Inherent risk for balance-related audit objectives related to payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 31) It would be appropriate for the payroll department to be responsible for which of the following functions? A) approval of employee time records B) maintain records of employment, firings, and raises C) temporary retention of unclaimed employee paychecks D) preparation of governmental reports as to employees' earnings and withholding taxes Answer: D Terms: Payroll department responsible for functions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 32) Which of the following best describes effective system of internal control over payroll? A) The preparation of the payroll must be under the control of the personnel department. B) The confidentiality of employee payroll data should be carefully protected to prevent fraud. C) The duties of hiring, payroll computation, and payment to employees should be segregated. D) The payment of cash to employees should be replaced with payment by checks. Answer: C Terms: Effective system of internal control over payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 33) Which of the following is an accurate statement regarding nonexistent employees? A) In order to prevent this type of fraud, the foreman should distribute the paychecks and approve the time cards. B) Records for all terminated employees should be destroyed to prevent this type of fraud. C) The person committing this type of fraud is generally the CEO or CFO of the company. D) This type of fraud often results from the continuance of an employee on the payroll after the employee has been terminated. Answer: D Terms: Tests for nonexistent employees Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

34) Which of the following is a key control for the transaction-related audit objective of accuracy? A) The time records are approved by a supervisor. B) The payroll checks are prenumbered and accounted for. C) The payroll database contents are internally verified. D) The batch totals are compared with computer summary reports. Answer: D Terms: Key controls Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 35) A weak internal control system allows a department supervisor to "clock in" for a fictitious employee and then approve the employee's time card at the end of the pay period. This fraud would be detected if other controls were in place, such as having an independent party A) distribute paychecks. B) recompute hours worked from time cards. C) foot the payroll journal and trace postings to the general ledger and the payroll database. D) compare the date of the recorded check in the payroll journal with the date on the canceled checks and time cards. Answer: A Terms: Weak system of internal control system; Fraud of fictitious employee Difficulty: Challenging Objective: LO 20-3 AACSB: Reflective thinking 36) Which of the following is not a correct statement regarding fraudulent hours? A) Fraudulent hours occur when an employee reports more time than was actually worked. B) It is difficult for an auditor to discover fraudulent hours. C) It is ordinarily easier for the client to prevent fraudulent hours by adequate system of internal controls than for the auditor to detect it. D) To detect fraudulent hours, the auditor should examine the cancelled checks written to the employees. Answer: D Terms: Fraudulent payroll hours Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

37) Which of the following statements is correct? A) The overhead charged to inventory at the balance sheet date can be understated if the salaries of administrative personnel are inadvertently or intentionally charged to indirect manufacturing overhead. B) When jobs are billed on a cost-plus basis, revenue and total expenses are both affected by charging labor to incorrect jobs. C) Payroll is a significant portion of inventory for retail and service industry companies. D) The valuation of inventory is affected if the direct labor cost of individual employees is improperly charged to the wrong job or process. Answer: D Terms: Effect of payroll costs on inventory Difficulty: Challenging Objective: LO 20-3 AACSB: Reflective thinking 38) When auditing the payroll and personnel cycle, the auditor should keep in mind that A) since payroll transactions are typically uniform, all companies have the same system of internal controls over payroll. B) the substantive tests of transactions for the payroll cycle are the same for all audit clients. C) controls the auditor intends to rely on to reduce assessed control risk must be tested with tests of controls. D) the tests of controls and the substantive tests of transactions for payroll cannot be combined. Answer: C Terms: Controls and the payroll cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 39) In auditing payroll, the auditor wants to determine that the individuals included in her/his sample were employees of the company for the period under review. What is the auditor's best source of evidence? A) examination of human resource records B) examination of the payroll database C) examination of the payroll transaction file D) examination of the payroll tax records Answer: A Terms: Auditor source of evidence to test individuals are employees of company Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

40) Auditors should determine whether the client has fulfilled its legal obligation in submitting payments of all payroll withholdings as part of their payroll tests. Answer: TRUE Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 41) Payroll checks should be distributed by someone independent of the payroll and timekeeping functions. Answer: TRUE Terms: Payroll checks distributed by someone independent Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 42) Auditors seldom expect to find misstatements when testing payroll transactions. Answer: TRUE Terms: Misstatements when testing payroll transactions Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 43) The nature, extent, and timing of substantive tests of payroll transactions vary depending, in part, on assessed control risk. Answer: TRUE Terms: Substantive tests of payroll transactions; Assessed control risk Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 44) "Physical control over assets" is not a type of control that is applicable to the payroll cycle. Answer: FALSE Terms: Physical control over assets control applicable to payroll cycle Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 45) When auditing the payroll and personnel cycle, tests of controls are routinely performed. Answer: TRUE Terms: Audit of payroll and personnel cycle and test of controls Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking

46) When labor is a material part of inventory valuation, auditors should emphasize testing system of internal controls over proper classification of payroll transactions. Answer: TRUE Terms: Labor material part of inventory Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 47) A detailed reconciliation of the information on the payroll tax forms and the payroll records must be prepared as part of the test of controls over the payroll cycle. Answer: FALSE Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 48) For proper system of internal control, the person(s) responsible for signing the payroll checks should not have access to timekeeping or be otherwise involved in the preparation of payroll. Answer: TRUE Terms: Proper system of internal control Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 49) It is usually very easy for an auditor to determine if an employee has overstated their hours worked. Answer: FALSE Terms: Payroll and personnel cycle Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 50) For most clients, the balance sheet accounts related to payroll are normally insignificant, except for labor charged to inventory. Answer: TRUE Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 51) Separation of duties in the payroll and personnel cycle will prevent overpayments, but not payments to nonexistent employees. Answer: FALSE Terms: Separation of duties Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

52) For good system of internal control, the payroll function should be independent of the human resources department. Answer: TRUE Terms: Good system of internal control; Payroll function independent of human resources department Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 53) Since the amount of expense report reimbursements is insignificant, auditors can ignore expense reports for officers and directors. Answer: FALSE Terms: Fraudulent expense reports Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 54) Tests of controls and tests of details of balances are the auditor's most important means of verifying account balances in the payroll and personnel cycle. Answer: FALSE Terms: Tests of controls and tests of details of balances Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 55) The primary purpose of a surprise payroll payoff is to detect employees who have reported more time than was actually worked (fraudulent hours). Answer: FALSE Terms: Purpose of surprise payroll payoff Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 56) Because of confidentiality requirements and potential losses of payroll funds, outside service center systems are rarely used by companies for payroll-related functions. Answer: FALSE Terms: Outside service centers for payroll-related functions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

57) Internal control over payroll is normally highly structured and well controlled. Answer: TRUE Terms: Internal controls over payment of payroll function Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 58) Most monetary misstatements of payroll are corrected by internal verification controls or by the PCAOB. Answer: FALSE Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 59) Despite the large dollar amounts involved in the payroll and personnel cycle, auditors typically spend less time auditing this cycle than others. Answer: TRUE Terms: Time spent auditing payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 60) It is generally more difficult for the auditor to detect payment of fraudulent hours than payment of fictitious employees. Answer: TRUE Terms: Detect payment of fraudulent hours and payment of fictitious employees Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 61) Examining payroll records for an indication of authorization is part of the timing transactionrelated audit objective. Answer: FALSE Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 62) The audit procedure "recompute hours worked from time cards" is normally performed when testing the completeness objective for payroll. Answer: FALSE Terms: Testing completeness objective for payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

63) A transaction-related audit objective includes ensuring payroll transactions are properly aggregated and disclosed in the financial statements. Answer: TRUE Terms: Financial statement presentation of payroll transactions Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 64) A key internal control which the auditor should determine is if the client has procedures designed to identify key provisions in employment contracts, compensation, and bonus plans which may require financial statement disclosure. Answer: TRUE Terms: Testing completeness objective for payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 65) The treasurer in some firms may be a source for the auditor to trace information back to regarding employment contracts, compensation, and bonus plans. Answer: TRUE Terms: Testing completeness objective for payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 66) Auditors should consider the use of data analytics tools to search for payroll-related anomalies including duplicate employee names, missing data in the payroll databases, or duplicate direct deposit bank account numbers. Answer: TRUE Terms: Testing completeness objective for payroll Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 67) Audit software also allows auditors to perform analytical auditing procedures on payrollrelated data at more disaggregated levels. Answer: TRUE Terms: Testing completeness objective for payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

68) Generally, is the inherent risk level for the audit of the payroll and personnel set at low, moderate, or high? Explain. Answer: Generally inherent risk is set low since there is only one class of transactions for payroll. Also, system of internal control for payroll is normally highly structured and well controlled to manage cash disbursed, to minimize employee complaints and dissatisfaction, and to minimize payroll fraud. Payroll transactions are typically uniform and uncomplicated and payroll transactions are subject to audit by federal and state governments for tax withholdings. Terms: Inherent risk level for audit of payroll and personnel Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 69) Discuss the procedures involved in, and the purpose of a surprise payroll payoff. Answer: A surprise payroll payoff is a procedure in which each employee must pick up and sign for his or her check in the presence of a supervisor and the auditor. Any checks that are not claimed are subject to an extensive investigation to determine whether an unclaimed check is fraudulent. The purpose is to test for nonexistent employees; that is, the issuance of payroll checks to individuals who do not work for the company. Terms: Procedures and purpose of surprise payroll payoff Difficulty: Easy Objective: LO 20-3 AACSB: Reflective thinking 70) There are several key internal controls over the payment of payroll function that should be present. For example, the payroll should be distributed by someone who is not involved in the other payroll functions. Discuss other key internal controls over the payment of payroll function as it relates to the physical control over assets and records. Answer: • If employees are paid through direct deposit, access to systems used to authorize payments should be restricted. • If employees are paid by check, access to unsigned payroll checks should be restricted. • Checks should be signed by a responsible employee. • Payroll should be distributed by someone independent of the payroll and timekeeping functions. • Any unclaimed checks should be returned for redeposit. • If checks are signed by a signature machine, access to the machine should be restricted. Terms: Internal controls over payment of payroll function Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

71) Discuss the two circumstances under which auditors would extend their procedures considerably in the audit of payroll. Answer: Auditors often extend their procedures considerably in the audit of payroll under the following circumstances: (1) when payroll significantly affects the valuation of inventory and (2) when the auditor is concerned about the possibility of material fraudulent payroll transactions, such as nonexistent employees or fraudulent hours. Terms: Circumstances for auditors to extend procedures in audit of payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 72) What is one audit procedure that may be used to test for proper handling of terminated employees? Answer: A procedure that tests for proper handling of terminated employees is to select several files from the human resource records for employees who were terminated in the current year to determine whether each received termination pay consistent with company policy. Continuing payments to terminated employees can be tested by using audit software to compare termination dates according to the human resources department to payroll disbursement dates in the payroll journal to verify the employee is no longer being paid. Terms: Audit procedure to test for proper handling of terminated employees Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 73) In testing for the transaction-related audit objective of occurrence, an auditor is verifying that the recorded payroll payments are for work actually performed by existing employees. List three key system of internal controls that a company should have in place in this area. Answer: • Time records are approved by the supervisor. • Time clock is used to record time. • Adequate human resource files are maintained. • Employment is authorized. • There is separation of duties among human resources, timekeeping, and payroll disbursements. • Only employees existing in the computer data files are accepted when they are entered. • Disbursements are authorized before issuance. Terms: Important system of internal controls in occurrence transaction-related audit objective for payroll Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

74) What key separation of duties should the auditor expect to find within the payroll and personnel cycle? Answer: The human resources department should be independent of the payroll function and should be responsible for hiring and terminating employees, as well as changes in pay rates and deductions. In addition, payroll processing should be separate from the issuance of payroll disbursements. Terms: Key separation of duties in payroll and personnel cycle Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking 75) Describe at least five auditing procedures which an auditor can perform which could test for the possibility of nonexistent employees being paid by an audit client. Answer: • Compare the names on cancelled payroll checks or the account into which payroll has been deposited with time records and other records for authorized signatures and reasonableness of the endorsements. • Audit software can be used to compare all bank accounts numbers into which payroll is being deposited to search for duplicates. • Examine payroll checks that are recorded as voided to make sure these checks have not been fraudulently used. • If fraud is suspected, the auditor may access online banking records to review endorsements on cancelled checks of suspected disbursements. • Trace selected payroll transactions recorded in the payroll journal to the human resources department to determine whether employees were actually employed during the payroll period. • If payroll checks are being used, compare the endorsement on the cancelled payroll check with the authorized signature on the employee's withholding authorization forms in human resources. • For a sample of terminated employees, obtain their files from human resources and determine if their termination pay was consistent with company policies. • Use audit software to compare termination dates to payroll disbursement dates in the payroll journal. • Request and perform a surprise payroll payoff. Terms: Tests for nonexistent employees Difficulty: Moderate Objective: LO 20-3 AACSB: Reflective thinking

20.4 Learning Objective 20-4 1) Which of the following types of audit procedures is ordinarily emphasized the least when auditing payroll? A) tests of controls B) tests of transactions C) substantive analytical procedures D) tests of details of balances Answer: D Terms: Audit procedure emphasized least in auditing payroll Difficulty: Easy Objective: LO 20-4 AACSB: Reflective thinking 2) There is inherent risk of payroll fraud because most transactions involve A) expense accounts. B) accrued liabilities. C) estimates. D) cash. Answer: D Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 3) The primary concern in testing payroll-related liabilities is to make sure that A) accruals are properly valued. B) transactions are recorded in the proper period. C) there are no understated or omitted accruals. D) the accruals are not overstated. Answer: C Terms: Primary concern in testing payroll-related liabilities Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 4) Verification of the legitimacy of year-end unpaid bonuses to officers and employees can be accomplished by comparing the recorded accrual to the amount A) in the expense account. B) used in the prior period. C) authorized in the minutes of the board. D) paid in the subsequent period. Answer: C Terms: Verification of legitimacy of unpaid bonuses Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 33 Copyright © 2023 Pearson Education, Inc.

5) The usual audit test for a public company's officer compensation is to obtain the authorized salary of each officer from the minutes of the board of directors and compare it with A) the SEC's 10-K report. the company's federal income tax return. Yes Yes B) the SEC's 10-K report. No

the company's federal income tax return. No

C) the SEC's 10-K report. Yes

the company's federal income tax return. No

D) the SEC's 10-K report. No

the company's federal income tax return. Yes

Answer: A Terms: Audit test for public company officer compensation Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 6) Which of the following is a major balance-related audit objective in testing payroll liabilities? A) Payroll tax expense is properly recorded. B) Transactions in the payroll and personnel cycle are recorded in the proper period. C) Accrual of salaries is the same as the amounts paid on the payroll tax returns. D) Time records are recorded by supervisors. Answer: B Terms: Balance-related audit objective in testing payroll liabilities Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking

7) What are the two major balance-related audit objectives in testing payroll liabilities? A) accuracy and detail tie-in B) completeness and valuation C) completeness and rights and obligations D) accuracy and cutoff Answer: D Terms: Major balance-related audit objective in testing payroll liabilities Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 8) Once the auditor determines that the company's policy for accruing wages is consistent with prior years, the appropriate audit procedure to test for accuracy and cutoff is A) recalculating the client's accrual. B) performing extensive tests of controls. C) performing extensive tests of details. D) none of the above. Answer: A Terms: Audit procedure to test for accuracy and cutoff for accruing wages Difficulty: Challenging Objective: LO 20-4 AACSB: Reflective thinking 9) The most important consideration in evaluating the fairness of the amounts accrued for vacation pay, sick pay, and other benefits is the A) consistent accrual of these liabilities relative to those of preceding periods. B) actual expense incurred for the prior period. C) amount expended to date in the current period. D) profitability of the client which will enable these liabilities to be met. Answer: A Terms: Consideration in evaluating amounts for vacation pay, sick pay and other benefits Difficulty: Challenging Objective: LO 20-4 AACSB: Reflective thinking 10) When performing the tests of details of balances for expense accounts, ________ is (are) generally not necessary. A) extensive additional testing B) analytical procedures C) tests of controls D) substantive tests of transactions Answer: A Terms: Payroll expense accounts; tests of details of balances Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 35 Copyright © 2023 Pearson Education, Inc.

11) An auditor traces a sample of electronic time cards before and after the bi-weekly payroll report and then traces to the payroll database to determine that payroll transactions are reported in the correct period. The auditor is gathering evidence for which audit objective? A) completeness B) existence C) cutoff D) accuracy Answer: C Terms: Tracing to determine payroll transactions are reported in correct period is testing which audit objective Difficulty: Challenging Objective: LO 20-4 AACSB: Analytic thinking 12) Although significant client business risks affecting payroll are unlikely for most companies, an area that would have the most business risk would be A) payment of hourly employees. B) payment of salaried employees. C) payments to employees for stock options and bonus plans. D) payments to employees who have direct deposit of their payroll checks. Answer: C Terms: Payroll and personnel cycle Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 13) Required disclosures for payroll and personnel cycle transactions and balances are extensive. Answer: FALSE Terms: Presentation and disclosure objectives for payroll Difficulty: Easy Objective: LO 20-4 AACSB: Reflective thinking 14) The two major balance-related audit objectives in testing payroll liabilities are accuracy and cutoff. Answer: TRUE Terms: Balance-related audit objectives in testing payroll liabilities; Accuracy and cutoff Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking

15) On most audits, the calculation for payroll tax expense is costly and is not necessary unless analytical procedures indicate a problem that cannot be resolved through other procedures. Answer: TRUE Terms: Audit of payroll tax expense Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking 16) An analytical procedure to determine a possible misstatement of commission expense is to compare commission expense to salaries payable. Answer: FALSE Terms: Analytical procedures for payroll cycle Difficulty: Easy Objective: LO 20-4 AACSB: Reflective thinking 17) The Securities and Exchange Commission requires public companies to disclose the ratio of the compensation of the chief executive officer (CEO) to the median compensation of its employees in proxy statements and in annual reports requiring executive compensation disclosure. Answer: TRUE Terms: Securities and Exchange Commission pay ratio disclosure Difficulty: Easy Objective: LO 20-4 AACSB: Reflective thinking 18) Payroll tax expense is tested by the auditor in connection with tests of the payroll tax accruals; payroll tax expense can also be tested using audit software. Answer: FALSE Terms: Analytical procedures for payroll cycle Difficulty: Easy Objective: LO 20-4 AACSB: Reflective thinking 19) Mathews and Company has $112,000 in an accrued payroll account. The company's weekly payroll is $186,700 and the accrual represents 3 days out of 5 working days. If the auditor has determined that controls are effective over payroll, what additional work should the auditor perform for this account? Answer: 186,700 ∗ 0.60 (3/5) = 112,020 which is very close to the actual accrual of 112,000. Auditor would accept the client balance with no further work. Terms: Test of accruals Difficulty: Moderate Objective: LO 20-4 AACSB: Analytic thinking

20) How do auditors commonly verify sales commission expense? Answer: If all employees receive the same commission rate, then verifying the expense is done by multiplying the commission rate by the amount of the sales. If there are different commission rates, it is necessary first to determine the nature of the commission agreement and then test the calculations based on the agreement. The auditor should compare the method of accruing commissions with that of previous years for purposes of consistency. Terms: Auditors verify sales commission expense Difficulty: Moderate Objective: LO 20-4 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 21 Audit of the Inventory and Warehousing Cycle 21.1 Learning Objective 21-1 1) Receipt of ordered materials by the receiving department will generate the completion of a form called the A) bill of lading. B) receiving report. C) materials requisition. D) inventory acquisition summary. Answer: B Terms: Receipt of ordered materials generates completion of form Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 2) ________ is normally characterized as a difficult and complex account to audit. A) Property, plant and equipment B) Cash C) Inventory D) Prepaid insurance Answer: C Terms: Complex and difficult account to audit Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 3) Inventory is a complex area to audit for all except which of the following reasons? A) Inventory is often in different locations. B) There are several acceptable valuation methods and some entities use different methods for different types of inventory. C) Inventory is often the largest account on the balance sheet. D) Inventory valuation includes few estimates. Answer: D Terms: Reasons inventory is complex to audit Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking

4) In most manufacturing companies, the inventory and warehousing cycle begins with the A) receipt of a customer's order. B) completion of production of a customer's order. C) initiation of production of a customer's order. D) acquisition of raw materials for production. Answer: D Terms: Inventory and warehousing cycle begins with Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 5) ________ accumulate costs by individual jobs as material is issued into production and labor costs are incurred. A) Just-in-time production systems B) Job cost systems C) Process cost systems D) Manufacturing systems Answer: B Terms: Accumulate costs by individual jobs Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 6) Databases, spreadsheets, and reports that accumulate material, labor, and overhead as the costs are incurred are A) accounting systems. B) storeroom documents. C) cost accounting records. D) finished goods inventory records. Answer: C Terms: databases, worksheets, and reports that accumulate material, labor and overhead as costs Difficulty: Moderate Objective: LO 21-1 AACSB: Reflective thinking

7) The main difference between job order and process costing systems is that A) one accumulates costs by materials issued and the other by labor incurred. B) one accumulates costs by individual jobs and the other by particular processes. C) one emphasizes costs accumulated in completed products and the other emphasizes costs associated with work-in-process. D) one emphasizes costs adding value to the product and the other emphasizes costs incurred because of waste, scrap, and obsolescence. Answer: B Terms: Main difference between job order and process costing systems Difficulty: Moderate Objective: LO 21-1 AACSB: Reflective thinking 8) The inventory and warehousing cycle can be thought of as having two separate but closely related systems, one involving the actual physical flow of goods, and the other the A) related costs. B) storage of the goods. C) system of internal control over those goods. D) prevention of waste, obsolescence, and theft. Answer: A Terms: Inventory and warehousing cycle; Separate but closely related systems Difficulty: Moderate Objective: LO 21-1 AACSB: Reflective thinking 9) Auditors test the quantity of materials charged to work-in-process by tracing these quantities to A) cost ledgers. B) perpetual inventory records. C) receiving reports. D) material requisitions. Answer: D Terms: Test quantity of materials charged to work-in-process by tracing to Difficulty: Moderate Objective: LO 21-1 AACSB: Reflective thinking

10) Which of the following is a continuously updated computerized record of inventory items purchased, used, sold, and on hand for merchandise, raw materials, and finished goods? A) job cost system B) standard cost records C) cost accounting records D) perpetual inventory database Answer: D Terms: Perpetual inventory database Difficulty: Moderate Objective: LO 21-1 AACSB: Reflective thinking 11) In the flow of inventory and costs, when work-in-progress is credited, ________ is (are) debited. A) raw materials B) cost of goods sold C) finished goods D) direct labor Answer: C Terms: Flow of inventory and costs Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 12) Separate perpetual records are likely to be kept only for raw materials inventory. Answer: FALSE Terms: Perpetual inventory records for inventories Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 13) In process cost systems, costs are accumulated by individual jobs. Answer: FALSE Terms: Process cost system Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 14) In job cost systems, costs are accumulated by individual jobs. Answer: TRUE Terms: Job cost systems Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking

15) In some inventory systems, raw materials can be requisitioned by automated computer software when raw materials reach a predetermined level. Answer: TRUE Terms: Raw materials requisitions Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 16) The inventory and warehousing cycle is unique because of its close relationship to other transaction cycles. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 17) The inventory and warehousing cycle ends with the sale of goods in the sales and collection cycle. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 18) Inventory items such as jewels, chemicals, and electronic parts are easy for auditors to observe and to value. Answer: FALSE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 19) It is not allowed under accounting standards to use different inventory valuation methods for different parts of the inventory. Answer: FALSE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 20) Inventory valuation issues include the estimation of inventory obsolescence and the allocation of manufacturing costs to inventory. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

21) Purchase requisitions are often initiated by stockroom personnel as raw materials are needed. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 22) The receiving department prepares a receiving report which often is electronic notification of the receipt of goods that become part of the document before payment is made to the vendor. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 23) An adequate cost accounting system is an important part of the processing of goods function for all manufacturing companies. Answer: TRUE Terms: Inventory and warehousing cycle Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking 24) What are two factors affecting the complexity of the audit of inventory? Answer: • Inventory is often the largest account on the balance sheet. • Inventory is often in different locations, making physical control and counting difficult. • Diverse inventory items (jewels, chemicals, and electronic parts) are often difficult for auditors to observe and value. • Inventory valuation is difficult when estimation of inventory obsolescence is necessary and when manufacturing costs must be allocated to inventory. • There are several acceptable inventory valuation methods and some organizations may prefer to use different valuation methods for different parts of the inventory, which is acceptable under accounting standards. Terms: Factors affecting complexity of audit of inventory Difficulty: Easy Objective: LO 21-1 AACSB: Reflective thinking

21.2 Learning Objective 21-2 1) The audit tests to verify that the client is using an inventory method which is generally accepted and to verify that physical counts were correctly summarized are performed during the audit of the A) acquisition and payments cycle. B) payroll and personnel cycle. C) inventory and warehousing cycle. D) sales and collection cycle. Answer: C Terms: Audit tests to verify client is using inventory method which is generally accepted Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 2) Handling the receipt of ordered goods is a part of the ________ cycle. A) purchasing B) acquisition and payment C) inventory D) inventory and warehousing Answer: B Terms: Handling receipt of ordered goods Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 3) Which of the following is not a function within the inventory and warehousing cycle? A) process the goods B) store raw materials C) ship finished goods D) process invoices for shipped goods Answer: D Terms: Functions within inventory and warehousing cycle Difficulty: Easy Objective: LO 21-2 and LO 21-1 AACSB: Reflective thinking

4) Inventory is often a significant part of a company's current assets. Because of its importance, A) auditors are required by auditing standards to observe the client taking a physical inventory count. B) price tests must be performed to verify whether the physical counts were correctly summarized. C) companies are required to use perpetual inventory systems. D) auditors are required by auditing standards to take the physical inventory for the client. Answer: A Terms: Physical inventory Difficulty: Moderate Objective: LO 21-2 AACSB: Reflective thinking 5) Inventory compilation tests are used to verify that the inventory is recorded at the lower of cost or market. Answer: FALSE Terms: Inventory compilation tests Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 6) An approved purchase requisition form authorizes shipment of goods to customers. Answer: FALSE Terms: Approved purchase requisition authorizes shipment of goods Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 7) The receipt of raw materials is a part of the acquisition and payment cycle. Answer: TRUE Terms: Acquisition and payment cycle Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 8) The physical observation of the inventory and the acquisition of raw materials are part of the inventory and warehousing cycle. Answer: FALSE Terms: Inventory and warehousing cycles Difficulty: Moderate Objective: LO 21-2 AACSB: Reflective thinking

9) Physical examination is an essential type of evidence used to verify the existence and count of inventory. Answer: TRUE Terms: Physical counting of inventory Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 10) Costs used to value inventory must be tested by the auditor only to determine whether the client has followed an inventory method which is in accordance with generally accepted accounting principles. Answer: FALSE Terms: Inventory pricing and compilation tests Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 11) Audit procedures verifying the costs used to value inventories are called compilation tests. Answer: FALSE Terms: Inventory pricing and compilation tests Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 12) The pricing and compilation of inventory are audited using substantive analytical procedures and test of details of the balances. Answer: TRUE Terms: Inventory pricing and compilation tests Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 13) As part of the risk assessment process, the auditor will consider whether any of the identified risks of material misstatement found during the audit of the inventory and warehousing cycle are considered a significant risk. Answer: TRUE Terms: Inventory pricing and compilation tests Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking

14) It is acceptable practice for CPA firms to use drones to evaluate inventories and other assets such as mineral deposits during audits. Answer: TRUE Terms: Inventory drone revolution Difficulty: Easy Objective: LO 21-2 AACSB: Reflective thinking 15) The audit of the inventory and warehousing cycle will be affected by the results from other business processes. Identify the "other" business cycles and how they impact the audit of inventory. Answer: Acquisition and payment, and payroll and personnel: Acquire and record raw materials, labor, and overhead. Sale and collection: Ship goods and record revenue and costs. Terms: Audit of inventory and warehousing cycle affected by other business cycles Difficulty: Moderate Objective: LO 21-2 AACSB: Reflective thinking 16) The audit of the inventory and warehousing cycle consists of five parts. State the five parts and, for each part, identify the cycle in which that part is tested by the auditor. Answer: The five parts are: • Acquire and record raw materials, labor, and overhead. This is tested during the audits of the acquisition and payment cycle, and the payroll and personnel cycle. • Internally transfer assets and costs. This is tested in the inventory and warehousing cycle. • Ship goods, and record revenue and costs. This is tested during the audit of the sales and collection cycle. • Physically observe inventory. This is tested in the inventory and warehousing cycle. • Price and compile inventory. This is tested in the inventory and warehousing cycle. Terms: Parts of inventory and warehousing cycle and cycle in which tested by auditor Difficulty: Challenging Objective: LO 21-2 AACSB: Reflective thinking

17) State the six functions that make up the inventory and warehousing cycle and, for each function, identify the related documents that would be used by a manufacturing company. Answer: The six functions are: • Process purchase orders. Related documents are the purchase requisition and the purchase order. • Receive raw materials. Related documents are the receiving report and vendor's invoice. • Store raw materials. Related document is the raw materials perpetual inventory database. • Process the goods. Related documents are the raw materials requisition and the cost accounting records. • Store finished goods. Related documents are the finished goods perpetual inventory database and the cost accounting records. • Ship finished goods. Related documents are the shipping document, the finished goods perpetual inventory database, and the cost accounting records. Terms: Functions that make up the inventory and warehousing cycle and related documents/records Difficulty: Challenging Objective: LO 21-2 AACSB: Reflective thinking 21.3 Learning Objective 21-3 1) Auditor tests of the physical controls over raw materials, work in process, and finished goods are generally limited to A) observation and confirmation. B) observation and inquiry. C) inquiry and reconciliation. D) observation and reconciliation. Answer: B Terms: Auditor tests of physical controls over inventory limited Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking 2) Almost all companies need physical controls over their assets to prevent loss. Which of the following is not an example of such a control? A) perpetual inventory databases B) segregated, limited-access storage areas C) custody of assets assigned to specific responsible individuals D) approved prenumbered documents for authorizing movement of inventory Answer: A Terms: Physical controls over assets to prevent loss Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking

3) The reliability of perpetual inventory databases affects the timing and ________ of the auditor's physical examination of inventory. A) cutoff B) accuracy C) nature D) extent Answer: D Terms: Perpetual inventory database Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking 4) When auditing inventory cost accounting, the auditor is concerned with all of the following except for A) net realizable value. B) unit cost records. C) physical controls over inventory. D) documents and records for transferring inventory. Answer: A Terms: Tests of inventory cost accounting Difficulty: Easy Objective: LO 21-3 AACSB: Analytic thinking 5) Auditors usually test cost accounting records as part of the A) acquisition tests. B) payroll tests. C) sales tests. D) All of the above are correct. Answer: D Terms: Cost accounting controls related to physical inventory and costs Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 6) To ensure proper segregation of duties, who should maintain the perpetual inventory databases? A) production personnel B) inventory storeroom personnel C) inventory receiving personnel D) accounting department personnel Answer: D Terms: Segregation of duties; Maintain perpetual inventory databases Difficulty: Challenging Objective: LO 21-3 AACSB: Reflective thinking 12 Copyright © 2023 Pearson Education, Inc.

7) Which of the following statements is correct regarding the audit of inventory cost accounting? A) Cost accounting systems and controls are the same for all manufacturing companies. B) All companies that have work-in-process must use a perpetual inventory system. C) Auditors test perpetual inventory databases by examining documentation that supports additions and reductions of inventory amounts in the databases. D) Manufacturing companies keep their cost accounting records separate from the production and other accounting records. Answer: C Terms: Audit of cost accounting for inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 8) Which of the following is an accurate statement regarding perpetual inventory databases? A) When perpetual inventory databases are accurate, auditors can test the physical inventory after the balance sheet date. B) It is a difficult procedure for the auditor to test the accuracy of the perpetual inventory databases. C) Auditors test the perpetual records for reductions in finished goods for sale as part of the sales and collection cycle. D) All of the above are accurate statements. Answer: C Terms: Perpetual inventory database Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 9) Which of the following is a significant audit concern related to the transfer of inventory from one location to another? A) Recorded transfers occurred. B) Transfers were properly transported. C) Transfers were properly planned. D) Transfers represent efficient movement of assets. Answer: A Terms: Significant audit concern related to transfer of inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking

10) When auditing manufacturing overhead costs assigned to inventory, auditors should keep in mind that A) GAAP has strict procedures that must be followed when assigning overhead to work-inprocess inventory. B) overhead costs must be allocated to raw materials, work-in-process, and finished goods inventory. C) management typically allocates overhead using total direct labor dollars as the basis for the allocation. D) determining the reasonableness of the allocation method is relatively simple for work-inprocess inventory. Answer: C Terms: Audit of cost accounting for inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 11) A major difficulty in the verification of inventory cost records for the purpose of inventory valuation is in determining the reasonableness of the A) direct labor costs. B) raw material costs. C) manufacturing overhead costs. D) period costs. Answer: C Terms: Difficulty in verification of inventory cost records for valuation Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking

12) Auditor tests of physical controls over raw materials, work-in-process, and finished goods are performed by A) Examination Observation Inquiry Yes No Yes B) Examination No

Observation Yes

Inquiry No

Examination Yes

Observation Yes

Inquiry No

Examination No

Observation Yes

Inquiry Yes

Answer: D Terms: Auditor tests of physical controls over inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 13) If the perpetual inventory databases show lower quantities of inventory than the physical count, an explanation of the difference might be unrecorded A) sales. B) sales discounts. C) purchases. D) purchase discounts. Answer: C Terms: Perpetual inventory database shows lower quantities of inventory than physical count Difficulty: Challenging Objective: LO 21-3 AACSB: Analytic thinking 14) Cost accounting controls are those related to the physical inventory and the consequent costs from the point at which A) materials are ordered for purchase until the finished product is sold. B) the customer's order is received until the finished product is shipped. C) raw materials are requisitioned until the finished product is sent to storage. D) raw materials are requisitioned until the finished product is completely manufactured. Answer: C Terms: Cost accounting controls related to physical inventory and costs Difficulty: Challenging Objective: LO 21-3 AACSB: Reflective thinking 15 Copyright © 2023 Pearson Education, Inc.

15) In order to strengthen controls over cost accounting information, a company should consider implementing A) perpetual inventory databases. B) a job order cost accounting system. C) an accounting system that keeps separate the records of the accounting department from the records of the production department. D) an economic quantity order system. Answer: A Terms: Strengthen system of internal controls over accounting for materials used in production Difficulty: Challenging Objective: LO 21-3 AACSB: Reflective thinking 16) The auditor is concerned with four aspects of cost accounting, including A) documents and records for transferring inventory. B) perpetual inventory databases. C) unit cost records. D) all of the above. Answer: D Terms: Tests of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 17) One of the auditor's primary concerns in verifying the transfer of inventory from one location to another is that A) recorded transfers exist. B) all actual transfers are recorded. C) the quantity, date, and description of all recorded transfers are accurate. D) all of the above. Answer: D Terms: Audit tests of cost accounting system Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking

18) The audit of cost accounting begins with the internal transfer of assets from raw materials to work-in-process to A) manufacturing overhead. B) finished goods inventory. C) the perpetual inventory databases. D) retail sales. Answer: B Terms: Audit of cost accounting for inventory Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking 19) Management typically allocates overhead using total raw materials as the basis for the allocation. Answer: FALSE Terms: Audit of cost accounting for inventory Difficulty: Easy Objective: LO 21-3 AACSB: Reflective thinking 20) When verifying the transfer of inventory from one location to another, the audit objectives with which the auditor is primarily concerned are occurrence of recorded transfers, completeness of recorded transfers, and accuracy of recorded transfers. Answer: TRUE Terms: Transfer of inventory; Occurrence, completeness, and accuracy Difficulty: Challenging Objective: LO 21-3 AACSB: Reflective thinking 21) Cost accounting systems and controls are the same for all manufacturing companies. Answer: FALSE Terms: Cost accounting controls related to physical inventory and costs Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 22) The extent and timing of an auditor's physical examination of inventory is significantly influenced by the adequacy of the client's perpetual inventory records. Answer: TRUE Terms: Extent and timing of auditor's physical examination of inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking

23) In evaluating management's overhead cost allocations, the auditor must simply consider the reasonableness of the allocation method and determine if the valuation method complies with generally accepted accounting principles. Answer: FALSE Terms: Tests of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 24) Management may decide to allocate manufacturing overhead based upon machine hours. In this situation, the auditor must test and verify the reasonableness of the use of machine hours to allocate overhead. Answer: TRUE Terms: Tests of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 25) Internal controls over cost accounting records are very similar among companies. Answer: FALSE Terms: Tests of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 26) Auditors should design appropriate tests of system of internal controls over cost accounting records based upon their understanding of those records and the extent they will be relied upon for reducing substantive tests. Answer: TRUE Terms: Tests of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking

27) Discuss the four aspects of the audit of cost accounting with which the auditor is most concerned. Answer: The auditor is most concerned with: • Physical controls over inventory. Generally limited to observation and inquiry to determine if inventory is protected from theft and misuse. • Documents and records for transferring inventory. The auditor's primary concerns in verifying the transfer of inventory from one location to another are that the recorded transfers exist, all actual transfers are recorded, and the quantity, description, and date of all recorded transfers are accurate. • Perpetual inventory records. The adequacy of perpetual inventory databases has a major effect on the timing and extent of the auditor's physical examination of inventory. • Unit cost records. To maintain accurate cost data, clients must integrate their cost accounting records with production and other accounting records. The auditor is concerned that there is accurate cost data for raw materials, direct labor, and manufacturing overhead to ensure that raw materials, work-in-process, and finished goods inventories are fairly stated. Terms: Four aspects of audit of cost accounting Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking 28) What are the auditor's primary concerns in verifying the transfer of inventory from one location to another? Answer: 1. Recorded transfers exist. 2. All actual transfers are recorded. 3. The quantity, description, and date of all recorded transfer are accurate. Terms: Methodology for designing tests of details of balances for inventory Difficulty: Moderate Objective: LO 21-3 AACSB: Reflective thinking

21.4 Learning Objective 21-4 1) Which one of the following substantive analytical procedures would be most useful in alerting the auditor to the possibility of obsolete inventory? A) Compare gross margin percentage with that of previous years. B) Compare unit costs of inventory with previous years. C) Compare inventory turnover ratio with previous years. D) Compare current year manufacturing costs with previous years. Answer: C Terms: Analytical procedure useful in alerting for obsolete inventory Difficulty: Moderate Objective: LO 21-4 AACSB: Reflective thinking 2) Which one of the following substantive analytical procedures would be most useful in alerting the auditor to the possibility inventory and cost of goods sold being overstated or understated? A) Compare extended inventory value with that of previous years. B) Compare unit costs of inventory with previous years. C) Compare inventory turnover ratio with previous years. D) Compare current year manufacturing costs with previous years. Answer: C Terms: Analytical procedure useful in alerting for obsolete inventory Difficulty: Moderate Objective: LO 21-4 AACSB: Reflective thinking 3) A comparison of the current year's inventory turnover ratio with previous years' may indicate the presence of obsolete inventory. Answer: TRUE Terms: Comparison of inventory turnover ratios Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking 4) Ratios such as the gross margin percentage calculated as part of risk assessment procedures may be performed using aggregate data. Answer: TRUE Terms: Comparison of inventory turnover ratios Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking

5) Significant improvements in audit effectiveness and efficiency may be achieved by the use of audit data analytics in the inventory and warehousing cycle. Answer: TRUE Terms: Use of audit data analytics in audit of inventory Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking 6) It is permissible for an auditor to test the entire inventory population for certain types of audit tests in order to eliminate the need for more costly tests involving sampling. Answer: TRUE Terms: Use of audit data analytics in audit of inventory Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking 7) Many of the system of internal controls over inventory and the details of the entire inventory population can be tested using audit software. Answer: TRUE Terms: Use of audit data analytics in audit of inventory Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking 8) In addition to performing analytical procedures that examine the relationship of inventory account balances with related financial statement accounts, auditor's will often use nonfinancial measures in determining the reasonableness of inventory balances. List below at least two nonfinancial measures that may be useful to auditors. Answer: size and weight of inventory products methods of storage capacity of storage facilities Terms: Nonfinancial measures to determine reasonableness of inventory Difficulty: Easy Objective: LO 21-4 AACSB: Reflective thinking

9) Given the following information about your audit client, perform analytical procedures and comment on your findings.

Inventory Cost of Sales

2022 $20,000 $240,000

2023 $32,000 $320,000

Industry Average $25,000 $400,000

Answer: Inventory turnover for 2022 is 12, and for 2023 is 10, industry average is 16. (Basic accounting information that should be known applied to the inventory chapter.) Inventory is increasing with lower inventory turnover, and a turnover that is well below the industry average. Principal audit concern would be that inventory is overvalued on the balance sheet. Another concern will be the realizable value of the inventory. Terms: Analytical procedures Difficulty: Challenging Objective: LO 21-4 AACSB: Analytic thinking 21.5 Learning Objective 21-5 1) You are auditing the inventory account and are concerned about the possibility of an inventory overstatement. What is the best audit procedure to detect damaged inventory? A) Observe the condition of inventory during the client's physical count. B) Compare the condition of inventory from the previous year's count to the current year. C) Compare inventory turnover from the previous year's inventory to the current year's inventory. D) Reconcile the inventory counts to the cost accounting records. Answer: A Terms: Best audit procedure to detect damaged inventory Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 2) When determining the sample size for the number of items the auditor should count during the physical inventory, A) it is easy to quantify the number of items based on a formula developed by the AICPA. B) one of the key determinants that must be considered is system of internal control over the physical count. C) one of the key determinants that must be considered is the cost involved. D) generally accepted auditing standards require that at least 80% of the dollar value of the inventory should be included in the sample. Answer: B Terms: Audit procedure observe client taking physical inventory count Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

3) There must be a periodic physical count by the client of the inventory items on hand A) only if the client uses the LIFO method. B) only if the client uses a lower-of-cost-or-market method. C) regardless of the client's inventory valuation method. D) only if the client uses either the LIFO or FIFO method. Answer: C Terms: Periodic physical count on inventory on hand Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 4) If the auditor concludes that physical controls over inventory are so inadequate that the inventory will be difficult to count, the auditor should ordinarily A) withdraw from the engagement. B) issue a qualified audit report. C) conduct expanded observation tests of physical inventory. D) hire a specialist to assist the auditor. Answer: C Terms: Auditor concludes physical controls over inventory are so inadequate Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 5) From which of the following evidence-gathering audit procedures would an auditor obtain most assurance concerning the existence of inventories? A) observation of physical inventory counts B) written inventory representations from management C) confirmation of inventories in a public warehouse D) auditor's recomputation of inventory extensions Answer: A Terms: Evidence-gathering audit procedures for auditor to obtain most assurance concerning existence of inventories Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 6) When auditors observe the client counting inventory, they should be careful to do all of the following except A) inquire about items that are likely to be obsolete or damaged. B) calculate the unit cost of the inventory items. C) discuss with management the reasons for excluding any material items. D) observe the counting of the most significant items. Answer: B Terms: Physical counting of inventory Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 23 Copyright © 2023 Pearson Education, Inc.

7) It is frequently possible to test the physical inventory prior to the balance sheet date when A) the perpetual inventory records are accurate and related controls operate effectively. B) year-end sales are small. C) the internal control system is no better at year-end than at an earlier point in time. D) the client counts inventory at interim dates. Answer: A Terms: Test of physical inventory prior to balance sheet date Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 8) Comparing the physical counts with the perpetual inventory databases satisfies the balancerelated audit objective of A) classification. B) observation. C) completeness. D) accuracy. Answer: D Terms: Tests of perpetual inventory databases Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

9) Which of the following statements is correct regarding the auditor's responsibility with respect to the year-end inventory procedures of an audit client? A) The auditor is responsible for The auditor is responsible for The auditor is responsible for setting up the procedures for taking and compiling the observing the physical taking an accurate physical inventory. counting of inventory. inventory. Yes No No B) The auditor is responsible for The auditor is responsible for The auditor is responsible for setting up the procedures for taking and compiling the observing the physical taking an accurate physical inventory. counting of inventory. inventory. No No Yes C) The auditor is responsible for The auditor is responsible for The auditor is responsible for setting up the procedures for taking and compiling the observing the physical taking an accurate physical inventory. counting of inventory. inventory. Yes No Yes D) The auditor is responsible for The auditor is responsible for The auditor is responsible for setting up the procedures for taking and compiling the observing the physical taking an accurate physical inventory. counting of inventory. inventory. No Yes No Answer: B Terms: Auditor's responsibility for year-end inventory procedures Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

10) McKesson & Robbins Company is a well-known audit case involving auditor responsibility. What occurred at the McKesson & Robbins Company to change the way in which auditors audit inventory? A) The company recorded nonexistent inventory. B) The auditor did not perform any audit tests of the inventory. C) The auditor and company colluded to overstate inventory balances. D) The company counted inventory three months prior to year-end. Answer: A Terms: McKesson & Robbins Company audit case; Auditor responsibility in auditing inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 11) When a physical count of inventory is performed at an interim date, the auditor observes it at that time and tests the perpetual records for transactions A) throughout the year. B) which are a representative sample of the period under audit. C) from the date of the count to year-end. D) from the date of the count to the end of the audit field work. Answer: C Terms: Count of inventory performed at interim date Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 12) When there are no perpetual inventory files and inventory is material, A) an audit cannot be performed, so the auditor must issue a disclaimer. B) a physical inventory should be taken by the client near the end of the accounting period. C) the auditor will have to perform the inventory count and determine valuation. D) the auditor need not observe inventory counts but must do test counts. Answer: B Terms: No perpetual inventory files and inventory is material Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 13) The most important part of the observation of inventory is to determine whether A) all counts are accurate. B) the inventory-takers are qualified. C) obsolete inventory has been identified. D) the physical count is being taken in accordance with the client's instructions. Answer: D Terms: Most important part of observation of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

14) A useful starting point for becoming familiar with the client's inventory is for the auditor to A) read the AICPA's Industry Audit Guide. B) review accounting theory covering special inventory problems. C) read the client's accounting manual. D) tour the client's facility. Answer: D Terms: Starting point for becoming familiar with client's inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 15) A common inventory observation procedure is to select a random sample of tag numbers and identify the tag with that number attached to the actual inventory item. The audit objective being achieved by this procedure is A) inventory as recorded on tags actually exists (existence). B) existing inventory is counted and tagged (completeness). C) inventory is counted accurately (accuracy). D) inventory is classified correctly (classification). Answer: A Terms: Audit objective of procedure to select random sample Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 16) If a client intends to count inventory at an interim date, the auditor should expect there to be all of the following except A) controls over the preparation and maintenance of perpetual inventory records. B) competent personnel assigned to count the inventory. C) third-party inventory counting specialists. D) an adequately designed plan to count the inventory. Answer: C Terms: Inventory count at interim date Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

17) A common inventory observation procedure is to be alert for items that are damaged, rust- or dust-covered, or located in inappropriate places. The balance-related audit objective being achieved by this procedure is A) classification. B) cutoff. C) realizable value. D) rights. Answer: C Terms: Balance-related audit objective for alert for items that are damaged Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 18) The test of details of balance procedure which requires the auditor to account for unused inventory tag numbers to make sure none have been deleted is associated with the audit objective of A) accuracy. B) existence. C) detail tie-in. D) completeness. Answer: D Terms: Audit objective related to test of details of balances procedure to account for unused inventory tag numbers Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 19) Which of the following is an accurate statement regarding inventory and risk? A) Inventory with a high business risk includes products with potential obsolescence. B) Auditors often have a greater concern for misstatements when inventory is stored in one warehouse. C) Inherent risk is generally set at low for manufacturing companies. D) Performance materiality for inventory is determined before assessing client business risk. Answer: A Terms: Inventory and risk Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

20) The auditor's tour of the client's inventory facilities should be led by A) a member of the audit committee. B) the CFO. C) a plant supervisor. D) the company president. Answer: C Terms: Physical counting of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Analytic thinking 21) The physical counting of inventory may be performed at which of the following times? A) Interim dates On a cycle basis during the year Yes Yes B) Interim dates No

On a cycle basis during the year No

Interim dates Yes

On a cycle basis during the year No

Interim dates No

On a cycle basis during the year Yes

Answer: A Terms: Physical counting of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 22) When an auditor observes that personnel who are responsible for physically counting inventory are not following the inventory instructions, the auditor should A) contact a client's supervisor to correct the problem. B) modify the client's physical inventory instructions. C) not discuss the problem with the client's supervisor in order to maintain independence. D) assign audit staff to the inventory count. Answer: A Terms: Observation of personnel taking inventory not following instructions Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

23) Auditors need to understand the client's physical inventory count controls before the count of the inventory begins so that A) the auditors can accurately count and tag the inventory for the client. B) the auditors can make constructive suggestions as to the adequacy of the procedures. C) the client will be informed on exactly what items the auditor intends to test count. D) the auditor can communicate any weaknesses directly to the audit committee. Answer: B Terms: Auditor's objective during observation of physical inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 24) The audit of year-end physical inventories should include steps to verify that the client's purchases and sales cutoffs were adequate. The audit steps should be designed to detect whether merchandise included in the physical count at year-end was not recorded as a A) sale in the current period. B) sale in the subsequent period. C) purchase in the current period. D) purchase return in the subsequent period. Answer: A Terms: Audit of year-end physical inventories Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 25) Which one of the following procedures would not be appropriate for an auditor in discharging his responsibilities concerning the client's physical inventories? A) confirmation of goods in the hands of public warehouses B) supervising the taking of the annual physical inventory C) carrying out physical inventory procedures at an interim date D) obtaining written representation from the client as to the existence, quality, and dollar amount of the inventory Answer: B Terms: Procedures not appropriate for auditor in discharging responsibilities concerning physical inventories Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

26) The auditor generally decides whether the inventory count can be taken before year-end primarily on the basis of A) audit efficiency. B) accuracy of the perpetual inventory databases. C) client convenience. D) audit staff availability. Answer: B Terms: Basis that auditor decides whether inventory count can be taken before year-end Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 27) An auditor selects a random sampling of tag numbers and identifies the tag with that number attached to the actual inventory. The purpose of the procedure is to A) obtain proper cutoff information. B) uncover the inclusion of nonexistent items as inventory. C) determine if the client has adequately priced the inventory item. D) verify that the client has not changed the recorded counts after the auditor left the premises. Answer: B Terms: Physical counting of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 28) An auditor must inquire about consigned or customer inventory included on the client's premises to satisfy the balance-related audit objective of A) cutoff. B) classification. C) rights. D) completeness. Answer: C Terms: Audit of year-end physical inventories Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 29) To best ascertain that a company has properly included merchandise that it owns in its ending inventory, the auditor should review and test the A) terms of the open purchase orders. B) purchase cutoff procedures. C) contractual commitments made by the purchasing department. D) purchase invoices received on or around year-end. Answer: B Terms: Auditor should review and test for proper inclusion of merchandise in ending inventory Difficulty: Challenging Objective: LO 21-5 AACSB: Reflective thinking 31 Copyright © 2023 Pearson Education, Inc.

30) Boxes or other containers holding inventory should also be opened during test counts to determine the ________ of the inventory. A) classification B) detail tie-in C) existence D) realizable value Answer: C Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 31) When may auditors observe the physical inventory count? A) At an interim date At year-end Yes Yes B) At an interim date No

At year-end No

C) At an interim date Yes

At year-end No

D) At an interim date No

At year-end Yes

Answer: A Terms: Auditors observe physical inventory count Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 32) Auditing standards recommend that auditors observe physical inventory counts by the client. Answer: FALSE Terms: Audit standards; Auditors observe physical inventory Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking

33) In the audit of inventory, the auditor and client are jointly responsible for making and recording the count of physical inventory, while the auditor is responsible for drawing conclusions about the adequacy of the physical inventory. Answer: FALSE Terms: Responsibility for making and recording count of physical inventory count Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 34) A common source of business risk for inventory is the reliance on a few key suppliers. Answer: TRUE Terms: Inventory and risk Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 35) To test for proper sales cutoff, an auditor would obtain the number of the last bill of lading issued during the period under audit and verify that the item shipped had been excluded from the inventory listing. Answer: TRUE Terms: Test for proper sales cutoff Difficulty: Easy Objective: LO 21-5 AACSB: Reflective thinking 36) When the client's perpetual inventory databases are inadequate, the auditor will probably choose to test the physical inventory prior to the balance sheet date. Answer: FALSE Terms: Client's perpetual inventory databases are inadequate Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 37) When part of the client's inventory is in a public warehouse or in the possession of other outside custodians, the auditor does not need to observe a physical count of the inventory if a written confirmation is obtained directly from the inventory custodians. Answer: TRUE Terms: Client's inventory in pubic warehouse Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

38) The adequacy of system of internal controls over the physical count of inventory is one of the key determinants of the amount of time needed to test inventory. Answer: TRUE Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 39) Inherent risk is typically assessed at a low level for inventory due to the nature of the asset. Answer: FALSE Terms: Inherent risk for inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 40) Discuss the auditor's responsibilities for inventory maintained in public warehouses or with other outside custodians. Answer: An auditor's physical examination of inventory is not required if inventory is housed in a public warehouse or overseen by outside custodians. In these situations, auditors verify inventory by confirmation with the custodian. However, the auditor may perform additional procedures if the amounts involved are significant. These additional procedures may include: an investigation of the custodian's inventory procedures, obtaining an independent accountant's report on the custodian's control procedures over the custody of goods, or observing the physical count of goods held by the custodian, if practical. Terms: Auditor responsibilities for inventory maintained in public warehouses Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 41) Discuss the key control procedures relating to the client's physical count of inventory. Answer: The key control procedures relating to the client's physical count of inventory include: 1. proper client instructions for the physical count 2. supervision by responsible company personnel 3. independent internal verification of the counts by other client personnel 4. independent reconciliations of the physical counts with perpetual inventory databases 5. adequate client control over count sheets or tags used to record inventory counts Terms: Control procedures related to physical count of inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

42) Auditing standards require that auditors satisfy themselves about the effectiveness of the client's methods of counting inventory and the reliance they can place on the client's representations about the quantities and physical condition of the inventories. To meet this requirement, auditors must perform four activities. List them below. Answer: • be present at the time the client counts the inventory for determining year-end balances • observe the client's counting procedures • make inquiries of client personnel about their counting procedures • make their own independent tests of the physical count Terms: Effectiveness of client's method of counting inventory Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking 43) When auditors observe the client counting inventory, the auditor should take special care in three areas with regards to selection of inventory items. What action should be taken in these areas? Answer: • Observe the counting of the most significant items and a representative sample of typical inventory items. • Inquire about items likely to be damaged or obsolete. • Discuss with management reasons for excluding any material items from the inventory count. Terms: Selection of inventory items for the auditor to audit Difficulty: Moderate Objective: LO 21-5 AACSB: Reflective thinking

21.6 Learning Objective 21-6 1) If an auditor were concerned with obtaining evidence about the appropriateness of the value of inventory, which of the following tests would be most appropriate? A) compilation tests B) price tests C) confirmation of inventory held by outside parties D) physical examination of the inventory Answer: B Terms: Tests of evidence about appropriateness of value of inventory Difficulty: Easy Objective: LO 21-6 AACSB: Reflective thinking 2) The first step in verifying the valuation of purchased inventory is in determining the valuation method used by the client. The next step is A) determining that all inventory that is purchased is expensed through cost of goods sold. B) determining which costs should be included in the valuation of an item of inventory. C) determining that all inventory on hand reconciles to the perpetual inventory records. D) determining that cutoff procedures have been adhered to prior to counting inventory. Answer: B Terms: Second step in verifying the valuation of purchased inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 3) You are gathering evidence for the audit objective that existing inventory items are included in the inventory listing schedule. The audit procedure that would provide you with the best evidence to confirm this objective is A) trace from inventory tags to the inventory listing schedule and make sure the inventory on the tags is included. B) trace the inventory totals to the general ledger. C) perform tests of lower-of-cost-or-market. D) account for unused tags shown in the auditor's documentation to make sure no tags have been added. Answer: A Terms: Audit procedure that provides evidence to confirm audit objective of existence of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking

4) The test of details of balance procedure which requires the auditor to perform tests of lower of cost or market, selling price, and obsolescence is an attempt to satisfy the objective of A) existence. B) completeness. C) accuracy. D) realizable value. Answer: D Terms: Objective for tests of details of balance procedure to perform lower-of-cost-or-market, selling price, and obsolescence Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 5) A major source of cutoff information for sales and purchases of inventory is A) confirmations from outside parties. B) the test of details of balances. C) physical observation. D) the performance of analytical procedures. Answer: C Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 6) Pricing manufactured inventory is difficult. Auditors must evaluate the method of allocating manufacturing overhead for all but which of the following? A) reasonableness B) computational correctness C) compliance with generally accepted auditing standards D) consistency Answer: C Terms: Auditors must evaluate method of allocating manufacturing overhead Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking

7) Controls which provide a means of ensuring that the physical counts are properly summarized, priced at the same amount as the unit records, correctly extended and totaled, and included in the general ledger at the proper amount are known as A) standard cost controls. B) pricing system of internal controls. C) compilation system of internal controls. D) count quantity system of internal controls. Answer: C Terms: Controls which provide means of ensuring physical counts are properly summarized Difficulty: Challenging Objective: LO 21-6 AACSB: Reflective thinking 8) Assume that the client's valuation of an inventory item is $10 per unit for 1,000 units, using first-in, first-out (FIFO). If the most recent acquisition of inventory was for 600 units at $10 per unit and the immediately preceding acquisition was for 700 units at $9 per unit, the inventory item is in error and it is A) understated $400. B) understated $300. C) overstated $400. D) overstated $700. Answer: C Terms: Inventory errors—First-in, first-out (FIFO) Difficulty: Challenging Objective: LO 21-6 AACSB: Analytic thinking 9) The auditor traces inventory tags identified as non-owned during the physical observation to the inventory listing schedule to make sure these have not been included. This test satisfies the balance-related audit objective of A) cutoff. B) rights. C) accuracy. D) existence. Answer: B Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Analytic thinking

10) Which of the following is an accurate statement regarding the audit of pricing and compilation of inventory? A) Inventory compilation tests include all of the tests of the client's unit prices to determine whether they are correct. B) The review for obsolete inventory should be performed by the accounting department. C) The most important system of internal control for accurate unit costs is external verification by an outside consultant. D) Inventory compilation system of internal controls are needed to ensure that the physical counts are correctly summarized and priced. Answer: D Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 11) In valuing inventory, the auditor must consider all but which of the following factors? A) The valuation method must be in accordance with GAAP. B) The valuation method must be applied on a consistent basis. C) The inventory must be valued at the lower of cost or market. D) LIFO must be used for work-in-process inventory. Answer: D Terms: Factors considered in valuing inventory Difficulty: Challenging Objective: LO 21-6 AACSB: Reflective thinking 12) In pricing raw materials in manufactured products, auditors must consider both the unit cost of the raw materials and the number of units required to manufacture a unit of output. Answer: TRUE Terms: Pricing manufactured inventory Difficulty: Easy Objective: LO 21-6 AACSB: Reflective thinking 13) The audit procedure "Perform tests of lower-of-cost-or-market, selling price, and obsolescence" provides assurance mainly for the realizable value objective for inventory pricing and compilation. Answer: TRUE Terms: Assurance for realizable value objective for inventory pricing and compilation Difficulty: Easy Objective: LO 21-6 AACSB: Reflective thinking

14) When performing price tests for purchased inventory, the auditor would not be concerned with the most recent vendors' invoices if the client uses the FIFO valuation method. Answer: FALSE Terms: Performing price tests for purchased inventory; FIFO valuation method Difficulty: Easy Objective: LO 21-6 AACSB: Reflective thinking 15) When a client has standard cost records, an efficient and useful method of determining valuation is to review and analyze variances. Answer: TRUE Terms: Audit of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 16) Inventory price tests include testing the client's summarization of the inventory counts. Answer: FALSE Terms: Inventory price tests and inventory compilation tests Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 17) The audit procedure "Foot the inventory listing schedules for raw materials, work-in-process, and finished goods" provides assurance mainly for the accuracy objective for inventory pricing and compilation. Answer: FALSE Terms: Accuracy objective for inventory pricing and compilation Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 18) The auditor need not be concerned about inventory being classified and disclosed, properly, into finished goods, work-in-process and raw materials (separately) in the financial statements; this is management's responsibility, only. Answer: FALSE Terms: Balance-related audit objective Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking

19) When performing inventory valuation tests, the auditor must be concerned that the method is in accordance with accounting standards. Answer: TRUE Terms: Valuation of inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 20) Explain why the audit of work in process and finished goods inventory is generally more complex than the audit of purchased inventory. Answer: The need to verify the cost of raw materials, direct labor, and manufacturing overhead in pricing work in process and finished goods has the effect of making the audit of work in process and finished goods inventory more complex than the audit of purchased inventory. Terms: Audit of work-in-process and finished goods inventory Difficulty: Moderate Objective: LO 21-6 AACSB: Reflective thinking 21.7 Learning Objective 21-7 1) When labor is a significant part of inventory, verifying the proper accounting of these costs should be tested in the payroll cycle. Answer: FALSE Terms: Labor a significant part of inventory Difficulty: Easy Objective: LO 21-7 AACSB: Reflective thinking 2) Accounting standards require disclosure of inventory valuation methods. Answer: TRUE Terms: Disclosures for inventory Difficulty: Easy Objective: LO 21-7 AACSB: Reflective thinking 3) Cost of goods sold is generally a residual of beginning inventory less acquisitions plus ending inventory. Answer: FALSE Terms: Cost of goods sold as a residual Difficulty: Easy Objective: LO 21-7 AACSB: Reflective thinking

4) Cost of goods sold is generally one of the largest accounts on the income statement. Answer: TRUE Terms: Cost of goods sold as a residual Difficulty: Easy Objective: LO 21-7 AACSB: Reflective thinking 5) Cost of goods sold is generally a residual of beginning inventory plus acquisitions less ending inventory. Answer: TRUE Terms: Cost of goods sold as a residual Difficulty: Moderate Objective: LO 21-7 AACSB: Reflective thinking 6) The design of tests of details of balances for inventory is affected by audit results from multiple cycles. Identify the cycles, other than the inventory and warehousing cycles, that affect the audit of inventory. Answer: Tests of details of balances for inventory are also affected by the results of tests of controls and substantive tests of transactions in the sales and collection cycle, acquisition and payment cycle, and the payroll and personnel cycle. Terms: Cycles that affect inventory Difficulty: Moderate Objective: LO 21-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 22 Audit of the Capital Acquisition and Repayment Cycle 22.1 Learning Objective 22-1 1) Which of the following statements is correct regarding the capital acquisition and payment cycle? A) Bonds are frequently issued by companies in small amounts. B) There are relatively few transactions and each transaction is typically highly material. C) A primary emphasis in auditing debt is on existence. D) Audit procedures for notes payable and interest income are often performed simultaneously. Answer: B Terms: Capital acquisition and payment cycle Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 2) The capital acquisition and repayment cycle does not include A) payment of interest. B) payment of dividends. C) payment of vendor invoices. D) acquisition of capital through interest-bearing debt. Answer: C Terms: Capital acquisition and payment cycle Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 3) Which of the following statements regarding the capital acquisition and repayment cycle is most correct? A) A relatively few transactions affect the cycle, and most are smaller amounts. B) A large number of transactions affect the cycle, and most are smaller amounts. C) A relatively few transactions affect the cycle, and most are highly material. D) A large number of transactions affect the cycle, and most are highly material. Answer: C Terms: Capital acquisition and repayment cycle Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking

4) The primary audit objectives to focus on when auditing accounts in the capital acquisition and repayment cycle are A) accuracy and completeness. B) accuracy and existence. C) completeness and valuation. D) accuracy and valuation. Answer: A Terms: Primary audit objectives focus on when auditing debt Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 5) Performance materiality is often set at a(n) ________ level for notes payable. A) high B) moderate C) low D) unknown Answer: C Terms: Performance materiality for notes payable Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 6) When auditing interest-bearing debt, the auditor should ________ verify the related interest expense and interest payable. A) not B) attempt to C) simultaneously D) never Answer: C Terms: Audit of interest-bearing debt and related interest expense and interest payable Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 7) Assessed control risk and results of substantive tests of transactions are normally unimportant for designing tests of details of balances for which of the following accounts? A) accounts receivable B) inventory C) accounts payable D) notes payable Answer: D Terms: Assessed control risk; Results of substantive tests of transactions; Unimportant for designing tests of details of balances Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

8) In the audit of the transactions and amounts in the capital acquisition and repayment cycle, the auditor must take great care in making sure that the significant legal requirements affecting the financial statements have been properly fulfilled and A) any violations are reported to the SEC. B) are adequately disclosed in the financial statements. C) must issue a disclaimer if they haven't been fulfilled. D) any departures from the agreements are made with management's knowledge and consent. Answer: B Terms: Audit of transactions and amounts in the capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 9) All corporations must have A) preferred stock. B) capital stock. C) paid-in capital in excess of par. D) dividends payable. Answer: B Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 10) One unique characteristic of the capital acquisition and repayment cycle is that relatively few transactions affect the account balances, but each transaction is often highly material in amount. Answer: TRUE Terms: Characteristic of capital acquisitions and repayment cycle Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking 11) Auditors seldom learn about the capital acquisition and repayment cycle when gaining an understanding of the client's business and industry. Answer: FALSE Terms: Capital acquisition and repayment cycle Difficulty: Easy Objective: LO 22-1 AACSB: Reflective thinking

12) When auditing the capital acquisition and repayment cycle, it is common to verify each transaction taking place in the cycle for the entire year as a part of verifying the balance sheet accounts. Answer: TRUE Terms: Auditing capital acquisition and repayment cycle; Verify transactions Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 13) There is an indirect relationship between the interest and dividends accounts and debt and equity. Answer: FALSE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 14) The capital acquisition and repayment cycle includes the payment of interest on debt and dividends to shareholders. Answer: TRUE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 15) Audit schedules for most of the accounts in the capital acquisition and repayment cycle include the beginning balance, a list of transactions that occurred in the account, and the ending balance. Answer: TRUE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 16) The dollar amounts of bond issues are normally large, making it difficult for auditors to verify each transaction in this account. Answer: FALSE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking

17) If a legal relationship exists between the client and the holder of bonds, the auditor must determine if the client has met the requirements of the bondholder agreement. Answer: TRUE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 18) Mergers and acquisitions can make the audit of the debt and the equity cycle more complex, especially when acquisitions are financed through debt. Answer: TRUE Terms: Capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-1 AACSB: Reflective thinking 19) List the four characteristics of the capital acquisition and repayment cycle that make it unique from other cycles. Answer: The four characteristics are: • Relatively few transactions affect the account balances, but each transaction is often highly material in amount. • The exclusion or misstatement of a single transaction can be material. • There is a legal relationship between the client entity and the holder of the stock, bond, or similar ownership document. • There is a direct relationship between the interest and dividends accounts and debt and equity. Terms: Unique characteristics of capital acquisition and repayment cycle Difficulty: Challenging Objective: LO 22-1 AACSB: Reflective thinking

20) List six accounts in the capital acquisition and repayment cycle commonly found on balance sheets of corporations. What characteristics do these accounts have in common that distinguish them from other accounts? Answer: Balance sheet accounts in the capital acquisition and repayment cycle include: • Notes payable • Contracts payable • Mortgages payable • Bonds payable • Accrued interest and interest expense • Cash in the bank • Capital stock-common • Capital stock-preferred • Paid-in capital in excess of par • Donated capital • Retained earnings • Appropriations of retained earnings • Treasury stock • Dividends declared • Dividends payable • Proprietorship - capital account • Partnership - capital account The unique characteristics of these accounts are: • Relatively few transactions affect the account balances, but each transaction is often highly material in amount. • The exclusion of a single transaction could be material in itself. • There is a legal relationship between the client entity and the holder of the stock, bond, or similar ownership document. • There is a direct relationship between the interest and dividends accounts and debt and equity. Terms: Accounts commonly found in capital acquisition and repayment cycle and unique characteristics Difficulty: Challenging Objective: LO 22-1 AACSB: Reflective thinking

22.2 Learning Objective 22-2 1) Which of the following is not an objective of the auditor's examination of notes payable? A) to determine whether system of internal controls are adequate B) to determine whether client's financing arrangements are effective and efficient C) to determine whether transactions regarding the principal and interest of notes are properly authorized D) to determine whether the liability for notes and related interest expense and accrued liabilities are properly stated Answer: B Terms: Objectives of auditor's examination of notes payable Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 2) Responsibility for the issuance of new notes payable would normally be vested in the A) board of directors. B) purchasing department. C) accounting department. D) accounts payable department. Answer: A Terms: Responsibility for issuance of notes payable Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 3) An auditor is determining whether an issuance of notes payable for cash was correctly recorded. Her or his best course of action would be to A) confirm with the bond trustee as to the amount of bonds issued. B) confirm with the underwriter as to the appropriate market yield on the bonds. C) trace the cash received from the proceeds to the accounting records. D) verify that the amount was included in a footnote disclosure. Answer: C Terms: Audit of bonds payable Difficulty: Challenging Objective: LO 22-2 AACSB: Analytic thinking

4) The auditor's independent estimate of interest expense from notes payable uses average interest rates and A) average notes payable outstanding. B) year-end notes payable outstanding. C) only notes payable above the level of materiality. D) only notes payable to major lenders. Answer: A Terms: Auditor's independent estimate of interest expense from notes payable Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 5) The tests of details of balances procedure which requires the auditor to trace the totals of the notes payable list to the general ledger satisfies the audit objective of A) accuracy. B) existence. C) detail tie-in. D) completeness. Answer: C Terms: Tests of details of balances procedures for notes payable Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 6) The audit objective to determine that notes payable in the schedule actually exist is verified by the test of details of balances procedure to A) foot the notes payable list. B) confirm notes payable. C) recalculate interest expense. D) examine the balance sheet for proper disclosure of noncurrent portions. Answer: B Terms: Audit objective to determine notes payable actually exist Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking

7) Actual interest expense is significantly higher than the auditor's estimate. This would most likely lead the auditor to conclude that the client has not A) recorded all long-term interest-bearing debt in the accounting records. B) recorded all interest expense paid or accrued. C) properly accounted for the discount of bonds payable account. D) properly recorded interest income. Answer: A Terms: Substantive analytical procedures result in interest expense higher than actually recorded Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 8) You are auditing the long-term notes payable account for a client. Which of the following audit procedures would you most likely employ? A) Compare interest expense recorded by the client with the notes payable account for reasonableness. B) Confirm bonds payable with individual bond holders. C) Perform analytical procedures on the bond discount or premium account. D) Examine bond documents for the presence of hybrid securities. Answer: A Terms: Audit of long-term bonds payable Difficulty: Challenging Objective: LO 22-2 AACSB: Analytic thinking 9) The two most important balance-related audit objectives for notes payable are A) completeness and detail tie-in. B) completeness and valuation. C) accuracy and valuation. D) accuracy and completeness. Answer: D Terms: Most important balance-related audit objectives for notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking

10) Which of the following audit tests would provide evidence regarding the balance-related audit objective of existence for an audit of notes payable? A) Examine due dates on duplicate copies of notes. B) Examine balance sheet for proper presentation and disclosure of notes payable. C) Examine corporate minutes for loan approval. D) Foot the notes payable list for notes payable and accrued interest. Answer: C Terms: Audit tests to provide evidence regarding the balance-related audit objective of existence for audit of notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 11) Which of the following balance-related audit objectives is not applicable to the audit of notes payable? A) realizable value B) detail tie-in C) cutoff D) classification Answer: A Terms: Balance-related audit objectives not related to audit of notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 12) When there are not numerous transactions involving notes payable during the year, the normal starting point for the audit of notes payable is A) a schedule of notes payable and accrued interest prepared by the audit team. B) a schedule of notes payable and accrued interest obtained from the client. C) a schedule of only those notes with unpaid balances at the end of the year prepared by the client. D) the notes payable account in the general ledger. Answer: B Terms: Starting point for audit of notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking

13) The tests of details of balances procedure which requires the auditor to examine notes paid after year-end to determine whether they were liabilities at the balance sheet date is an attempt to satisfy the audit objective of A) existence. B) completeness. C) accuracy. D) classification. Answer: B Terms: Tests of details of balances procedures to examine notes paid after year-end satisfies audit objective Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 14) The audit objective that requires that existing notes payable be included in the notes payable schedule is satisfied by performing which of the following audit procedures? A) Confirm notes payable. B) Trace the total of the notes payable schedule to the general ledger. C) Review the notes payable schedule to determine whether any are related parties. D) Review the bank reconciliation for new notes credited directly to the bank account by the bank. Answer: D Terms: Audit objective that requires existing notes payable be included in notes payable schedule Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 15) The audit objective that requires the auditor to determine that notes payable on the notes payable schedule are properly classified can be tested by performing the procedure to A) confirm notes payable. B) examine corporate minutes for loan approval. C) examine notes, minutes, and bank confirmations for restrictions. D) review the notes to determine whether any are with related parties. Answer: D Terms: Audit objective that requires auditor to determine that notes payable are properly classified Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking

16) During the course of an audit, a CPA observes that the recorded interest expense seems to be excessive in relation to the balance in the long-term debt account. This observation could lead the auditor to suspect that A) long-term debt is understated. B) discount on bonds payable is overstated. C) long-term debt is overstated. D) premium on bonds payable is understated. Answer: A Terms: CPA observes recorded interest expense excessive in relation to balance in long-term debt account Difficulty: Challenging Objective: LO 22-2 AACSB: Analytic thinking 17) To determine if notes payable is included in the proper period, the auditor should A) trace the cash received from the issuance to the accounting records. B) examine duplicate copies of notes to determine whether the notes were dated on or before the balance sheet date. C) examine duplicate copies of notes for principal and interest rates. D) trace the individual notes payable to the database. Answer: B Terms: Balance-related audit objective to examine duplicate copies of notes payable Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking 18) In the audit of notes payable, it is common to include tests of principal and interest payments as a part of the audit of the acquisitions and payment cycle because the payments are in the cash disbursements journal that is being sampled. It is also normal to test these transactions as part of the capital acquisitions and repayment cycle because A) it is not unusual for the auditor to duplicate a process, thereby gathering a larger quantity of evidence. B) replicating the evidence will provide the auditor with a higher level of assurance. C) the tests done in the acquisitions and payments cycle will look only at the cash credit side so the tests done in the capital acquisitions and repayment cycle will look at the debit side of the transaction. D) due to the infrequency of these transactions, in many cases no transactions involving notes payable are included in the sample tests of acquisitions and payments. Answer: D Terms: Audit of notes payable tests of principal and interest payments Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking

19) Which of the following is not an important control over notes payable? A) There is proper authorization over the issuance of new notes payable. B) Notes payable are issued when the business climate is favorable. C) Adequate controls exist over repayment of interest and principal. D) There exist proper documents and records. Answer: B Terms: Issuance of mortgage bonds Difficulty: Moderate Objective: LO 22-2 AACSB: Analytic thinking 20) Which of the following is an accurate statement regarding the audit of the capital acquisition and repayment schedule? A) When system of internal controls over notes payable are deficient, auditors are required to confirm the notes payable. B) As auditors perform tests of details of balances for balance-related audit objectives, the evidence obtained helps satisfy the notes payable presentation and disclosure requirements. C) The normal starting point for the audit of notes payable is a list of fixed asset acquisitions. D) The schedule of notes payable and accrued interest must be prepared regardless of the number of transactions involved. Answer: B Terms: Capital acquisition and repayment cycle Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking 21) Which balance-related audit objective is important for uncovering both errors and fraud? A) completeness B) existence C) accuracy D) detail tie-in Answer: A Terms: Acquisition and payment cycle Difficulty: Moderate Objective: LO 22-2 AACSB: Analytic thinking 22) Notes payable are generally for a period of sixty days or less. Answer: FALSE Terms: Notes payable time Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking

23) When performing substantive analytical procedures for notes payable, if actual interest expense is materially larger than the auditor's expectation, one possible cause would be interest payments on unrecorded notes payable. Answer: TRUE Terms: Analytical procedures for notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 24) The balance-related audit objective realizable value is not applicable when auditing notes payable. Answer: TRUE Terms: Auditing notes payable and balance-related audit objective realizable value Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 25) The three most important balance-related audit objectives for notes payable are existence, realizable value, and accuracy. Answer: FALSE Terms: Balance-related audit objectives for notes payable; Existence, realizable value and accuracy Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 26) The audit procedure "Foot the notes payable list and trace the totals to the general ledger" is performed when verifying the accuracy objective for notes payable. Answer: FALSE Terms: Verifying accuracy objective for notes payable audit procedure Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 27) The audit procedure "Review the notes to determine whether any are related party notes or accounts payable" is performed when verifying the classification objective for notes payable. Answer: TRUE Terms: Audit procedure to verify classification objective for notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking

28) If loans require significant restrictions on the activities of the company, they must be disclosed in the footnotes. Answer: TRUE Terms: Notes payable and disclosure requirements Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 29) Accounts including preferred stock, additional paid-in capital, and treasury stock are not included in the capital acquisition and repayment cycle. Answer: FALSE Terms: Accounts in the capital acquisition and repayment cycle Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 30) Typically, auditors set inherent risk at a low level for notes payable, as the correct value is usually easy to determine. Answer: TRUE Terms: Accounts in the capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 31) Auditors often set performance materiality at a low level for accounts in the capital acquisition and repayment cycle because it is usually possible to completely audit the account balance and each of the transactions in these accounts. Answer: TRUE Terms: Accounts in the capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 32) Because the accounts in the capital acquisition and repayment cycle contain few transactions, control risk and the results of substantive transactions are normally more important for designing tests of details of balances in these accounts. Answer: FALSE Terms: Accounts in the capital acquisition and repayment cycle Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking

33) Why are substantive analytical procedures essential for notes payable? Answer: They are essential because tests of details for interest expense and accrued interest can often be eliminated if the results from the analytical procedures are favorable. Terms: Analytical procedures for notes payable Difficulty: Easy Objective: LO 22-2 AACSB: Reflective thinking 34) What are the three most important balance-related audit objectives in notes payable? Answer: • existing notes payable are included (completeness) • notes payable are accurately recorded (accuracy) • notes payable are properly aggregated and presented and related disclosures are adequate and understandable (presentation) Terms: Balance-related audit objectives in notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 35) Identify three substantive analytical procedures commonly performed for notes payable. Answer: Some possible analytical procedures for notes payable include: • Recalculate approximate interest expense on the basis of average interest rates and overall monthly notes payable. • Compare individual notes outstanding with the prior years. • Compare total balance in notes payable, interest expense, and accrued interest with prior year balances. Terms: Analytical procedures for notes payable Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 36) The starting point for the audit of notes payable is a schedule of notes payable and accrued interest. Discuss the information typically included in the schedule. Answer: The usual schedule includes detailed information of all transactions that took place during the entire year for principal and interest, the beginning and ending balances for notes and interest payable, and descriptive information about the notes, such as the due date, the interest rate, and the assets pledged as collateral. Terms: Information included in notes payable schedule Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking

37) You are employing tests of details of balances for notes payable and interest expense. Describe below specific audit procedures you would perform for the balance-related audit objectives of detail tie-in and existence. List at least two for each objective. Answer: Detail tie-in: (1) foot the notes payable list for notes payable and accrued interest, (2) trace the totals on the notes payable list to the general ledger, (3) trace the individual notes payable to the database. Existence: (1) confirm notes payable, (2) examine duplicate copies for authorization, (3) examine corporate minutes for loan approval. Terms: Tests of details of balances for notes payable - detail tie-in and existence of balancerelated audit objectives Difficulty: Moderate Objective: LO 22-2 AACSB: Reflective thinking 38) Discuss the four key controls over notes payable. Answer: The four key controls over notes payable are: • Proper authorization for the issue of new notes. Responsibility for the issuance of new notes should be vested in the board of directors or high-level management personnel, with signatures of multiple properly authorized officials required for all loan agreements. • Adequate controls over the repayment of principal and interest. At the time notes are issued, the accounting department should receive a copy in the same manner in which it receives vendors' invoices and receiving reports. The accounts payable department should automatically issue checks for the notes when they become due, in the same manner in which it prepares checks for acquisitions of goods and services. • Proper documents and records. These include the maintenance of subsidiary records and control over blank and paid notes by an authorized person. Paid notes should be cancelled and retained under the custody of an authorized official. • Periodic independent verification. The detailed note records should be reconciled periodically with the general ledger and compared with the note holders' records by an employee who is not responsible for maintaining the detailed records. At the same time, an independent person should recompute interest expense on notes to test the accuracy of the record keeping. Terms: Key controls Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking

39) Discuss the overall objectives of the audit of notes payable. Answer: The overall objectives of the audit of notes payable are to determine whether: • The system of internal controls over notes payable are adequate. • Transactions for principal and interest involving notes payable are properly authorized and recorded in accordance with the seven transaction-related audit objectives. • The liability for notes payable and the related interest expense and accrued liability are properly stated as defined by seven of the nine balance-related audit objectives (realizable value is excluded). • Notes payable and the related interest expense are properly aggregated and presented, and related disclosures are adequate and understandable. Terms: Objectives of audit of notes payable Difficulty: Challenging Objective: LO 22-2 AACSB: Reflective thinking

22.3 Learning Objective 22-3 1) Which of the following would generally not need to be approved by the board of directors? A) issuing capital stock B) repurchasing capital stock C) declaration of a dividend D) payment of a dividend Answer: D Terms: Not need approval by board of directors Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 2) Which of the following owners' equity transactions usually require specific authorization from a company's board of directors? A) Repurchase of common Issuance of common Declaration of dividends stock stock Yes Yes Yes B) Repurchase of common stock Yes

Issuance of common stock Yes

Declaration of dividends

C) Repurchase of common stock No

Issuance of common stock Yes

Declaration of dividends

D) Repurchase of common stock No

Issuance of common stock No

Declaration of dividends

Yes

Answer: A Terms: Owners' equity transactions that require specific authorization Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

3) When a company maintains its own records of stock transactions and outstanding stock, system of internal controls must be adequate to ensure that A) actual owners are recorded in the bylaws. B) the correct amount of dividends is paid to stockholders owning the stock on the dividend record date. C) the correct amount of dividends is paid to stockholders owning the stock on the declaration date. D) actual owners are recorded in the minutes. Answer: B Terms: Internal controls to maintain records of stock transactions and outstanding stock Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 4) The amount of time spent verifying owners' equity is frequently minimal for closely held corporations because A) these companies are so small that it is not necessary to audit the capital section. B) the few owners all have access to the books so the auditor spends more time on accounts like liabilities, which affect outsiders. C) there are few if any transactions during the year for the capital stock accounts, except for earnings and dividends. D) there is no public interest in these companies. Answer: C Terms: Time spent verifying owners' equity for closely held corporations Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 5) Which of the following types of owners' equity transactions would require authorization by the board of directors? A) issuance of capital stock B) repurchase of capital stock C) declaration of dividends D) all of the above Answer: D Terms: Owners' equity transaction requiring authorization by board of directors Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

6) The record of the issuance and repurchase of capital stock for the life of the corporation is maintained in the A) shareholders' capital stock database. B) capital stock certificate record. C) schedule of stock owners. D) corporate directory. Answer: B Terms: Record of issuance and repurchase of capital stock Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 7) The record of the outstanding shares at any given time is maintained in the A) corporate directory. B) stock certificate books. C) schedule of stock owners. D) shareholders' capital stock database. Answer: D Terms: Record of outstanding shares Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 8) When a dividend is declared by the board of directors, the source for determining who should receive dividend checks is the A) shareholders' capital stock database. B) stock certificate books. C) common stock account in the general ledger. D) corporate directory. Answer: A Terms: Source for determining who should receive dividend checks Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 9) The authorization of an issuance of capital stock normally includes all but which of the following? A) type of stock to be issued B) number of shares to be issued C) date shares are to be issued D) amount of dividend to be paid on shares issued Answer: D Terms: Authorization of issuance of capital stock includes Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 21 Copyright © 2023 Pearson Education, Inc.

10) Any company with stock listed on a securities exchange is required to engage a(n) A) equity analyst. B) stock transfer agent. C) independent registrar. D) equity placement specialist. Answer: C Terms: Company with stock listed on securities exchange required to engage Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 11) All of the following are owners' equity accounts except for A) common stock. B) paid-in-capital in excess of par. C) sales. D) retained earnings. Answer: C Terms: Owners' equity accounts Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking 12) Common hybrid securities do not include which of the following? A) treasury stock B) certain types of preferred stock C) convertible debt D) redeemable debt Answer: A Terms: Hybrid securities Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 13) The Securities and Exchange Commission requires companies listed on exchanges to employ stock transfer agents. Answer: FALSE Terms: Securities and Exchange Commission; Stock transfer agents Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking

14) Public companies whose stock is listed on a stock exchange must employ an independent registrar. Answer: TRUE Terms: Public companies with stock listed on stock exchange; Independent registrar Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking 15) The shareholders' capital stock database is used as the basis for the payment of dividends and also acts as a check on the accuracy of the common stock balance in the general ledger. Answer: TRUE Terms: Shareholders' capital database use Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking 16) Independent registrars commonly disburse cash dividends to shareholders. Answer: FALSE Terms: Independent registrars Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking 17) Few large companies employ stock transfer agents, but small companies commonly do so. Answer: FALSE Terms: Stock transfer agents Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 18) Most closely held corporations have numerous transactions during the year for capital stock accounts. Answer: FALSE Terms: Closely held company Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 19) A shareholders' capital stock database is a record of the issuance and repurchase of capital stock over the life of the corporation. Answer: TRUE Terms: Shareholders' capital stock database Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

20) The board of directors must authorize the amount of the dividend per share and the dates of record and payment date of the dividend. Answer: TRUE Terms: Board of directors and dividends Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 21) Financial instruments or securities that combine features of both debt and equity are commonly known as hybrid securities. Answer: TRUE Terms: Hybrid securities Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 22) When a company maintains its own records of stock transactions and capital stock outstanding, its system of internal controls must be adequate to accomplish three objectives. List them below. Answer: 1. Actual owners of the stock are recognized in the corporate records. 2. The correct amount of dividends is paid to stockholders owning the stock as of the dividend record date. 3. The potential for misappropriation of assets is minimized. Terms: Internal controls and objectives when records maintained of stock transactions and capital stock outstanding Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking

23) What is the difference between an independent registrar and a stock transfer agent? Answer: Companies whose shares are listed on a securities exchange are required to enlist the services of an independent registrar as a control to prevent the improper issue of stock certificates. The registrar is responsible for making sure that stock is issued by a corporation in accordance with the capital stock provisions in the corporate charter and the authorization by the board of directors. When there is a change in the ownership of the stock, the registrar is responsible for signing all newly issued stock certificates and making sure that old certificates are received and cancelled before a replacement certificate is issued. A stock transfer agent maintains stockholder records, including those documenting transfers of stock ownership. The employment of a transfer agent helps strengthen control over the stock records by putting the records in the hands of an independent organization and helps reduce the cost of record keeping by using a specialist. Many companies also have the transfer agent disburse cash dividends to shareholders, further improving system of internal control. Terms: Independent registrar and stock transfer agent differences Difficulty: Easy Objective: LO 22-3 AACSB: Reflective thinking 24) What are two important system of internal control procedures that companies should implement to prevent misstatements in owners' equity when a company maintains its own records of stock transactions and outstanding stock? Answer: Control procedures should include: 1. well-defined policies for preparing stock certificates and recording capital stock transactions 2. proper assignment of personnel 3. adequate record-keeping procedures 4. independent internal verification of information in the records. Terms: Procedures to prevent misstatements in owners' equity Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

25) Discuss the system of internal controls related to owners' equity that are of concern to the auditor. Answer: • Proper authorization of transactions. Material transactions should be approved by the board of directors, including issuance of capital stock, repurchase of capital stock, and declaration of dividends. • Proper recordkeeping and segregation of duties. This should include well-defined policies for preparing stock certificates and recording capital stock transactions, and independent internal verification of information in the records. Internal controls should be adequate to ensure that actual owners of the stock are recognized in the corporate records, the correct amount of dividends paid to the stockholders owning stock as of the record date, and the potential for misappropriations of assets is minimized. Many companies use a capital stock certificate book and a shareholders' capital stock database to improve control over capital stock transactions. • Independent registrar and stock transfer agent. An independent registrar acts as a control to prevent the improper issuance of stock certificates. A stock transfer agent acts as a control over the stock records. Terms: Internal controls related to owners' equity Difficulty: Challenging Objective: LO 22-3 AACSB: Reflective thinking

26) Match six of the terms (a-i) used in the capital acquisitions and repayment cycle with the descriptions provided below (1-6). a. capital acquisition and repayment cycle b. capital stock certificate record c. closely held corporation d. independent registrar e. notes payable f. publicly held corporation g. stock transfer agent h. schedule of notes payable and accrued interest i. stock maintenance agent ________ 1. an outside person engaged by a corporation to make sure that its stock is issued in accordance with capital stock provisions in the corporate charter and authorizations by the board of directors ________ 2. the normal starting point for the audit of notes payable; includes detailed information of all transactions related to notes payable that took place during the year ________ 3. a record of the issuance and repurchase of capital stock for the life of the corporation ________ 4. an outside person engaged by a corporation to maintain the stockholder records, and often to disburse cash dividends ________ 5. an entity that is required to engage an independent registrar ________ 6. the cycle that concerns the acquisition of capital resources through interest-bearing debt and owners' equity and repayment of the capital Answer: 1. d 2. h 3. b 4. g 5. f 6. a Terms: Capital acquisition and payment cycle; Capital stock certificate book; Independent registrar; Publicly held corporation; Stock transfer agent; Schedule of notes payable and accrued interest Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

27) One of the balance-related audit objectives of notes payable balances includes Are notes payable correctly classified on the balance sheet? (presentation). List two common tests of details for notes payable which should be considered in meeting this audit objective. Answer: Examine the due dates on notes payable to determine whether all or part of the notes are a noncurrent liability; review notes payable to determine whether any are related-party notes or accounts payable. Terms: Balance-related audit objectives for notes payable Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 28) One of the balance-related audit objectives of notes payable balances includes Are notes payable properly aggregated and presented, and are disclosures adequate and understandable? (presentation). List two common tests of details for notes payable which should be considered in meeting this audit objective. Answer: Trace aggregated notes payable balances to proper presentation in the financial statements; examine footnote disclosures to ensure all required disclosures are included and understandable. Terms: Balance-related audit objectives for notes payable Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking 29) Name some of the auditing procedures the auditor should consider in auditing hybrid financial instruments. Answer: Understand the legal structure of the security; understand and apply the relevant accounting standards; make a determination with regards to the initial recording of the security; consult with legal counsel, valuation experts, and technical accounting experts in addition to management with regards to the initial recording of the security; determine appropriate financial statement disclosures to convey the terms of the hybrid instrument, including information related to any conversion features, embedded features, and how the exercise of the embedded features impact the company and the financial statements. Terms: Hybrid securities Difficulty: Moderate Objective: LO 22-3 AACSB: Reflective thinking

22.4 Learning Objective 22-4 1) In auditing debits and credits to retained earnings, other than net income and dividends, the auditors first concern is A) whether the transactions should have been included in retained earnings. B) whether the transactions have been accurately recorded. C) whether the transactions are classified correctly in the footnotes. D) whether the transactions existed as of the balance sheet date. Answer: A Terms: Audit of retained earnings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 2) Which of the following is an important source of information for determining whether the presentation and disclosure-related objectives for capital stock activities are satisfied? A) the corporate charter B) the minutes of board of directors' meetings C) the auditor's analysis of capital stock transactions D) all of the above Answer: D Terms: Capital stock is properly presented and disclosed Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 3) Which of the following audit objectives is least important in the audit of capital stock and paid-in-capital in excess of par? A) completeness B) accuracy C) rights and obligations D) presentation and disclosure Answer: C Terms: Audit objective least important in audit of capital stock and paid-in capital Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking

4) The primary concern in determining whether retained earnings is correctly disclosed on the balance sheet is A) correct calculation of the net income or loss for the year. B) correct calculation of dividend payments for the year. C) whether prior-period adjustments have been made correctly. D) whether there are any restrictions on the payment of dividends. Answer: D Terms: Primary concern in determining correct disclosure of retained earnings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 5) When verifying if capital stock is accurately recorded, A) the ending balance in the account does not need to verified. B) the number of shares outstanding at the balance sheet date is verified by examining the corporate minutes. C) the recorded par value can be determined by multiplying the number of shares by the market price of the stock. D) a confirmation from the transfer agent is the simplest way to verify the number of shares outstanding at the balance sheet date. Answer: D Terms: Confirmation to auditor from capital stock registrar and/or transfer agent Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking

6) What type of audit test will auditors use when testing to see if the amounts of capital stock transactions are accurately recorded? A) Tests of details of Substantive tests of Tests of controls balances transactions No Yes Yes B) Tests of details of balances Yes

Substantive tests of transactions No

Tests of controls

Tests of details of balances No

Substantive tests of transactions Yes

Tests of controls

Tests of details of balances Yes

Substantive tests of transactions No

Tests of controls

Yes

Answer: D Terms: Capital stock transactions accurately recorded Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 7) Which of the following statements is correct regarding the audit of dividends? A) The emphasis is on the ending balance in the dividends account. B) When auditors verify that the dividends are paid to stockholders that exist, they are concerned with the completeness objective. C) If the client uses a transfer agent to disburse dividends, the total can be traced to a cash disbursement entry to the agent and also confirmed. D) All of the above are correct statements. Answer: C Terms: Audit of dividends Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking

8) When conducting the audit of stockholders' equity, it is normal practice to verify all capital stock transactions A) only when the client is small. B) that are in excess of a material amount. C) if there aren't very many during the year. D) regardless of the controls in existence, because of their materiality and permanence in the records. Answer: D Terms: Audit of stockholders' equity and verification of capital stock transactions Difficulty: Challenging Objective: LO 22-4 AACSB: Reflective thinking 9) If a company employs a capital stock registrar and/or transfer agent, the registrar or agent, or both, should be requested to confirm directly to the auditor the number of shares of each class of stock A) surrendered and canceled during the year. B) authorized at the balance sheet date. C) issued and outstanding at the balance sheet date. D) sold at a price above par during the year. Answer: C Terms: Confirmation to auditor from capital stock registrar and/or transfer agent Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 10) Auditing capital stock transactions as part of a merger is challenging because judgment is often involved. Answer: TRUE Terms: Audit of capital stock Difficulty: Easy Objective: LO 22-4 AACSB: Reflective thinking 11) A prior period adjustment may result in a debit or credit to a company's retained earnings account. Answer: TRUE Terms: Prior period adjustment and retained earnings Difficulty: Easy Objective: LO 22-4 AACSB: Reflective thinking

12) Any restrictions on the payment of dividends must be disclosed in the footnotes to the financial statements. Answer: TRUE Terms: Restrictions on payment of dividends disclosed in footnotes Difficulty: Easy Objective: LO 22-4 AACSB: Reflective thinking 13) The accuracy of a dividend declaration can be audited by recalculating the amount on the basis of the dividend per share times the number of shares outstanding. Answer: TRUE Terms: Accuracy of dividend declaration audit procedure Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 14) For most companies, the only transactions involving retained earnings are net earnings for the year and dividends declared. Answer: TRUE Terms: Transactions involving retained earnings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 15) Examining the minutes of the board of directors' meetings for proper authorization ordinarily tests the existence objective for capital stock transactions. Answer: FALSE Terms: Test existence objective for capital stock transactions; Examine minutes of board of directors' meetings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 16) Examining the minutes of the board of directors' meetings for proper authorization ordinarily tests the occurrence objective for capital stock transactions. Answer: TRUE Terms: Test occurrence objective for capital stock transactions; Examine minutes of board of directors' meetings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking

17) The emphasis in the audit of dividends is on the ending balance rather than the transactions. Answer: FALSE Terms: Emphasis in audit of dividends Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 18) Auditors can test whether dividend payments have been made to shareholders by selecting a sample of recorded dividend payments and agreeing payee information to the records produced by the stock transfer agent. Answer: TRUE Terms: Audit of dividends Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 19) Auditors can test whether dividend payments have been made to shareholders by selecting a sample of recorded dividend payments and agreeing payee information on the cancelled check to the dividend records. Answer: TRUE Terms: Audit of dividends Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 20) Unpaid dividends to shareholders should be tested by the auditor to ensure they are recorded as current assets on the balance sheet. Answer: FALSE Terms: Audit of dividends Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking 21) If there is an adjustment to retained earnings resulting from a change in accounting principle, the auditor should test the prior period effects of the change, but not test the entry to adjust prior period balances or retained earnings. Answer: FALSE Terms: Audit of retained earnings Difficulty: Moderate Objective: LO 22-4 AACSB: Reflective thinking

22) State the four most important audit objectives for capital stock and describe how the auditor typically verifies each of the four objectives. Answer: The four most important audit objectives for capital stock are: • Existing capital stock transactions are recorded (completeness). Confirm with the registrar or transfer agent whether any capital stock transactions occurred. • Recorded capital stock transactions occurred and are accurately recorded (occurrence and accuracy). Existence can be tested by examining the minutes of the board of directors' meetings for proper authorization. Accuracy can be tested by confirming the amount with the transfer agent and tracing the amount of the recorded capital stock transactions to the cash receipts journal. • Capital stock is accurately recorded (accuracy). The ending balance in the capital stock account is verified by first determining, via confirmation from the transfer agent, the number of shares outstanding at the balance sheet date. The recorded par value in the capital account can be verified by multiplying the number of shares outstanding by the par value of the stock. • Capital stock is properly presented and disclosed (presentation and disclosure). Using the corporate charter, the minutes of board of directors' meeting and the auditor's analysis of capital stock transactions, the auditor should determine that there is a proper description of each class of stock. The proper presentation and disclosure of stock options, stock warrants, and convertible securities should also be verified by examining legal documents or other evidence of the provisions of these agreements. Terms: Important audit objectives for capital stock and how they are verified Difficulty: Challenging Objective: LO 22-4 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 23 Audit of Cash and Financial Instruments 23.1 Learning Objective 23-1 1) Which of the following is not a "cash equivalent"? A) time deposits B) certificates of deposit C) money market funds D) marketable securities Answer: D Terms: Cash equivalent Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking 2) An imprest petty cash fund would least likely be used to pay for which of the following items? A) minor office supplies B) monthly interest expense C) stamps for small mailings D) small contributions to a local charity Answer: B Terms: Imprest petty cash fund Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking 3) An imprest petty cash fund A) is a bank account. B) is used for large, unusual purchases. C) is usually reimbursed at least once a week for good internal control. D) is being replaced by pre-approved purchase cards in many companies. Answer: D Terms: Examination of imprest petty cash fund Difficulty: Moderate Objective: LO 23-1 AACSB: Analytic thinking

4) Financial instruments A) include debt securities and money market funds. B) such as derivatives can be used as a way of hedging. C) must be classified as held-to-maturity securities. D) All of the above are correct. Answer: B Terms: Financial instruments Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking 5) Companies may purchase marketable securities as a way to temporarily invest excess cash. Answer: TRUE Terms: Financial instruments Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking 6) Examples of cash equivalents include time deposits, certificates of deposit, and marketable securities. Answer: FALSE Terms: Cash equivalent Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking 7) Branch bank accounts are useful for building banking relations in local communities. Answer: TRUE Terms: Types of cash accounts Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 8) Cash is the only account included in every cycle except inventory and warehousing. Answer: TRUE Terms: Cash accounts Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 9) The evidence accumulated for cash balances depends heavily on the results of tests performed in the other major transaction cycles. Answer: TRUE Terms: Cash accounts Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

10) Cash is important because of its susceptibility to theft, and cash can be significantly misstated as illustrated in the China Media Express case. Answer: TRUE Terms: Cash accounts Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 11) Financial instruments, which include investments in debt and equity securities as well as derivative instruments, vary in significance across audit clients. Answer: TRUE Terms: Types of cash accounts Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 12) A growing number of organizations, especially larger organizations, use pre-approved Vcards to make miscellaneous purchases instead of maintaining a petty cash fund. Answer: FALSE Terms: P-cards (purchasing cards) usage Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 13) Consistent with financial accounting standards, equity investments are normally recorded at cost until they are disposed of in the future. Answer: FALSE Terms: Financial instruments Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking 14) Debt instruments can be classified as trading securities, available-for-sale securities, or heldto-maturity securities; auditors should ensure that such debt instruments are classified, properly, in the financial statements consistent with accounting standards. Answer: TRUE Terms: Financial instruments Difficulty: Easy Objective: LO 23-1 AACSB: Reflective thinking

15) Describe each of the major types of cash accounts maintained by business entities. Answer: • General cash account. This is the focal point of cash for most organizations because virtually all cash receipts and disbursements flow through this account. • Imprest payroll account. As a means of improving system of internal control, many companies establish a separate imprest bank account for making payroll payments to employees. In such an account, a fixed balance, such as $1,000, is maintained. Immediately before each pay period, one check or electronic transfer is drawn on the general cash account to deposit the total amount of the net payroll into the imprest payroll account. • Branch bank account. For a company operating in multiple locations or having different company branches, it is often desirable to have a separate bank balance at each location. Branch bank accounts are useful for building public relations in local communities and permitting the centralization of operations at the branch level. • Imprest petty cash fund. This fund is used for small cash acquisitions that can be paid more conveniently and quickly by cash than by check, or for the convenience of employees in cashing personal or payroll checks. • Cash equivalents. Excess cash accumulated during certain parts of the operating cycle that will be needed in the reasonably near future is often invested in short-term, highly liquid cash equivalents such as time deposits, certificates of deposit, and money market funds. Terms: Major types of cash accounts Difficulty: Moderate Objective: LO 23-1 AACSB: Reflective thinking

23.2 Learning Objective 23-2 1) Which of the following misstatements is most likely to be uncovered during an audit of a client's bank reconciliation? A) duplicate payment of a vendor's invoice B) billing a customer at a lower price than indicated by company policy C) failure to record a collection of a note receivable by the bank on the client's behalf D) payment to an employee for more than the hours actually worked Answer: C Terms: Bank reconciliation Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking 2) Which of the following is likely to be detected as part of the audit of the bank reconciliation? A) failure to bill a customer B) duplicate payment of a vendor invoice C) cash received by the client after year-end, but included in cash receipts in the current year D) an embezzlement of cash by intercepting cash receipts from customers before they are recorded Answer: C Terms: Bank reconciliation Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking 3) Which of the following would normally be discovered as part of the audit of the bank reconciliation? A) failure to bill a customer B) failure to include a deposit in transit on the bank reconciliation C) duplicate payment of a vendor's invoice D) payment to an employee for more hours than she or he worked Answer: B Terms: Bank reconciliation Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking

4) The general cash account is considered a significant account in almost all audits A) where the ending balance is material. B) even when the ending balance is immaterial. C) except those of not-for-profit organizations. D) where either the beginning or ending balance is material. Answer: B Terms: General cash account Difficulty: Moderate Objective: LO 23-2 AACSB: Reflective thinking 5) Which of the following is an accurate statement regarding cash? A) The amount of cash flowing into and out of the cash account is often larger than that for any other account in the financial statements. B) The susceptibility of cash to embezzlement is greater than that for other types of assets. C) Auditors must verify whether recorded cash in the general ledger correctly reflects all cash transactions that took place during the year. D) All of the above are accurate statements. Answer: D Terms: Cash in bank Difficulty: Moderate Objective: LO 23-2 AACSB: Reflective thinking 6) Which of the following cycles does not affect cash in bank? A) capital acquisitions cycle B) inventory and warehousing C) payroll and personnel cycle D) acquisitions and disbursements Answer: B Terms: Cash in bank Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking 7) The general cash account will not be audited if the ending balance is immaterial. Answer: FALSE Terms: Cash in bank Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking

8) List at least three misstatements that are designed to be detected by a bank reconciliation. Answer: 1. Failure to include a check that has not cleared the bank on the outstanding checklist, even though it has been recorded on the cash disbursement journal 2. Cash received by the client subsequent to the balance sheet date, but recorded as cash receipts in the current year 3. Deposits recorded as cash receipts near the end of the year, deposited in the bank in the same month, and included in the bank reconciliation as a deposit in transit 4. Payments on notes payable debited directly to the bank balance by the bank but not entered in the client's records Terms: Bank reconciliation audit tests; Detected misstatements Difficulty: Easy Objective: LO 23-2 AACSB: Reflective thinking 9) "Failure to bill a customer" is an example of an error that results in the failure to receive cash, but would not be discovered as part of the audit of the bank reconciliation. State three other examples of errors or irregularities that result in the improper payment of, or failure to receive, cash, but that would not be discovered during the audit of the bank reconciliation. How are these types of misstatements normally uncovered in the audit? Answer: • An embezzlement of cash by intercepting cash receipts from customers before they are recorded with the account charged off as a bad debt • Duplicate payment of a vendor's invoice • Improper payments of officers' personal expenditures • Payment for raw materials that were not received • Payment to an employee for more hours than he or she worked • Payment of interest to a related party for an amount that exceeds the market rate If these misstatements are to be uncovered in the audit, their discovery must occur through tests of controls and substantive tests of transactions. Terms: Improper payment or failure to receive cash but not discovered during audit of bank reconciliation Difficulty: Challenging Objective: LO 23-2 AACSB: Reflective thinking

23.3 Learning Objective 23-3 1) The test of details of balances procedure that requires the auditor to foot the outstanding check and electronic payment list and deposits in transit is an attempt to satisfy which audit objective? A) cutoff B) presentation and disclosure C) detail tie-in D) completeness Answer: C Terms: Test of details of balances procedure Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 2) The audit objective of determining that cash in bank, as stated on the reconciliation, foots correctly and agrees with the general ledger can be tested by which of the following procedures? A) performing tests for kiting B) receiving and testing a cutoff bank statement C) proving the bank reconciliation as to additions and subtractions, including all reconciling items D) examining the minutes of the board of directors for restrictions on the use of cash Answer: C Terms: Audit objective; Cash in bank; Reconciliation Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 3) The test of details of balances procedure that requires the auditor to trace the book balance on the reconciliation to the general ledger is an attempt to satisfy the audit objective of A) detail tie-in. B) existence. C) completeness. D) accuracy. Answer: A Terms: Test details of balances procedure; Reconciliation Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking

4) Which of the following statements is correct? A) Auditors must obtain bank confirmations for audits of nonpublic entities. B) Auditors are required to obtain bank confirmations under international auditing standards. C) Auditing standards do not address specific requirements regarding bank confirmations. D) Auditing standards do not require bank confirmations. Answer: D Terms: Bank confirmation Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 5) A partial-period bank statement and the related copies of or digital access to cancelled checks, duplicate deposit slips, and other documents included in bank statements, mailed by the bank directly to the CPA firm's office, is called A) a four-column proof of cash. B) a year-end bank statement. C) a cutoff bank statement. D) a short-period bank statement. Answer: C Terms: Partial-period bank statement Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 6) Which of the following statements is correct? A) Bank personnel are responsible for providing reasonable assurance that a response to a bank confirmation is accurate. B) Bank personnel are responsible for providing complete assurance that a bank confirmation is complete. C) Bank personnel are not responsible for searching their records for bank balances or loans beyond those included on the bank confirmation. D) Bank personnel are not responsible for providing information related to interest on the bank confirmation. Answer: C Terms: Bank confirmation Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking

7) In addition to confirming bank balances of your audit client, a bank confirmation would normally contain A) the client's bank loans with due date, interest rate, and collateral requested. B) the client's credit history as regards to paying back loans. C) the client's managements bank account information. D) the client's business prospects. Answer: A Terms: Bank confirmation Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 8) Which of the following balance-related audit objectives typically is assessed as having high inherent risk for cash? A) existence B) cutoff C) detail tie-in D) presentation and disclosure Answer: A Terms: Balance-related audit objectives; High inherent risk for cash Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 9) Because cash is the most desirable asset for people to steal, it has a higher A) control risk. B) inherent risk. C) detection risk. D) liquidity risk. Answer: B Terms: Cash; Risk Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 10) The starting point for the verification of the balance in the general bank account is to obtain A) a bank reconciliation from the client. B) the client's cash account from the general ledger. C) a cutoff bank statement directly from the bank. D) the client's year-end bank statement. Answer: A Terms: Verification of balance in the general bank account Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

11) In an effort to satisfy the completeness objective, the auditor could perform which of the following tests of details of balance procedures? A) Trace the book balance on the reconciliation to the general ledger. B) Trace outstanding checks to subsequent period bank statements. C) Perform a four-column proof of cash. D) Review financial statements to make sure that material savings accounts and certificates of deposit are disclosed separately. Answer: C Terms: Completeness objective; Test of details of balance procedures Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 12) The audit procedure which requires the auditor to record the last check number used on the last day of the year and subsequently trace to the outstanding checks and the cash disbursements records is performed to satisfy the audit objective of A) detail tie-in. B) existence. C) completeness. D) cutoff. Answer: D Terms: Audit procedure to record last check number used Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 13) The direct receipt of a confirmation from every bank with which the client does business is A) required by auditing standards for every audit. B) not necessary unless material fraud is suspected. C) recommended but not required by auditing standards. D) necessary for every audit except when there are an unusually large number of active accounts. Answer: C Terms: Direct receipt of confirmation from every bank Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

14) The reason for testing the client's bank reconciliation is to verify whether the client's recorded bank balance is the same amount as the actual cash in bank, except for deposits in transit, checks outstanding, and other reconciling items. The information needed to complete the tests of the reconciliation is provided by the A) client's records and ledgers for the year under audit. B) cutoff bank statement. C) client's records and ledgers for the subsequent year. D) canceled checks for the year under audit. Answer: B Terms: Bank reconciliation; Deposits in transit; Outstanding checks Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 15) Which of the following items would not normally appear on bank reconciliations? A) balance per bank B) list of deposits in transit C) outstanding deposits D) outstanding checks Answer: C Terms: Bank reconciliation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

16) If a bank does not respond to a bank confirmation request, the auditor would most likely A) Perform alternative Send a second Ask the client to procedures request communicate with the bank to ask them to complete and return the confirmation No Yes Yes B) Perform alternative procedures

Send a second request

C) Perform alternative procedures

Send a second request

Yes

D) Perform alternative procedures

Send a second request

Yes

Ask the client to communicate with the bank to ask them to complete and return the confirmation Yes

Ask the client to communicate with the bank to ask them to complete and return the confirmation No

Answer: A Terms: Bank confirmation request Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 17) The most important balance-related audit objectives in the audit of cash include all except which of the following? A) existence B) accuracy C) completeness D) occurrence Answer: D Terms: Balance-related audit objectives in the audit of cash Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

18) The bank reconciliation A) must be done on a daily basis if the client uses electronic banking. B) should be performed by someone independent of the handling or recording of cash receipts. C) should be performed by someone who handles cash disbursements. D) ensures that no cash has been embezzled. Answer: B Terms: Bank fraud protection tools Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 19) ________ is an automated fraud detection tool offered by most banks. A) Positive pay B) A bank confirmation C) Fraud buster D) Check matching Answer: A Terms: Bank reconciliation Difficulty: Moderate Objective: LO 23-3 AACSB: Analytic thinking 20) Which of the following balance-related objectives applies to auditing the general cash account? A) Rights Classification Realizable value Yes No Yes B) Rights No

Classification Yes

Realizable value No

Rights Yes

Classification Yes

Realizable value Yes

Rights No

Classification No

Realizable value No

Answer: D Terms: Balance-related objective applied to auditing the general cash account Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking

21) The standard bank confirmation form has been agreed upon by the A) SEC and FASB. B) AICPA and the SEC. C) SEC and the American Bankers' Association. D) AICPA and the American Bankers' Association. Answer: D Terms: Standard bank confirmation Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking 22) The auditors test the client's monthly bank reconciliation to verify whether the client's recorded bank balance is the same amount as the actual cash in the bank. Which of the following would not explain a difference between the company's cash balance and the bank's balance for the client? A) Deposits in transit B) Checks are written by the client in the same month the checks clear the bank. C) Other reconciling items D) Outstanding checks Answer: B Terms: Bank reconciliation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 23) If an auditor waits until the subsequent period bank statement is available to verify reconciling items, it is primarily a test for A) errors. B) omissions. C) kiting. D) intentional misstatements. Answer: D Terms: Auditor proves the bank statement Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking

24) Which of the following verifications would generally not be performed by the auditor in the month subsequent to the balance sheet date? A) Foot the lists of all canceled checks, debit memos, deposits, and credit memos. B) Verify the bank statement balances when the footed totals are used. C) Verify the book statement balances tie to the cash receipts and disbursements journals for the year under audit. D) Review the items included in the footings to make sure that they were cancelled by the bank. Answer: C Terms: Verifications performed in the month subsequent to balance sheet date Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 25) When assessing risks affecting cash, A) if a business defers preparing bank reconciliations for long periods, the value of the control is reduced and may affect the auditor's assessment of control risk for cash. B) most companies are likely to have significant client business risks affecting their cash balances. C) there is a low inherent risk for the existence and completeness objectives for cash. D) all of the above are accurate statements. Answer: A Terms: Cash; Risk Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 26) Which of the following is not included in Phase I of the auditing of year-end general cash balances? A) Identify client business risks affecting cash. B) Design and perform tests of controls and substantive tests of transactions. C) Set performance materiality and assess inherent risk. D) Assess control risk. Answer: B Terms: Methodology for auditing year-end cash Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 27) The bank reconciliation control is enhanced when a qualified employee reviews the monthly reconciliation as soon as possible after its completion. Answer: TRUE Terms: Bank reconciliation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

28) Many of the auditor's procedures in the audit of cash center around the client's bank confirmations. Answer: FALSE Terms: Audit of cash; Bank confirmations Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 29) Tracing outstanding checks to subsequent period bank statements tests the cutoff audit objective. Answer: TRUE Terms: Tracing outstanding checks; Cutoff audit objective Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 30) When auditing the year-end cash balance, one of the areas of focus is on the accuracy objective. Answer: TRUE Terms: Auditing year-end cash balance; Accuracy objective Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 31) The three most important audit objectives for cash are accuracy, existence, and classification. Answer: FALSE Terms: Audit objectives for cash Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 32) The starting point for the verification of the balance in the general bank account is to obtain a bank cutoff statement. Answer: FALSE Terms: General bank account; Bank cutoff statement Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 33) When auditing the general cash account, receipt of a standard bank confirmation is the starting point for verifying the company's general cash account balance. Answer: FALSE Terms: General cash account; Standard bank confirmation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 17 Copyright © 2023 Pearson Education, Inc.

34) To test the client's list of outstanding checks on the bank reconciliation for completeness, the auditor should trace from the list to the checks included with the cutoff bank statement. Answer: FALSE Terms: Outstanding checks on bank reconciliation for completeness; Cutoff bank statement Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 35) The client may mail the bank confirmation requests if the auditor believes doing so will increase the likelihood that the confirmation will be returned promptly. Answer: FALSE Terms: Bank confirmation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 36) Auditors usually design bank confirmations that address the client's specific circumstances. Answer: FALSE Terms: Bank confirmation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 37) Ordinarily, all deposits-in-transit listed on the year-end bank reconciliation should appear as deposits on the cutoff bank statement. Answer: TRUE Terms: Deposits-in-transit; Year-end bank reconciliation; Cutoff bank statement Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 38) Auditors are not always required to obtain bank confirmations. Answer: TRUE Terms: Bank confirmation Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking 39) The auditor is generally concerned about the realizable value and the rights to cash. Answer: FALSE Terms: Audit of cash Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

40) A statement near the bottom of the standard bank confirmation form requires the bank to inform auditors of open lines of credit and compensating balance requirements. Answer: FALSE Terms: Bank confirmation Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 41) The methodology for auditing year-end cash is generally the same as the auditing for all other balance sheet accounts. Answer: TRUE Terms: Audit objectives of the general cash account Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 42) A monthly bank reconciliation of the general bank account on a timely basis by someone involved in either the handling or the recording of cash receipts and disbursements is an essential control over the ending cash balance. Answer: FALSE Terms: Importance of monthly bank reconciliation and separation of duties Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 43) Positive pay reduces potential check fraud by matching account number, check number, and dollar amounts of each check presented for payment against the electronic records of checks provided by the company. Answer: TRUE Terms: Positive pay reducing check fraud Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 44) The presentation of cash in the financial statements is normally straightforward unless restrictions on cash or compensating balance agreements with a bank exist. Answer: TRUE Terms: Presentation of cash in the financial statements Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking

45) A common test of details the auditor should perform with regards to determining if cash is appropriately described and presented in the financial statements is to review the Board of Director minutes and loan agreements for any restrictions on cash. Answer: TRUE Terms: Positive pay reducing check fraud Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 46) Internal controls over year-end cash balances in the general account can be divided into two categories. List the two below. Answer: 1. controls over the transaction cycles affecting the recording of cash receipts and cash disbursements 2. independent bank reconciliations Terms: Internal controls over year-end cash balances Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking 47) Explain what is meant by a cutoff bank statement, and discuss the purpose of the cutoff bank statement in the audit of cash. Answer: A cutoff bank statement is a partial-period bank statement and the related copies of or digital access to cancelled checks, duplicate deposit slips, and other documents included in bank statements, mailed by the bank directly to the CPA firm's office or through online access to the bank's electronic records of the client's bank account information. The purpose of the cutoff bank statement or electronic access to account information on the bank's system is to verify the reconciling items on the client's year-end bank reconciliation with evidence that is maintained by the bank, not the client. Terms: Cutoff bank statement; Audit of cash Difficulty: Easy Objective: LO 23-3 AACSB: Reflective thinking

48) Explain the purpose of testing the client's bank reconciliation, and discuss the major audit procedures involved. Answer: Auditors test the bank reconciliation to determine whether client personnel have carefully prepared the bank reconciliation and to verify whether the client's recorded bank balance is the same amount as the actual cash in the bank except for deposits in transit, outstanding checks, and other reconciling items. Procedures include: • Verify that the client's bank reconciliation is mathematically accurate. • Trace the balance on the bank confirmation and/or the beginning balance shown in online client banking records or in the cutoff statement to the balance per bank on the bank reconciliation to ensure they are the same. • Trace checks written and recorded before year-end and included with the cutoff bank statement to the list of outstanding checks on the bank reconciliation and to the cash disbursements journal in the period or periods prior to the balance sheet date. • Investigate all significant checks included on the outstanding check list that have not cleared the bank on the cutoff statement. • Trace deposits in transit to the cutoff bank statement. • Account for other reconciling items on the bank statement and bank reconciliation. Terms: Testing client's bank reconciliation and major audit procedures Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking 49) Instead of receiving a cutoff bank statement or if online access to client bank account information is not available to the auditor, auditors can wait until the subsequent period bank statement is available to verify reconciling items. Discuss the purpose of reviewing the subsequent period bank statement and list the verifications the auditor performs on this bank statement. Answer: The purpose of such a proof is to test whether the client's employees have omitted, added, or altered any of the documents accompanying the statement. Obviously, this tests for intentional misstatements. The audit procedures include footing the lists of all the cancelled checks, debit memos, deposits, and credit memos; verifying that the bank statement balances when the footed totals are used; and reviewing the items included in the footings to make sure that they were cancelled by the bank in the proper period and do not include any erasures or alterations. Terms: Prove subsequent period bank statement and audit procedures Difficulty: Challenging Objective: LO 23-3 AACSB: Reflective thinking 50) In testing the year-end balance in the general cash account, the auditor must accumulate sufficient appropriate evidence to evaluate whether cash, as stated on the balance sheet, is fairly stated and properly disclosed in accordance with six of the nine balance-related audit objectives used for all tests of details of balances. Name those six audit objectives. Answer: Existence; completeness; accuracy; cutoff; detail tie-in; and presentation Terms: Audit objectives of the general cash account Difficulty: Moderate Objective: LO 23-3 AACSB: Reflective thinking 21 Copyright © 2023 Pearson Education, Inc.

23.4 Learning Objective 23-4 1) Auditors are likely to prepare a proof of cash when the client has A) material system of internal control weaknesses in cash. B) material system of internal control weaknesses in accounts receivable and revenue. C) material system of internal control weaknesses in accounts payable and inventory. D) material system of internal control weaknesses in payroll. Answer: A Terms: Proof of cash Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 2) The auditor uses a proof of cash to determine whether A) All recorded cash disbursements All amounts that were paid by the were paid by the bank. bank were recorded. Yes Yes B) All recorded cash disbursements were paid by the bank. No

All amounts that were paid by the bank were recorded. No

C) All recorded cash disbursements were paid by the bank. Yes

All amounts that were paid by the bank were recorded. No

D) All recorded cash disbursements were paid by the bank. No

All amounts that were paid by the bank were recorded. Yes

Answer: A Terms: Proof of cash Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking

3) A proof of cash represents A) a test of controls and substantive test of transactions. B) a substantive test of transactions. C) a substantive test of transactions and test of details of balances. D) a test of details of balances. Answer: C Terms: Proof of cash Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 4) A major consideration in the audit of the general cash balance is the possibility of fraud. The auditor must extend his or her procedures in the audit of year-end cash to determine the possibility of a material fraud when there are A) large cash balances at the end of the year. B) large cash receipts and disbursements during the year. C) no imprest accounts used for payroll. D) inadequate system of internal controls. Answer: D Terms: Material fraud; Extend procedures in audit of year-end cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 5) The audit and accounting concern addressed in a monthly proof of cash is with A) adjusting account balances. B) reconciling the amounts recorded in the books with the amounts included in the bank statement. C) determining the month-end balance. D) identifying cash transfers. Answer: B Terms: Monthly proof of cash Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 6) A proof of cash is effective at identifying which of the following misstatements? A) checks written for an improper amount B) checks issued to invalid vendors C) fraudulent checks D) checks recorded in the books for an amount different from that on the check Answer: D Terms: Proof of cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 23 Copyright © 2023 Pearson Education, Inc.

7) The process of transferring money from one bank account to another and improperly recording the transaction is referred to as A) kiting. B) lapping. C) scamming. D) embezzling. Answer: A Terms: Transferring money from one bank account to another and improperly recording the transaction Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 8) Which of the following is a correct statement? A) The proof of cash receipts is a test of the balance in the cash account at a point in time. B) The proof of cash disbursements is effective for discovering a check written for the incorrect amount for which the dollar amount in cash disbursements is also incorrect. C) It is extremely difficult for an auditor to detect thefts of cash, especially omitted transactions and account balances. D) Segregation of duties is not an important control procedure for cash in a small business. Answer: C Terms: Audit of cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking

The following information applies to the questions below. Listed below are four interbank cash transfers, indicated by the numbers 1, 2, 3, and 4, of a client for late December 2022 and early January 2023: Bank Account One Disbursing Date (Month/Day) Per Bank Per Books 1. 12/31 12/30 2. 1/2 12/30 3. 1/3 12/31 4. 1/3 12/31

Bank Account Two Receiving Date (Month/Day) Per Bank Per Books 12/31 12/30 12/31 12/31 1/2 1/2 1/2 12/31

9) Based on the schedule of interbank transfers above, which of the cash transfers indicates an error in cash cutoff at December 31, 2022? A) 1 B) 2 C) 3 D) 4 Answer: C Terms: Interbank cash transfers Difficulty: Challenging Objective: LO 23-4 AACSB: Analytic thinking 10) Based on the schedule of interbank transfers above, which of the cash transfers would appear as a deposit in transit on the December 31, 2022 bank reconciliation? A) 1 B) 2 C) 3 D) 4 Answer: D Terms: Interbank cash transfers Difficulty: Challenging Objective: LO 23-4 AACSB: Analytic thinking

11) Based on the schedule of interbank transfers above, which of the cash transfers would not appear as an outstanding check on the December 31, 2022 bank reconciliation? A) 1 B) 2 C) 3 D) 4 Answer: A Terms: Interbank cash transfers Difficulty: Challenging Objective: LO 23-4 AACSB: Analytic thinking 12) A proof of cash is not an effective procedure for identifying which of the following types of misstatements? A) All recorded disbursements were paid by the bank. B) All recorded cash receipts were deposited. C) All amounts that were paid by the bank were recorded. D) Some checks were written for incorrect amounts. Answer: D Terms: Proof of cash; Misstatements Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 13) Listing all bank transfers made a few days before and after the balance sheet date and tracing each to the accounting records for proper recording is a useful approach to test for A) kiting. B) lapping. C) income smoothing. D) channel stuffing. Answer: A Terms: Bank transfers Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 14) Procedures that may uncover fraud in the cash receipts include A) confirmation of accounts payable. B) comparison of purchase orders to invoices. C) tests performed to detect lapping. D) all of the above. Answer: C Terms: Fraud; Cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

15) Which of the following should be audited on the interbank transfer schedule? A) Receipts on the interbank transfer schedule should be correctly included in or excluded from year-end bank reconciliations as deposits in transit. B) Disbursements on the interbank transfer schedule must always be shown as outstanding checks. C) The interbank transfers cannot be recorded in both the receiving and disbursing banks. D) All transfers that occurred for the month before and the month after the year-end must be included on the interbank transfer schedule. Answer: A Terms: Interbank cash transfers Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 16) On the last day of the fiscal year, the cash disbursements clerk drew a company check on bank A and deposited the check in the company account in bank B to cover a previous theft of cash. The disbursement has not been recorded. The auditor will best detect this form of kiting by A) examining the composition of deposits in both bank A and bank B subsequent to year-end. B) examining paid checks returned with the bank statement of the next account period after yearend. C) preparing, from the cash disbursements records, a summary of bank transfers for one week prior to and subsequent to year-end. D) comparing the detail of cash receipts as shown by the client's cash receipts records with the detail on the confirmed duplicate deposit tickets for three days prior to and subsequent to yearend. Answer: B Terms: Cash disbursements; Kiting Difficulty: Challenging Objective: LO 23-4 AACSB: Analytic thinking 17) When the auditor believes the year-end bank reconciliation may be intentionally misstated, it is appropriate to perform extended tests of the year-end bank reconciliation. Assuming the client has an October 31 year-end, these extended tests would not include A) comparing all September 30 reconciling items with canceled checks and other documents in the October bank statement. B) comparing all canceled checks and deposit slips in the October bank statement with the October cash disbursements and receipts records. C) carrying out all proper procedures subsequent to the end of the year with the use of the bank cutoff statement. D) determining that all outstanding checks had cleared by the date of the bank cutoff statement. Answer: D Terms: Bank reconciliation; Extended tests Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 27 Copyright © 2023 Pearson Education, Inc.

18) A proof of cash involves a combination of substantive tests of transactions and tests of details of balances. Answer: TRUE Terms: Proof of cash; Substantive tests of transactions and tests of details of balances Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 19) A proof of cash includes a reconciliation of cash receipts deposited in the bank with the cash disbursements records for a given period. Answer: FALSE Terms: Proof of cash; Reconciliation of cash receipts deposited in the bank with cash disbursements Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 20) The transfer of money from one bank account to another and improperly recording the transfer so that the amount is recorded as an asset in both banks is referred to as kiting. Answer: TRUE Terms: Kiting Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking 21) Tests for kiting are performed using only a schedule of intrabank transfers. Answer: FALSE Terms: Tests for kiting Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 22) A proof of cash helps the auditor determine whether all recorded cash receipts were deposited in the bank and whether all recorded cash disbursements were paid by the bank. Answer: TRUE Terms: Proof of cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 23) A proof of cash receipts is not useful for uncovering the theft of cash receipts or the recording and deposit of an improper amount of cash. Answer: TRUE Terms: Proof of cash receipts; Theft of cash receipts Difficulty: Challenging Objective: LO 23-4 AACSB: Reflective thinking 28 Copyright © 2023 Pearson Education, Inc.

24) A proof of cash disbursements is not effective for discovering checks written for an improper amount, fraudulent checks, or misstatements in which the dollar amount appearing in the cash disbursements records is incorrect. Answer: TRUE Terms: Proof of cash disbursements Difficulty: Challenging Objective: LO 23-4 AACSB: Reflective thinking 25) The auditor must extend the audit procedures in the audit of year-end cash when there are inadequate system of internal controls. Answer: TRUE Terms: Audit procedures; Inadequate system of internal controls Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 26) Only tests of details of cash balances are useful when auditors are specifically testing for fraud. Answer: FALSE Terms: Fraud; Cash Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 27) Auditors will often prepare a proof of cash when the client has material system of internal control weaknesses in cash receipts and cash disbursements. The purpose of the proof of cash is to determine whether the client's accounting records for cash are reliable. List below the four requirements the proof of cash is designed to provide for the auditor. Answer: 1. All recorded cash receipts were deposited. 2. All deposits in the bank were recorded in the accounting records. 3. All recorded cash disbursements were paid by the bank. 4. All amounts that were paid by the bank were recorded. Terms: Proof of cash requirements Difficulty: Easy Objective: LO 23-4 AACSB: Reflective thinking

28) A proof of cash includes four reconciliation tasks. List below two of those tasks. Answer: 1. Reconcile the balance on the bank statement with the general ledger balance at the beginning of the proof-of-cash period. 2. Reconcile cash receipts deposited per the bank with the receipts recorded in the cash receipts journal for a given period. 3. Reconcile electronic payments and cancelled checks clearing the bank with those recorded in the cash disbursements journal for a given period. 4. Reconcile the balance on the bank statement with the general ledger balance at the end of the proof-of-cash period. Terms: Proof of cash requirements Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 29) What should be audited on an interbank transfer schedule? Answer: 1. The accuracy of the information on the interbank transfer schedule should be verified. 2. The interbank transfers must be recorded in both the receiving and disbursing banks. 3. The date of the recording of the disbursements and receipts for each transfer must be in the same fiscal year. 4. Disbursements on the interbank transfer schedule should be correctly included in or excluded from year-end bank reconciliations as outstanding checks. 5. Receipts on the interbank transfer schedule should be correctly included in or excluded from year-end bank reconciliations as deposits in transit. Terms: Audit of interbank transfer schedule Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking 30) Explain kiting, and discuss how it is performed. Answer: Kiting is the transfer of money from one bank to another and incorrectly recording the transaction to cover a theft of cash. Near the balance sheet date, a check is drawn on one bank account and immediately deposited in a second account for credit before the end of the accounting period. In making this transfer, the embezzler is careful to make sure that the check is deposited at a late enough date so that it does not clear the first bank until after the end of the period. If the interbank transfer is not recorded until after the balance sheet date, the amount of the transfer is recorded as an asset in both banks. Terms: Kiting Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking

31) Match six of the terms (a-k) with the descriptions/definitions provided below (1-6). a. b. c. d. e. f. g. h. i. j. k.

bank reconciliation branch cash account cash equivalents cutoff bank statement general cash account imprest payroll account imprest petty cash fund kiting proof of cash standard bank confirmation form lapping

________ 1. a fund of cash maintained within the company for small cash acquisitions, expenses, or to cash employees' checks ________ 2. a form approved by the AICPA and American Bankers' Association through which the bank responds to the auditor about bank balance and loan information ________ 3. excess cash invested in short-term, highly liquid investments such as time deposits, certificates of deposit, and money market funds ________ 4. the primary bank account for most organizations ________ 5. the transfer of money from one bank account to another and improperly recording the transfer so that the amount is recorded as an asset in both accounts ________ 6. the document usually prepared by client personnel of the differences between the cash balance recorded in the general ledger and the amount in the bank account Answer: 1. g 2. j 3. c 4. e 5. h 6. a Terms: Bank reconciliation; Cash equivalents; General cash account; Imprest petty cash fund; Kiting; Standard bank confirmation form Difficulty: Moderate Objective: LO 23-4 AACSB: Reflective thinking

32) Banks are working with their clients to raise awareness of masquerading for cash as a fraud technique. Name three of those suggested techniques. Answer: Establishing a multi-approval internal process for transactions above a certain amount; be on alert for wire transfer instructions that include tight deadlines; be suspicious of confidentiality; require a valid purchase order number as well as high-level approvals in the organization to spend money; regular change passwords for email accounts and social networking sites; enable multifactor authentication. Terms: Fraud; Cash Difficulty: Challenging Objective: LO 23-4 AACSB: Reflective thinking; Analytic thinking 23.5 Learning Objective 23-5 1) Which of the following is not a correct statement regarding business risk and financial instruments? A) Business risks associated with financial instruments will vary depending on the aggressiveness of a company's investing activity. B) Business risk will be higher for companies investing in less liquid securities. C) Financial services firms are exposed to very little risk with their financial instruments. D) Business risk for a company will be higher when investments represent a greater proportion of total assets. Answer: C Terms: Audit of financial instruments accounts; risk Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 2) Factors that impact inherent risk of financial instruments do not include A) management's objectives related to investment activity. B) the complexity of the securities. C) the cost of the securities. D) the company's prior experience with certain investments. Answer: C Terms: Audit of financial instruments accounts; risk Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

3) The use of unobservable inputs such as a pricing model or discounted cash flow is an example of a level ________ estimate. A) 1 B) 2 C) 3 D) 1 and 3 Answer: C Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 4) The majority of financial instruments are valued using A) cost. B) fair value estimates. C) lower of cost or market. D) realizable value. Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 5) When an audit client uses a service organization to manage their investment activity, A) the auditor can always rely on the system of internal controls of the service organization. B) the auditor must state in their audit opinion that the client uses a service organization. C) the auditor can rely on the system of internal controls of the service organization if the service organization's auditor issues a report on their system of internal control. D) the auditor must rely on the service organization to determine the fair level 1, 2, and 3 estimates. Answer: C Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

6) As part of their system of internal control procedures, management needs to have procedures in place to properly classify financial instruments as trading, available-for-sale, or held-tomaturity, based on A) cost. B) intent. C) maturity. D) probable future gain or loss. Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 7) Prices in an active market for identical assets is a level ________ fair value estimate. A) 1 B) 2 C) 3 D) 4 Answer: A Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 8) When auditing financial instruments, A) the auditor usually performs more extensive substantive testing to reduce reliance on controls. B) analytical procedures are critical in assessing the year-end balances for financial instruments. C) the auditor relies on statements and broker's advices from investment managers to test purchases and sales as long as controls were deemed effective. D) tests of transactions are generally not performed. Answer: C Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 9) When auditing financial instruments, analytical procedures can be used to A) test the reasonableness of interest and dividend income. B) test the year-end balance. C) determine if the financial instruments were properly valued. D) determine if the gain or loss on the sales were properly computed. Answer: A Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 34 Copyright © 2023 Pearson Education, Inc.

10) Which is not an important objective for financial instruments? A) existence B) cutoff C) accuracy D) realizable value Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 11) Level ________ estimates use observable inputs other than quoted prices. A) 1 B) 2 C) 3 D) 4 Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 12) A schedule of investment activity will include all of the following except A) the purchases and sales. B) ending balances. C) the gains and losses. D) the opinion of management as to the suitability of the investment to the company. Answer: D Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 13) When auditing financial instruments, a confirmation is sent to the broker-dealer A) only if the client has poor system of internal controls. B) to confirm interest and dividends. C) to provide assurance on realizable value. D) to confirm year-end holdings. Answer: D Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

14) The auditor is testing for the balance-related audit objective of detail tie-in when they A) prove the schedule of investment activity as to additions and subtractions. B) perform a physical inspection of the security. C) verify the quoted market prices. D) test management's assumptions related to valuation. Answer: A Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 15) When the auditor sends a confirmation to the broker-dealer, they are testing the balancerelated audit objective of A) detail tie-in. B) existence. C) cutoff. D) rights. Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 16) When dealing with financial instruments, the most difficult balance-related audit objective to test is A) existence. B) accuracy. C) rights. D) realizable value. Answer: D Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 17) An auditor is reviewing the minutes of board meetings to determine whether any securities are pledged as collateral. This test of the detail of balances relates to the audit objective of A) rights. B) cutoff. C) realizable value. D) classification. Answer: A Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 36 Copyright © 2023 Pearson Education, Inc.

18) Determining if the financial instruments included in the schedule of investment activity at year-end are stated at appropriate amounts in accordance with accounting standards is the balance-related audit objective of A) materiality. B) realizable value. C) consistency. D) classification. Answer: B Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 19) The majority of financial instruments are valued at the lower of cost or market. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 20) Business risks associated with financial instruments are the same for all companies. Answer: FALSE Terms: Audit of financial instruments accounts; risk Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 21) The starting point for testing the ending balance of financial instruments accounts is to obtain a gain or loss schedule for the year. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 22) The auditor needs to have an understanding of the client's system of internal controls over determining fair value estimates. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

23) A factor that increases inherent risk for financial instruments is the complexity of the relevant accounting standards. Answer: TRUE Terms: Audit of financial instruments accounts; risk Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 24) Level 1 estimates require more management judgment than level 2 or level 3 estimates. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 25) There is significant potential for misstatements and misclassification of financial instruments. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 26) Assessing system of internal controls related to financial instruments may be necessary in order to reduce audit risk to an acceptable level. Answer: TRUE Terms: Audit of financial instruments accounts; risk Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 27) When auditing financial instruments, interest income and dividends can be recomputed and compared to a public source. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 28) Analytical procedures may be used to assess the year-end balances for financial instruments. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

29) Completeness is an important objective for derivative financial instruments. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 30) The most important objectives for financial instruments are existence and consistency. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 31) Presentation and disclosure objectives are important when auditing financial instruments. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 32) Tests related to realizable value will vary according to the type of security and the associated accounting standard. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 33) Auditing guidance is provided for auditing accounting estimates specifically for fair values estimates as considerable auditor judgment is involved. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 34) Cutoff is important in testing transactions as a client may want to record a gain or a loss on the sale at the end of the year. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking

35) When an auditor is verifying quoted market prices, they are concerned about the balancerelated audit objective of accuracy. Answer: FALSE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 36) Securities and contracts will typically be held by the broker-dealer. Answer: TRUE Terms: Audit of financial instruments accounts Difficulty: Moderate Objective: LO 23-5 AACSB: Reflective thinking 37) When auditing financial instruments, the most difficult objective to test is existence. Answer: FALSE Terms: Financial instruments Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 38) The auditor should test for the proper classification of debt instruments as either trading securities, available-for-sale securities, or held-to-maturity securities in the financial statements. Answer: TRUE Terms: Financial instruments Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 39) The proper classification of debt instruments in the financial statements is based solely on the nature of the debt instrument. Answer: FALSE Terms: Financial instruments Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking 40) The majority of financial instruments are valued using fair value estimates. Answer: TRUE Terms: Financial instruments Difficulty: Easy Objective: LO 23-5 AACSB: Reflective thinking

41) List two common tests of details of balances procedures the auditor would perform when testing for the balance-related audit objective of realizable value. Answer: 1. Verify quoted market prices. 2. Test management classifications. 3. Test management's assumptions related to valuation. 4. Consider using a specialist for testing fair value estimates. 5. Consider whether an impairment loss is required. Terms: Audit of financial instruments accounts Difficulty: Challenging Objective: LO 23-5 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 24 Completing the Audit 24.1 Learning Objective 24-1 1) Auditors often integrate procedures for presentation and disclosure objectives with A) Tests for transaction-related objectives Tests for balance-related objectives Yes Yes B) Tests for transaction-related objectives No

Tests for balance-related objectives No

Tests for transaction-related objectives Yes

Tests for balance-related objectives No

Tests for transaction-related objectives No

Tests for balance-related objectives Yes

Answer: A Terms: Procedures for presentation and disclosure objectives Difficulty: Easy Objective: LO 24-1 AACSB: Reflective thinking 2) The auditor's primary concern relative to presentation and disclosure-related objectives is A) accuracy. B) existence. C) completeness. D) occurrence. Answer: C Terms: Presentation and disclosure-related objectives Difficulty: Easy Objective: LO 24-1 AACSB: Reflective thinking

3) An auditor is reconciling the amounts included in the long-term debt footnotes to the information examined and supported in the audit files for long-term debt. Which audit objective is being satisfied? A) accuracy and valuation B) occurrence and rights and obligations C) completeness D) classification and understandability Answer: A Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 4) Which of the following is an accurate statement regarding presentation and disclosure? A) Auditors generally set the risk as low that all required information may not be completely disclosed in the footnotes. B) Audit tests performed in earlier audit phases provides sufficient appropriate evidence about contingent liabilities and subsequent events. C) Auditors do not conduct tests of controls related to disclosures when the initial assessment of control risk is below maximum. D) In phase IV (completing the audit), auditors evaluate whether the overall presentation of the financial statements and related footnotes complies with accounting standards. Answer: D Terms: Presentation and disclosure-related audit objective performed in what phase of audit process Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 5) When an auditor reviews the financial statements to determine if assets are properly classified between current and noncurrent, he or she is satisfying the audit objective of occurrence and rights and obligations. Answer: FALSE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 6) As part of phase IV of the audit, auditors evaluate evidence they obtained during the first three phases of the audit to determine whether they should perform additional procedures for presentation and disclosure-related objectives. Answer: TRUE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

7) Auditors approach obtaining evidence for presentation and disclosure objectives differently from how they approach obtaining evidence for transaction-related and balance-related objectives. Answer: FALSE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 8) Often, procedures for the presentation objectives are integrated with the auditor's tests for transaction-related and balance-related audit objectives. Answer: TRUE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 9) An example of a presentation and disclosure-related objective is determining that current and noncurrent receivables are classified separately, and any factoring or discounting of notes receivable is disclosed. Answer: TRUE Terms: Presentation and disclosure-related objectives Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 10) Due to the unique nature of disclosures related to contingent liabilities and subsequent events, auditors often assess the risk as high that all required information may not be completely disclosed in the footnotes. Answer: TRUE Terms: Disclosures related to contingent liabilities and subsequent events Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking 11) Audit tests performed in earlier audit phases often provide sufficient appropriate evidence about contingent liabilities and subsequent events. Answer: FALSE Terms: Disclosures related to contingent liabilities and subsequent events Difficulty: Moderate Objective: LO 24-1 AACSB: Reflective thinking

12) In March 2022, the SEC released a proposed rule requiring public companies to disclose certain climate-related information in their registration statements and annual reports. Describe some of the company disclosures required by this proposed rule. Answer: Information about a company's climate-related risks reasonably expected to have a material effect on its business; qualitative disclosures and metrics including climate-related risks and their potential impact on its business; the governance and oversight processes in place to manage climate-related risks; greenhouse gas emissions in the aggregate and disaggregated for Scope 1 (direct emissions); Scope 2 (indirect emissions); and Scope 3 (indirect emissions not directly controlled by the company but parts of its value chain). Terms: Presentation and disclosure-related objectives Difficulty: Challenging Objective: LO 24-1 AACSB: Reflective thinking; Analytic thinking 24.2 Learning Objective 24-2 1) If a potential loss on a contingent liability is remote, the liability usually is A) disclosed in footnotes, but not accrued. B) neither accrued nor disclosed in footnotes. C) accrued and indicated in the body of the financial statements. D) disclosed in the auditor's report but not disclosed on the financial statements. Answer: B Terms: Contingent liability; remote Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 2) A commitment is best described as A) an agreement to commit the firm to a set of fixed conditions in the future. B) an agreement to commit the firm to a set of fixed conditions in the future that depends on company profitability. C) an agreement to commit the firm to a set of fixed conditions in the future that depends on current market conditions. D) a potential future obligation to an outside party for an as yet to be determined amount. Answer: A Terms: Commitments Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking

3) Which of the following groups has the responsibility for identifying and deciding the appropriate accounting treatment for recording or disclosing contingent liabilities? A) auditors B) legal counsel C) management D) management and the auditors Answer: C Terms: Recording or disclosing contingent liabilities Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 4) You are auditing Rodgers and Company. You are aware of a potential loss due to noncompliance with environmental regulations. Management has assessed that there is a 40% chance that a $10M payment could result from the non-compliance. The appropriate financial statement treatment is to A) accrue a $4 million liability. B) disclose a liability and provide a range of outcomes. C) since there is less than a 50% chance of occurrence, ignore. D) since there is greater than a remote chance of occurrence, accrue the $10 million. Answer: B Terms: Potential loss for noncompliance Difficulty: Moderate Objective: LO 24-2 AACSB: Analytic thinking

5) Which of the following is a contingent liability with which an auditor is particularly concerned? A) Notes receivable discounted Product warranties Yes Yes B) Notes receivable discounted No

Product warranties No

C) Notes receivable discounted Yes

Product warranties No

D) Notes receivable discounted No

Product warranties Yes

Answer: A Terms: Contingent liability; auditor particularly concerned Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 6) Audit procedures related to contingent liabilities are initially focused on A) accuracy. B) completeness. C) existence. D) occurrence. Answer: D Terms: Audit procedures related to contingent liabilities Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 7) With which of the following client personnel would it generally not be appropriate to inquire about commitments or contingent liabilities? A) controller B) president C) accounts receivable clerk D) vice president of sales Answer: C Terms: Inquire for commitments or contingent liabilities Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

8) Inquiries of management regarding the possibility of unrecorded contingencies will be useful in uncovering A) When management does not Management's intentional failure to comprehend accounting disclosure disclose existing contingencies. requirements. Yes Yes B) Management's intentional failure to disclose existing contingencies. No

When management does not comprehend accounting disclosure requirements. No

Management's intentional failure to disclose existing contingencies. Yes

When management does not comprehend accounting disclosure requirements. No

D) Management's intentional failure to disclose existing contingencies. No

When management does not comprehend accounting disclosure requirements. Yes

Answer: D Terms: Inquiries of management; Unrecorded contingencies Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 9) Which of the following is not considered a commitment? A) agreements to purchase raw materials B) pension plans C) agreements to lease facilities at set prices D) Each of the above is a commitment. Answer: D Terms: Commitments Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

10) If an auditor concludes there are contingent liabilities, then he or she must evaluate the A) Materiality of the potential liability. Nature of the disclosure to be included in the financial statements. Yes Yes B) Materiality of the potential liability. No

Nature of the disclosure to be included in the financial statements. No

C) Materiality of the potential liability. Yes

Nature of the disclosure to be included in the financial statements. No

D) Materiality of the potential liability. No

Nature of the disclosure to be included in the financial statements. Yes

Answer: A Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 11) One of the primary approaches in dealing with uncertainties in loss contingencies uses a(n) ________ threshold. A) monetary B) materiality C) probability D) analytical Answer: C Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

12) If the auditor concludes that there are contingent liabilities, he or she must evaluate the significance of the potential liability and the nature of the disclosure needed in the financial statements. Which of the following statements is not true? A) The potential liability is sufficiently well known in some instances to be included in the financial statements as an actual liability. B) Disclosure may be unnecessary if the contingency is highly remote or immaterial. C) A CPA firm often obtains a separate evaluation of the potential liability from its own legal counsel rather than relying on management or management's attorneys. D) The client's attorneys must remain independent when evaluating the likelihood of losing the lawsuit. Answer: D Terms: Contingent liabilities; significance of potential liability; nature of disclosure Difficulty: Challenging Objective: LO 24-2 AACSB: Reflective thinking 13) When using the probability threshold for contingencies, the likelihood of the occurrence of the event is classified as A) not likely, likely, or highly likely. B) remote, reasonably possible, or probable. C) slight, moderate, great. D) remote, likely, possible. Answer: B Terms: Contingent liabilities Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 14) When dealing with contingencies, A) all contingencies must be disclosed or footnoted. B) the auditor must exercise considerable professional judgment when evaluating whether the client has applied the appropriate treatment. C) it is easy for the auditor to uncover contingencies without management's cooperation. D) the review for contingent liabilities is only performed at the beginning and the end of the audit. Answer: B Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

15) Which of the following is not a common audit procedure used to search for contingent liabilities? A) examine letters of credit B) examine payroll reports C) review internal revenue agent reports D) analyze legal expense Answer: B Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 16) Contingent liability disclosure in the footnotes of the financial statements would normally be made when A) the outcome of the accounting event is deemed probable, but a reasonable estimation as to the amount cannot be made by the client or auditor. B) a reasonable estimation of the loss can be made, but the outcome is not probable. C) the outcome of the accounting event is deemed probable, and a reasonable estimation as to the amount can be made. D) the outcome of the accounting event as well as a reasonable estimation of the loss cannot be made. Answer: A Terms: Contingent liability disclosure Difficulty: Challenging Objective: LO 24-2 AACSB: Reflective thinking 17) Three conditions are required for a contingent liability to exist. Which of the following is not one of those conditions? A) There is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition. B) The outcome must be resolved by a third-party. C) There is uncertainty about the amount of the future payment or impairment. D) The outcome will be resolved by some future event or events. Answer: B Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

18) A lawsuit has been filed against your client. If, in the opinion of legal counsel, the likelihood your client will lose the lawsuit is remote, no financial statement accrual or disclosure of the potential loss would generally be required. Answer: TRUE Terms: Lawsuit is remote; financial statement accrual or disclosure Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 19) Current professional auditing standards make it clear that management, not the auditor, is responsible for identifying and deciding the appropriate accounting treatment for contingent liabilities. Answer: TRUE Terms: Auditing standards; Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 20) Many of the audit procedures for finding contingencies are usually performed as an integral part of various segments of the audit rather than as a separate activity near the end of the audit. Answer: TRUE Terms: Existence of contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 21) The probability threshold for dealing with uncertainty in loss contingencies uses the terms likely and unlikely. Answer: FALSE Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 22) The first stop in the audit of contingencies is to determine the amount of the contingency. Answer: FALSE Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

23) A lawsuit has been filed but not yet resolved against an audit client. This lawsuit does not meet the conditions required for a contingent liability. Answer: FALSE Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 24) Financial statement disclosure is required if the likelihood of occurrence of an event is probable, reasonably possible, or remote. Answer: FALSE Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 25) Auditing standards make it clear that the auditor is responsible for identifying and deciding the appropriate accounting treatment for contingent liabilities due to the complexity of this topic. Answer: FALSE Terms: Contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 26) Companies ordinarily describe all commitments either in a separate footnote or combine them with a footnote related to contingencies. Answer: TRUE Terms: Commitments Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 27) Distinguish between contingent liabilities and commitments. Answer: Contingent liabilities are potential future obligations to an outside party for an unknown amount resulting from activities that have already taken place. Commitments are agreements that an entity will hold to a fixed set of conditions in the future regardless of what happens to profits or the economy as a whole. Terms: Contingent liabilities; commitments Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking

28) Define the term contingent liability and discuss the criteria accountants and auditors use to classify these accounting events. Answer: A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place. Three conditions are required for a contingent liability to exist: (1) there is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition; (2) there is uncertainty about the amount for the future payment or impairment; and (3) the outcome will be resolved by some future event or events. Accounting standards describe three levels of likelihood of occurrence and the appropriate financial statement treatment for each likelihood as follows: a. Probable—future event likely to occur and amount can be reasonably estimated then the financial statement accounts are adjusted. If amount cannot be reasonably estimated, then a footnote disclosure is necessary. b. Reasonably possible—chance of occurring is more than remote, but less than probable. Footnote disclosure is necessary. c. Remote—chance of occurrence is slight, no disclosure is necessary. Terms: Contingent liabilities Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 29) With what types of contingencies might an auditor be concerned? Answer: The auditor is generally concerned with contingencies arising from: 1. pending litigation for patent infringement, product liability, environmental liability, or other actions 2. income tax disputes 3. product warranties 4. notes receivable discounted 5. guarantees of obligations of others 6. unused balances of outstanding letters of credit Terms: Types of contingencies Difficulty: Easy Objective: LO 24-2 AACSB: Reflective thinking 30) What are the three required conditions for a contingent liability to exist? Answer: 1. There is potential for future payment to an outside party or the impairment of an asset that resulted from an existing condition. 2. There is uncertainty about the amount of the future payment or impairment. 3. The outcome will be resolved by some future event or events. Terms: Conditions for contingent liability to exist Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

31) An environmental clean-up lawsuit is pending against your client. What information about the lawsuit would you as the auditor need in order to determine the proper accounting treatment? Answer: The first step is to determine if a contingency exists. Three conditions are required for a contingent liability to exist: (1) there is a potential future payment to an outside party or the impairment of an asset that resulted from an existing condition; (2) there is uncertainty about the amount for the future payment or impairment; and (3) the outcome will be resolved by some future event or events. Since the lawsuit meets the criteria for a contingent liability, the next step is to evaluate the significance of the potential liability and the nature of the disclosure needed in the financial statements to obtain evidence about the occurrence and right and obligations presentation and disclosure objective. Accounting standards describe three levels of likelihood of occurrence and the appropriate financial statement treatment for each likelihood as follows: a. Probable—future event likely to occur and amount can be reasonably estimated then the financial statement accounts are adjusted. If amount cannot be reasonably estimated, then a footnote disclosure is necessary. b. Reasonably possible—chance of occurring is more than remote, but less than probable. Footnote disclosure is necessary. c. Remote—chance of occurrence is slight. No disclosure is necessary. Terms: Correct accounting for lawsuit Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 32) Discuss three audit procedures commonly used to search for contingent liabilities. Answer: • Inquire of management (orally and in writing) about the possibility of unrecorded contingencies. • Review current and previous years' internal revenue agent reports for income tax settlements. • Review the minutes of directors' and stockholders' meetings for indications of lawsuits or other contingencies. • Analyze legal expense for the period under audit, and review invoices and statements from legal counsel for indications of contingent liabilities. • Obtain a letter from each major attorney performing legal services for the client as to the status of pending litigation or other contingent liabilities. • Review audit documentation for any information that may indicate a potential contingency. • Examine letters of credit in force as of the balance sheet date and obtain a confirmation of the used and unused balances. Terms: Audit procedures for search of contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking 14 Copyright © 2023 Pearson Education, Inc.

33) Describe some audit procedures commonly used to search for contingent liabilities. Answer: Inquire of management in writing or orally about the possibility of unrecorded contingent liabilities; review current and previous years' internal revenue agent reports for income tax settlements or assessments or disagreements; review the minutes of directors' and stockholders' meetings; analyze legal expense and review legal invoices and statements; obtain a letter from each major attorney performing major legal services regarding pending litigation or other contingent liabilities; review audit documentation for any indication of potential contingencies like loan guarantees; examine letters of credit in force and obtain confirmations for used and unused letter of credit balances. Terms: Search for contingent liabilities Difficulty: Moderate Objective: LO 24-2 AACSB: Reflective thinking

24.3 Learning Objective 24-3 1) Auditors will generally send a standard inquiry to the client's attorney letter to A) only those attorneys who have devoted substantial time to client matters during the year. B) every attorney that the client has been involved with in the current or preceding year, plus any attorney the client engages on occasion. C) every attorney whose legal fees for the year exceed a materiality threshold. D) only the attorney who represents the client in proceeding where the client is defendant. Answer: B Terms: Standard inquiry to the client's attorney letter Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 2) What needs to be included in a standard inquiry to the client's attorney letter sent to a client's legal counsel? A) Any pending threatened The amount of legal fees paid litigation with which the attorney by the client to the attorney has had significant involvement Yes Yes B) Any pending threatened The amount of legal fees paid litigation with which the attorney by the client to the attorney has had significant involvement No No C) Any pending threatened The amount of legal fees paid litigation with which the attorney by the client to the attorney has had significant involvement Yes No D) Any pending threatened The amount of legal fees paid litigation with which the attorney by the client to the attorney has had significant involvement No Yes Answer: C Terms: Standard inquiry to the client's attorney letter Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking

3) Auditors, as part of completing the audit, will request the client to send a standard inquiry to the client's attorney letter to those attorneys the company has been consulting with during the year under audit regarding legal matters of concern to the company. The primary reason the auditor requests this information is to A) determine the range of probable loss for asserted claims. B) obtain a professional opinion about the expected outcome of existing lawsuits and the likely amount of the liability, including court costs. C) obtain an outside opinion of the probability of losses in determining accruals for contingencies. D) obtain an outside opinion of the probability of losses in determining the proper footnote disclosure. Answer: B Terms: Completing the audit; Letter of inquiry Difficulty: Moderate Objective: LO 24-3 AACSB: Reflective thinking 4) The standard inquiry to the client's attorney should be prepared on A) plain paper (no letterhead) and be unsigned. B) lawyer's stationery and signed by the lawyer. C) auditor's stationery and signed by an audit partner. D) client's letterhead and signed by a company official. Answer: D Terms: Standard inquiry to the client's attorney letter Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking

5) What is one of the main reasons an attorney may refuse to provide auditors with complete information about contingent liabilities? A) The attorneys refuse to The attorneys refuse to respond due disclose information they to a lack of knowledge about matters consider confidential. involving contingent liabilities. Yes Yes B) The attorneys refuse to disclose information they consider confidential. No

The attorneys refuse to respond due to a lack of knowledge about matters involving contingent liabilities. No

C) The attorneys refuse to disclose information they consider confidential. Yes

The attorneys refuse to respond due to a lack of knowledge about matters involving contingent liabilities. No

D) The attorneys refuse to disclose information they consider confidential. No

The attorneys refuse to respond due to a lack of knowledge about matters involving contingent liabilities. Yes

Answer: A Terms: Standard inquiry to the client's attorney letter Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 6) An attorney is aware of a violation of a patent agreement that could result in a significant loss to the client if it were known. This is an example of a(n) A) commitment. B) unasserted claim. C) pending litigation. D) subsequent event. Answer: B Terms: Standard inquiry to the client's attorney letter Difficulty: Moderate Objective: LO 24-3 AACSB: Analytic thinking

7) Management furnishes the independent auditor with information concerning litigation, claims, and assessments. Which of the following is the auditor's primary means of initiating action to corroborate such information? A) Request that client lawyers undertake a reconsideration of matters of litigation, claims, and assessments with which they were consulted during the period under examination. B) Request that client management send a standard inquiry to the client's attorney letter to those lawyers with whom management consulted concerning litigation, claims, and assessments. C) Request that client lawyers provide a legal opinion concerning the policies and procedures adopted by management to identify, evaluate, and account for litigation, claims, and assessments. D) Request that client management engage outside attorneys to suggest wording for the text of a footnote explaining the nature and probable outcome of existing litigation, claims, and assessments. Answer: B Terms: Corroborate information concerning litigation, claims, and assessments Difficulty: Challenging Objective: LO 24-3 AACSB: Reflective thinking 8) If an attorney refuses to provide the auditor with information about material existing lawsuits or unasserted claims, A) the attorney may face sanctions from the American Bar Association. B) the auditors must modify their audit report to reflect the lack of available evidence. C) the attorney can no longer represent the client. D) the auditor must withdraw from the engagement. Answer: B Terms: Response to client's letter of inquiry Difficulty: Moderate Objective: LO 24-3 AACSB: Reflective thinking 9) As directed by the Sarbanes-Oxley Act, A) an attorney must report material violations of federal securities law to the public company's chief legal counsel or chief executive officer. B) attorneys cannot breach confidentiality rules even if a client is committing a crime or a fraud. C) if the audit committee fails to remedy any material violations of the federal securities law, the attorney must report the violation to the SEC. D) All of the above are required by Sarbanes-Oxley. Answer: A Terms: Legal letter to client's attorneys Difficulty: Moderate Objective: LO 24-3 AACSB: Reflective thinking

10) When preparing a standard inquiry to the client's attorney letter, the client's letterhead should be used, and the letter should be signed by the client company's officials. Answer: TRUE Terms: Standard inquiry to the client's attorney letter Difficulty: Moderate Objective: LO 24-3 AACSB: Reflective thinking 11) In a standard inquiry to the client's attorney letter, the attorney is requested to communicate about contingencies up to the balance sheet date. Answer: FALSE Terms: Standard inquiry to the client's attorney letter Difficulty: Moderate Objective: LO 24-3 AACSB: Reflective thinking 12) If an attorney refuses to provide the auditor with information about material existing lawsuits or unasserted claims, current professional standards require that the auditor consider the refusal as a scope limitation. Answer: TRUE Terms: Attorney refuses to provide auditor with information about material existing lawsuits Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 13) The standard letter sent by the auditor to the attorney requests the attorney communicate about contingencies up to approximately the date of the auditor's report. Answer: TRUE Terms: Standard letter sent by auditor to the attorney Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 14) Attorneys must report material violations of federal securities laws to the company's audit committee. Answer: TRUE Terms: Material violations of federal security laws Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking

15) The American Bar Association has refused to amend its attorney-client confidentiality rules to permit attorneys to breach confidentiality if a client is committing a crime or fraud. Answer: FALSE Terms: Material violations of federal security laws Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 16) Attorneys in recent years have become reluctant to provide certain information to auditors because of their own exposure to legal liability for providing incorrect or confidential information. State the two main reasons that attorneys refuse to provide the auditors with complete information. Answer: • The attorneys refuse to respond due to a lack of knowledge about matters involving contingent liabilities. • The attorneys refuse to disclose information that they consider confidential. Terms: Legal letter to client's attorneys Difficulty: Easy Objective: LO 24-3 AACSB: Reflective thinking 17) State three items that should be included in a standard inquiry to the client's attorney letter. Answer: • A list including (1) pending threatened litigation and (2) asserted or unasserted claims or assessments with which the attorney has had significant involvement. This list is typically prepared by management, but management may request that the attorney prepare the list. • A request that the attorney furnish information or comment about the progress of each item listed, the legal action the client intends to take, the likelihood of an unfavorable outcome, and an estimate of the amount or range of the potential loss. • A request for the identification of any unlisted pending or threatened legal actions or a statement that the client's list is complete. • A statement informing the attorney of his or her responsibility to inform management of legal matters requiring disclosure in the financial statements and to respond directly to the auditor. Terms: Inquiry of attorney letter Difficulty: Challenging Objective: LO 24-3 AACSB: Reflective thinking

24.4 Learning Objective 24-4 1) The auditor has a responsibility to review transactions and activities occurring after the balance sheet date to determine whether anything occurred that might affect the statements being audited. The procedures required to verify these transactions are commonly referred to as the review for A) contingent liabilities. B) subsequent year's transactions. C) late unusual occurrences. D) subsequent events. Answer: D Terms: Review transactions and activities occurring after balance sheet date Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 2) Which type of subsequent event requires consideration by management and evaluation by the auditor? A) Subsequent events that have a direct effect on Subsequent events that do not have a direct the financial statements and require effect on the financial statements but for adjustment which disclosure may be required Yes Yes B) Subsequent events that have a direct effect on Subsequent events that do not have a direct the financial statements and require effect on the financial statements but for adjustment which disclosure may be required No No C) Subsequent events that have a direct effect on Subsequent events that do not have a direct the financial statements and require effect on the financial statements but for adjustment which disclosure may be required Yes No D) Subsequent events that have a direct effect on Subsequent events that do not have a direct the financial statements and require effect on the financial statements but for adjustment which disclosure may be required No Yes Answer: A Terms: Subsequent events requiring consideration by management Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 22 Copyright © 2023 Pearson Education, Inc.

3) Whenever subsequent events are used to evaluate the amounts included in the statements, care must be taken to distinguish between conditions that existed at the balance sheet date and those that come into being after the balance sheet date. The subsequent information should not be incorporated directly into the statements if the conditions causing the change in valuation A) took place before the balance sheet date. B) did not take place until after the balance sheet date. C) occurred both before and after the balance sheet date. D) are reimbursable through insurance policies. Answer: B Terms: Subsequent events; balance sheet date and after the end of the year Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 4) An auditor has the responsibility to actively search for subsequent events that occur subsequent to the A) balance sheet date. B) date of the auditor's report. C) balance sheet date, but prior to the audit report. D) date of the management representation letter. Answer: C Terms: Subsequent events Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 5) Which of the following subsequent events is most likely to result in an adjustment to a company's financial statements? A) merger or acquisition activities B) bankruptcy (due to deteriorating financial condition) of a customer with an outstanding accounts receivable balance C) issuance of common stock D) an uninsured loss of inventories due to a fire Answer: B Terms: Subsequent events; Adjustment to financial statements Difficulty: Easy Objective: LO 24-4 AACSB: Analytic thinking

6) After the balance sheet date, but prior to the issuance of the audit report, the client suffers an uninsured loss of their inventory as a result of a fire. The amount of the loss is material. The auditor should A) adjust the financial statements for the year under audit. B) add a paragraph to the audit report. C) advise the client to disclose the event in the notes to the financial statements. D) advise the client to delay issuing the financial statements until the economic loss can be determined. Answer: C Terms: Event will have a material effect on the financial statements Difficulty: Easy Objective: LO 24-4 AACSB: Analytic thinking 7) The auditor has completed her or his assessment of subsequent events. The proper accounting for subsequent events that have a direct effect on the financial statements is to A) adjust the financial statements for the year under audit. B) disclose in the notes to the financial statements the amount of the adjustment. C) duly note in the audit workpapers that next year's financial statements need to be adjusted. D) make no adjustment of the financial statements for the year under audit. Answer: A Terms: Subsequent events; direct effect on the financial statements Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 8) The audit procedures for the subsequent events review can be divided into two categories: (1) procedures integrated as a part of the verification of year-end account balances, and (2) those performed specifically for the purpose of discovering subsequent events. Which of the following procedures is in the first category? A) Inquire of client regarding contingent liabilities. B) Obtain a letter of representation written by client. C) Examine subsequent period sales and purchase transactions to determine whether the cutoff is accurate. D) Review journals and ledgers of year 2 to determine the existence of any transactions related to year 1. Answer: C Terms: Audit procedures for subsequent events review Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking

9) The audit procedures for the subsequent events review can be divided into two categories: (1) procedures normally integrated as a part of the verification of year-end account balances, and (2) those performed specifically for the purpose of discovering subsequent events. Which of the following procedures is in the second category? A) Correspond with attorneys. B) Test the collectability of accounts receivable by reviewing subsequent period cash receipts. C) Examine subsequent period sales and purchase transactions to determine whether the cutoff is accurate. D) Compare the subsequent-period purchase price of inventory with the recorded cost as a test of lower of cost or market valuation. Answer: A Terms: Audit procedures for subsequent events review Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 10) Which of the following would be a subsequent discovery of facts which would not require a response by the auditor? A) discovery of the inclusion of material nonexistent sales B) discovery of the failure to write off material obsolete inventory C) discovery of the omission of a material footnote D) discovery of management's intent to increase selling prices in the future Answer: D Terms: Subsequent discovery of facts Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 11) In connection with the annual audit, which of the following is not a "subsequent events" procedure? A) Prepare any necessary closing journal entries. B) Examine the minutes of stockholders' and directors' meetings subsequent to the balance sheet date. C) Review journals and ledgers. D) Obtain a letter of representation. Answer: A Terms: Subsequent events procedure Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking

12) An auditor performs interim work at various times throughout the year. The auditor's subsequent events work should be extended to the date of A) the auditor's report. B) a post-dated footnote. C) the next scheduled interim visit. D) the final billing for audit services rendered. Answer: A Terms: Interim work; Subsequent events Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 13) Which event that occurred after the end of the fiscal year under audit but prior to issuance of the auditor's report would not require disclosure in the financial statements? A) sale of a bond or capital stock issue B) loss of plant or inventories as a result of fire or flood C) a significant decline in the market price of the corporation's stock D) a merger or acquisition Answer: C Terms: Event that occurred after the end of the fiscal year Difficulty: Moderate Objective: LO 24-4 AACSB: Analytic thinking 14) Which of the following material events occurring subsequent to the balance sheet date would require an adjustment to the financial statements before they could be issued? A) loss of a plant as a result of a flood B) sale of long-term debt or capital stock C) settlement of litigation in excess of the recorded liability D) major purchase of a business that is expected to double the sales volume Answer: C Terms: Events occurring subsequent to the balance sheet date; Adjustment Difficulty: Moderate Objective: LO 24-4 AACSB: Analytic thinking

15) If the auditor determines that a subsequent event that affects the current period financial statements occurred after fieldwork was completed but before the audit report was issued, what date(s) may the auditor use on the report? A) The date of the The date of the The date on which the last day of original last day of subsequent fieldwork occurred along with the fieldwork only event only date of the subsequent event Yes Yes No B) The date of the original last day of fieldwork only No

The date of the subsequent event only Yes

The date on which the last day of fieldwork occurred along with the date of the subsequent event Yes

The date of the subsequent event only Yes

The date on which the last day of fieldwork occurred along with the date of the subsequent event No

The date of the subsequent event only No

The date on which the last day of fieldwork occurred along with the date of the subsequent event Yes

C) The date of the original last day of fieldwork only No D) The date of the original last day of fieldwork only No

Answer: B Terms: Subsequent event; report date Difficulty: Challenging Objective: LO 24-4 AACSB: Analytic thinking 16) An auditor's decision concerning whether or not to dual date an audit report is primarily based on the auditor's decision to A) extend appropriate audit procedures. B) assume responsibility for events after the date of the auditor's report. C) assume responsibility for events from fiscal year-end to the date of the audit report. D) roll the dice and hope for a successful outcome. Answer: A Terms: Dual date audit report Difficulty: Challenging Objective: LO 24-4 AACSB: Reflective thinking

17) The auditor's responsibility for "reviewing the subsequent events" of a public company that is about to issue new securities is normally limited to the period of time A) beginning with the balance sheet date and ending with the date of the auditor's report. B) beginning with the start of the fiscal year under audit and ending with the balance sheet date. C) beginning with the start of the fiscal year under audit and ending with the date of the auditor's report. D) beginning with the balance sheet date and ending with the date the registration statement becomes effective. Answer: D Terms: Reviewing subsequent events; public company; issue new securities Difficulty: Challenging Objective: LO 24-4 AACSB: Reflective thinking 18) Subsequent events affecting the realization of assets ordinarily will require an adjustment of the financial statements under examination because such events typically represent A) the culmination of conditions that existed at the balance sheet date. B) additional new information related to events that were in existence on the balance sheet date. C) final estimates of losses relating to casualties occurring in the subsequent events period. D) preliminary estimate of losses relating to new events that occurred subsequent to the balance sheet date. Answer: B Terms: Subsequent events; realization of assets Difficulty: Challenging Objective: LO 24-4 AACSB: Reflective thinking 19) An auditor's decision concerning whether or not to "dual date" the audit report is based upon the auditor's willingness to A) extend auditing procedures and assume responsibility for a greater period of time. B) accept responsibility for subsequent events. C) permit inclusion of a footnote-captioned event (unaudited) subsequent to the date of the auditor's report. D) assume responsibility for events subsequent to the issuance of the auditor's report. Answer: A Terms: Dual date audit report Difficulty: Challenging Objective: LO 24-4 AACSB: Reflective thinking

20) Auditors of accelerated filer public companies A) are responsible for reviewing subsequent events for a period of up to six months after the balance sheet date. B) must always dual-date their audit reports. C) must inquire about and consider any information about subsequent events that materially affects the effectiveness of system of internal control over financial reporting. D) must perform all of the above procedures. Answer: C Terms: Accelerated filers and subsequent events Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 21) A client has a calendar year-end. Listed below are four events that occurred after December 31. Which one of these subsequent events might result in adjustment of the December 31 financial statements? A) sale of a major subsidiary B) adoption of accelerated depreciation methods C) write-off of a substantial portion of inventory as obsolete D) collection of 90% of the accounts receivable existing at December 31 Answer: C Terms: Subsequent events Difficulty: Challenging Objective: LO 24-4 AACSB: Analytic thinking 22) The auditor's responsibility with respect to events occurring between the balance sheet date and the end of the audit examination is best expressed by which of the following statements? A) The auditor is fully responsible for events occurring in the subsequent period and should extend all detailed procedures through the last day of fieldwork. B) The auditor is responsible for determining that a proper cutoff has been made and performing a general review of events occurring in the subsequent period. C) The auditor's responsibility is to determine that a proper cutoff has been made and that transactions recorded on or before the balance sheet date actually occurred. D) The auditor has no responsibility for events occurring in the subsequent period unless these events affect transactions recorded on or before the balance sheet date. Answer: B Terms: Events occurring between balance sheet date and end of audit examination Difficulty: Challenging Objective: LO 24-4 AACSB: Reflective thinking

23) The issuance of bonds by the client subsequent to the balance sheet date would require a footnote disclosure in, but no adjustment to, the financial statements under audit. Answer: TRUE Terms: Issuance of bonds by client subsequent to year-end Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 24) Subsequent events which require adjustment to the financial statements provide additional information about significant conditions/events which did not exist at the balance sheet date. Answer: FALSE Terms: Subsequent events Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 25) When subsequent events are used to evaluate the amounts included in the year-end financial statements, auditors must distinguish between conditions that existed at the balance sheet date and those that came into being after the balance sheet date. Answer: TRUE Terms: Subsequent events Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 26) The auditor's responsibility for reviewing subsequent events is normally limited to thirty days after the balance sheet date. Answer: FALSE Terms: Subsequent events; balance sheet date and after the end of the year Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking 27) When the auditor's name is associated with a registration statement under the Securities Act of 1933, the auditor's responsibility for reviewing subsequent events is limited to the date of auditor's report, not to the date the registration becomes effective. Answer: FALSE Terms: Auditor's name associated with registration statement under Securities Act of 1933 Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking

28) If the auditor is unable to determine the effect of a subsequent event on the effectiveness of system of internal control at year-end, the auditor must give an adverse opinion on system of internal control over financial reporting. Answer: FALSE Terms: Subsequent event reflecting a material weakness in system of internal control that existed at year-end Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking 29) An example of a nonrecognized subsequent event which may require disclosure if it is significant is the issuance of bonds or equity securities by a company. Answer: TRUE Terms: Subsequent events; balance sheet date and after the end of the year Difficulty: Easy Objective: LO 24-4 AACSB: Reflective thinking

30) The fieldwork for the December 31, 2022 audit of Schmidt Corporation ended on March 17, 2023. The financial statements and auditor's report were issued on March 29, 2023. In each of the material situations (1 through 5) below, indicate the appropriate action (a, b, c). The possible actions are as follows: a. Adjust the December 31, 2022 financial statements. b. Disclose the information in a footnote in the December 31, 2022 financial statements. c. No action is required. The situations are as follows: ________ 1. On March 1, 2023, one of Schmidt Corporation's major customers declared bankruptcy. The customer's financial condition in 2022 was deteriorating and they owed Schmidt Corporation a large sum of money as of the balance sheet date. ________ 2. On February 17, 2023, Schmidt Corporation sold some machinery for its book value. ________ 3. On February 20, 2023, a flood destroyed the entire uninsured inventory in one of Schmidt's warehouses. ________ 4. On January 5, 2023, there was a significant decline in the market value of the securities held for resale from their value as of the balance sheet date. ________ 5. On March 10, 2023, the company settled a lawsuit at an amount significantly higher than the amount recorded as a liability on the books as of the balance sheet date. Answer: 1. a 2. c 3. b 4. b 5. a Terms: Actions for subsequent events Difficulty: Challenging Objective: LO 24-4 AACSB: Analytic thinking

31) State the two primary types of subsequent events that require consideration by management and evaluation by the auditor, and give two examples of each type. Answer: 1. Events that occur after the balance sheet date which provide additional information to management that helps them determine the fair presentation of account balances as of the balance sheet date. Information about these events helps auditors in verifying the balances. These events have a direct effect on the financial statements and require adjustment. Examples include declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to deteriorating financial condition; settlement of litigation at an amount different from the amount recorded on the books; and the disposal of equipment not being used in operations at a price below the current book value. 2. Events that have no direct effect on the financial statements but for which disclosure is required. Subsequent events of this type are events that provide evidence about conditions which did not exist at the date of the balance sheet being reported on but arose after the balance sheet date and may be significant enough to require disclosure. Examples include a decline in the market value of securities held for temporary investment or resale; issuance of bonds or equity securities; a decline in the market value of inventory as a consequence of government action barring further sale of a product; the uninsured loss of inventories as a result of fire; and a merger or an acquisition. Terms: Types of subsequent events Difficulty: Moderate Objective: LO 24-4 AACSB: Reflective thinking

24.5 Learning Objective 24-5 1) The date of the management representation letter received from the client should A) be the date of latest subsequent event disclosed in the notes to the financial statements. B) be dated no earlier than the date of the audit report. C) have the same date as the date of the balance sheet. D) have the same date as the date of the engagement letter. Answer: B Terms: Management representation letter Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 2) Which of the following procedures and methods are important in assessing a company's ability to continue as a going concern? A) Discussions with management regarding Evaluation of management's plans to potential financial difficulties avoid bankruptcy Yes Yes B) Discussions with management regarding potential financial difficulties No

Evaluation of management's plans to avoid bankruptcy No

C) Discussions with management regarding potential financial difficulties Yes

Evaluation of management's plans to avoid bankruptcy No

D) Discussions with management regarding potential financial difficulties No

Evaluation of management's plans to avoid bankruptcy Yes

Answer: A Terms: Going concern Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking

3) The letter of representation obtained from an audit client should be A) dated as of the end of the period under audit. B) dated as of the audit report date. C) dated as of any date decided upon by the client and auditor. D) dated as of the issuance of the financial statement. Answer: B Terms: Letter of representation Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 4) When should auditors generally assess a client's ability to continue as a going concern? A) upon completion of the audit B) during the planning stages of the audit C) throughout the entire audit process D) during testing and completion phases of the audit Answer: C Terms: Going concern Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 5) Which of the following would the auditor expect to find in the client's management representation letter? A) management's recommendations for system of internal control effectiveness improvements B) management's plans for improving product quality C) management's compliance with contractual arrangements that impact the financial statements D) management's goals for improving earnings per share Answer: C Terms: Management representation letter Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 6) Auditing standards require that the auditor evaluate whether there is a substantial doubt about a client's ability to continue as a going concern for at least A) one quarter beyond the balance sheet date. B) one quarter beyond the date of the auditor's report. C) one year beyond the balance sheet date. D) one year beyond the date of the auditor's report. Answer: C Terms: Auditing standards; Going concern issues Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking

7) Auditing standards require auditors to evaluate whether there is substantial doubt about a client's ability to continue as a going concern. One of the most important audit procedures to perform to assess the going concern question is A) analytical procedures. B) confirmations from creditors. C) statistical sampling procedures. D) tests of system of internal controls. Answer: A Terms: Audit procedures to assess going concern Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 8) Which of the following statements regarding the letter of representation is not correct? A) It is prepared on the client's letterhead. B) It is addressed to the CPA firm. C) It is signed by high-level corporate officials, usually the president and chief financial officer. D) It is optional, not required, that the auditor obtain such a letter from management. Answer: D Terms: Letter of representation Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 9) Refusal by a client to prepare and sign the representation letter would require the auditor to issue a(n) A) qualified opinion or a disclaimer of opinion. B) adverse opinion or a disclaimer of opinion. C) qualified or an adverse opinion. D) unqualified opinion with an explanatory paragraph. Answer: A Terms: Refusal to prepare and sign the letter of representation Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 10) A management representation letter is A) prepared on the CPA's letterhead. B) addressed to the client. C) signed by high-level corporate officials. D) dated as of the balance sheet date. Answer: C Terms: Management representation letter Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 36 Copyright © 2023 Pearson Education, Inc.

11) Which of the following is correct regarding supplementary information? A) The auditor must express an opinion on the supplementary information. B) When reporting on supplementary information, the auditor uses a different materiality threshold from that used in forming an opinion on the basic financial statements. C) If the auditor's report on the audited financial statements contains an adverse opinion, the auditor can still issue an unqualified opinion on the supplementary information. D) The auditor can issue a separate report on the supplementary information; it does not need to be part of the report on the financial statements. Answer: D Terms: Supplementary information accompanying basic financial statements Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 12) Which of the following is not one of the categories of items included in the letter of representation? A) subsequent events B) completeness of information C) recognition, measurement, and disclosure D) materiality Answer: D Terms: Client letter of representation Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 13) Which of the following audit procedures would most likely assist an auditor in identifying conditions and events that may indicate there could be substantial doubt about an entity's ability to continue as a going concern? A) review compliance with the terms of debt agreements B) confirmation of accounts receivable from principal customers C) reconciliation of interest expense with debt outstanding D) confirmation of bank balances Answer: A Terms: Audit procedures; Entity's ability to continue as a going concern Difficulty: Challenging Objective: LO 24-5 AACSB: Reflective thinking

14) Which of the following statements is correct? A) A letter of representation is documentation of management's acceptance of responsibility for the financial statements and is deemed to be reliable evidence. B) A letter of representation is not deemed to be reliable evidence because of the potential incompetence of management. C) A letter of representation is not deemed to be reliable evidence because it is a written statement from a nonindependent source. D) A letter of representation is documentation of the CPA's acceptance of responsibility for the audit of the financial statement and is deemed to be reliable. Answer: C Terms: Letter of representation Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 15) Auditing standards require the auditor to ________ other information included in annual reports pertaining directly to the financial statements. A) audit B) express an opinion on C) read D) analyze Answer: C Terms: Other information included in annual reports Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 16) An auditor must obtain written client representations that might be signed by all but which of the following? A) treasurer B) chief financial officer C) vice president of operations D) chief executive officer Answer: C Terms: Client representations signed by Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking

17) Which of the following is not a reason why the auditor requests that the client provide a letter of representation? A) Professional auditing standards require the auditor to obtain a letter of representation. B) It impresses upon management its responsibility for the accuracy of the information in the financial statements. C) It provides written documentation of the oral responses already received to inquiries of management. D) It determines the type of opinion the auditor will issue on the financial statements. Answer: D Terms: Letter of representation Difficulty: Challenging Objective: LO 24-5 AACSB: Reflective thinking 18) At the completion of the audit, management is asked to make a written statement that it is not aware of any undisclosed contingent liabilities. This statement would appear in the A) management letter. B) letter of inquiry. C) letters testamentary. D) management letter of representation. Answer: D Terms: Completion of audit; written statement by management Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 19) Current professional auditing standards require the performance of analytical procedures during the planning and completion phases of the audit. Answer: TRUE Terms: Analytical procedures; Planning and completion phases of the audit Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 20) Current professional auditing standards mandate the use of analytical procedures during the testing phase of the audit. Answer: FALSE Terms: Professional auditing standards; Analytical procedures; Testing phase of audit Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking

21) Auditing standards require the auditor's assessment of going concern issues. Answer: TRUE Terms: Auditing standards; Going concern issues Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 22) Results from the final analytical procedures may indicate that additional audit evidence is necessary. Answer: TRUE Terms: Analytical procedures in stages of audit Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 23) Although the letter of representation is typed on the client's letterhead and signed by the client, it is common for the auditor to prepare the letter. Answer: TRUE Terms: Letter of representation Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 24) Auditors of public companies must obtain certain representations from management regarding system of internal control over financial reporting. Answer: TRUE Terms: Representations from management regarding system of internal control Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 25) At the completion of the audit, management is typically asked to make a written statement as a part of the engagement letter that it is aware of no undisclosed contingent liabilities. Answer: FALSE Terms: Completion of audit; written statement by management; undisclosed liabilities Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 26) Auditors are required to obtain a letter of representation that describes management's planned solutions to all system of internal control weaknesses identified during an audit. Answer: FALSE Terms: Letter of representation Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 40 Copyright © 2023 Pearson Education, Inc.

27) The letter of representation is prepared on the CPA firm's letterhead, addressed to the client's chief executive officer, and signed by the audit engagement partner. Answer: FALSE Terms: Letter of representation Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 28) If the client refuses to prepare and sign a letter of representation, the auditor would be required to issue either a qualified opinion or a disclaimer of opinion. Answer: TRUE Terms: Letter of representation; issue opinion Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 29) Because a management representation letter is a written statement from a nonindependent source, it cannot be regarded as reliable evidence. Answer: TRUE Terms: Client representation letter; reliable evidence Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking 30) An example of the use of data analytics at the end of the audit is using software to scan unusual journal entries that may require additional consideration by the auditor of their potential impact on the year-end financial statements. Answer: TRUE Terms: Final audit evidence accumulation Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 31) Accounting standards generally require the financial statements to be prepared on the assumption an entity will continue its operations for a reasonable amount of time. Answer: TRUE Terms: Evaluating going-concern assumption Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking

32) The Financial Accounting Standards Board (FASB) describes a reasonable period of time as two years after the date the financial statements are issued for management to evaluate the entity's ability to continue as a going concern. Answer: FALSE Terms: Evaluating going-concern assumption Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 33) The accounting standards state that management is responsible to evaluate the entity's ability to continue as a going concern within one year after the date the financial statements are issued. Answer: TRUE Terms: Evaluating going-concern assumption Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 34) The Securities and Exchange Commission has established regulations about the presentation of non-GAAP financial measures included in financial statements which include such measures should be relevant and reliable measures that do not mislead investors. Answer: TRUE Terms: Non-GAAP measures in financial statements Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 35) What two steps must an auditor take if they have reservations about the audit client continuing as a going concern? Answer: 1. Evaluate management's plan to avoid bankruptcy. 2. Determine the feasibility of management achieving those plans. Terms: Going concern Difficulty: Easy Objective: LO 24-5 AACSB: Reflective thinking 36) State the three purposes of the management representation letter. Answer: • To impress upon management its responsibility for the assertions in the financial statements • To remind management of potential misstatements or omissions in the financial statements • To document the responses from management to inquiries about various aspects of the audit Terms: Management representation letter Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking

37) List four specific matters that should be included in a client representation letter. Answer: • Management's acknowledgment of its responsibility for preparing and fair presentation of the financial statements • Management's acknowledgement of its responsibility for the design, implementation, and maintenance of system of internal controls relevant to the preparation and fair presentation of the financial statements • Management's acknowledgement of its responsibility for information provided and the completeness of information provided to the auditor, including access to all financial records and related data; minutes of meetings of stockholders, directors, and committees of directors, communications from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices • Management's acknowledgement of its responsibility to design, implement, and maintain system of internal controls to prevent and detect fraud; including disclosing the results of its fraud risk assessment to the auditor; including providing the auditor with information concerning fraud involving (a) management, (b) employees who have significant roles in system of internal control, or (c) others where the fraud could have a material effect on the financial statements • Statement from management that it has disclosed all instances of identified or suspected noncompliance with laws and regulations whose effects should be considered when preparing the financial statements • Statement from management stating that any unrecorded financial statement misstatements are immaterial to the financial statements (including a summary of those items included in or attached to the letter) • Management's acknowledgement they have disclosed information about actual or possible litigation and unasserted claims or assessments that the entity's lawyer has advised are probable of assertion and must be disclosed in accordance with accounting standards • Statement from management about its belief that significant assumptions used by management in making accounting estimates are reasonable • Management's acknowledgement that they have disclosed to the auditor the identity of the entities related-party relationships and transactions of which management is aware and that management has appropriately accounted for and disclosed such relationships and transactions • Management's acknowledgement they have adjusted or disclosed in the financial statements all events occurring after the date of the financial statements that impact fair presentation of those financial statements in accordance with accounting standards Terms: Management representation letter Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking

38) Besides the search for contingent liabilities and the review for subsequent events, the auditor has five important final evidence accumulation responsibilities, all of which are required by current professional auditing standards. Discuss each of these five responsibilities. Answer: • Final analytical procedures performed as a final review for material misstatements or financial problems and to help the auditor take a final objective look at the financial statements. • Evaluate the going-concern assumption. • Obtain a management representation letter documenting management's most important oral representations during the audit. • Consider supplementary information in relation to the financial statements taken as a whole. • Read other information in the annual report. Terms: Final evidence accumulation responsibilities required by professional auditing standards Difficulty: Challenging Objective: LO 24-5 AACSB: Reflective thinking 39) The accounting standards require management to evaluate an entity's ability to continue as a going concern within one year after the date the financial statements are issued. Describe the two steps management is required to perform in performing this evaluation. Answer: Management must first evaluate whether there are conditions and events that raise substantial doubt about the entity's ability to continue as a going concern; if management concludes that substantial doubt is raised, management is also responsible to consider whether its plans alleviate that doubt. Terms: Evaluating going-concern assumption Difficulty: Moderate Objective: LO 24-5 AACSB: Reflective thinking

24.6 Learning Objective 24-6 1) To make a final evaluation as to whether sufficient appropriate evidence has been accumulated, the auditor will do all of the following except A) review the audit documentation for the entire audit to determine whether all material classes of transactions have been adequately tested. B) make sure that all parts of the audit program have been accurately completed and documented. C) obtain the management representation letter. D) decide whether the audit program is adequate. Answer: C Terms: Sufficient evidence to draw a conclusion Difficulty: Easy Objective: LO 24-6 AACSB: Reflective thinking 2) When reviewing the summary of misstatements found in the audit, A) an adjusting journal entry must be made by the auditor for all material misstatements. B) auditors must combine individually immaterial misstatements to evaluate whether the combined amount is material. C) the auditor is not required to consider the impact on the current financial statements of misstatements in the prior year that were not corrected. D) auditors only need to consider the misstatements that impact the income statement. Answer: B Terms: Sufficient evidence to draw a conclusion Difficulty: Easy Objective: LO 24-6 AACSB: Reflective thinking 3) Which of the following is an accurate statement regarding audit documentation review? A) The audit partner must review the work of the least experienced auditor in more detail than the work of the audit supervisor. B) The audit senior must review all audit documentation. C) For larger audits, it is common to have the financial statements and the entire set of audit files reviewed by someone who has not participated in the audit, but is a member of the audit firm doing the audit. D) Checklists can never be used to verify that all financial statement disclosures have been made. Answer: C Terms: Audit documentation Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking

4) There are three reasons why an experienced member of the audit firm must thoroughly review audit documentation of the completion of the audit, including A) to evaluate the performance of inexperienced personnel. B) to make sure that the audit meets the CPA firm's standard of performance. C) to counteract the bias that often enters into the auditor's judgment. D) all of the above. Answer: D Terms: Audit documentation Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking 5) An independent review must be performed of all audits. Answer: FALSE Terms: Independent review Difficulty: Easy Objective: LO 24-6 AACSB: Reflective thinking 6) If, during the completion phase of the audit, the auditor determines that he or she has not obtained sufficient evidence to draw a conclusion about the fairness of the client's financial statements, there are two choices: accumulate additional evidence or issue either a qualified or an adverse opinion. Answer: FALSE Terms: Sufficient evidence to draw a conclusion Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking 7) After performing all audit procedures in each area, the auditor must integrate the results into an overall conclusion about the financial statements. Answer: TRUE Terms: Sufficient evidence to draw a conclusion Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking

8) Match seven of the terms (a-p) with the description/definitions provided below (1-7). a. commitments b. completing the engagement checklist c. contingent liability d. dual-dated audit report e. financial statement disclosure checklist f. independent review g. inquiry of client's attorneys h. letter of representation i. other information in annual reports j. review for subsequent events k. subsequent events l. unadjusted misstatement worksheet m. management letter n. pending claim o. unasserted claim p. Audit documentation review ________ 1. a review of the financial statements and the entire set of audit files by an independent reviewer to whom the audit team must justify the evidence accumulated and the conclusions reached ________ 2. a potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place ________ 3. a written communication from the client to the auditor formalizing statements that the client has made about matters pertinent to the audit ________ 4. a potential legal claim against a client where the condition for a claim exists but no claim has been filed ________ 5. transactions that occurred after the balance sheet date, which affect the fair presentation or disclosure of the statements being audited ________ 6. agreements that the entity will hold to a fixed set of conditions, such as the purchase or sale of merchandise at a stated price ________ 7. the use of one audit report date for normal subsequent events and a later date for one or more subsequent events

Answer: 1. f 2. c 3. h 4. o 5. k 6. a 7. d Terms: Independent review; Contingent liability; Letter of representation; Unasserted claim; Subsequent events; Commitments; Dual-dated audit report Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking 9) List the three reasons why an experienced member of the audit firm must thoroughly review audit documentation at the completion of the audit. Answer: 1. To evaluate the performance of inexperienced personnel 2. To make sure that the audit meets the CPA firm's standard of performance 3. To counteract the bias that often enters into the auditor's judgment Terms: Audit documentation Difficulty: Moderate Objective: LO 24-6 AACSB: Reflective thinking

24.7 Learning Objective 24-7 1) The auditor is responsible for communicating significant system of internal control deficiencies to the audit committee, or those charged with governance. This communication A) may be oral or written. B) must be oral. C) must be written. D) must be oral via direct communication. Answer: C Terms: Communicate significant system of internal control deficiencies Difficulty: Easy Objective: LO 24-7 AACSB: Reflective thinking 2) Which of the following statements is most correct about an auditor's required communication with management and those charged with corporate governance? A) The auditor is required to inform those charged with governance about significant errors discovered and subsequently corrected by management. B) Any significant matter reported to those charged with governance must also be communicated to management. C) Communication is required before the audit report is issued. D) The auditor does not have any requirement to communicate with anyone other than the company's senior management. Answer: A Terms: Required communication with management; corporate governance Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 3) While there is no professional requirement to do so on audit engagements, CPAs frequently issue a formal "management" letter to clients. The primary purpose of this letter is to provide A) evidence indicating whether the auditor is reasonably certain that internal accounting control is operating as prescribed. B) a permanent record of the internal accounting control work performed by the auditor during the course of the engagement. C) the client with the CPA's recommendations for improving any part of the client's business. D) a summary of the auditor's observations that resulted from the auditor's special study of system of internal control. Answer: C Terms: Management representation letter Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking

4) When communicating with the audit committee and management, A) only material fraud and illegal acts are required by auditing standards to be communicated. B) all system of internal control deficiencies are required by auditing standards to be communicated. C) the communications should be made in a timely manner to allow those charged with governance to take appropriate actions. D) all communications with the audit committee and management must be in writing. Answer: C Terms: Communicated to the audit committee or designate body Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 5) Auditing standards require the auditor to communicate all management frauds and illegal acts to the audit committee A) only if the act is immaterial. B) only if the act is material. C) only if the act is highly material. D) regardless of materiality. Answer: D Terms: Auditing standards; Frauds and illegal acts; Audit committee Difficulty: Easy Objective: LO 24-7 AACSB: Reflective thinking 6) Auditors are required to communicate either orally or in writing with the audit committee about system of internal control weaknesses. Answer: FALSE Terms: Auditors required to communicate with audit committee; system of internal control weaknesses Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 7) The Sarbanes-Oxley Act includes additional communication requirements for auditors of public companies. Answer: TRUE Terms: Sarbanes-Oxley and communication requirements Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking

8) Client representation letters are required by professional auditing standards, whereas management letters are optional. Answer: TRUE Terms: Client representation letters; Management letters; Auditing standards Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 9) PCAOB auditing standards require the auditor to communicate key audit matters or critical audit matters in the standard unqualified audit report. Answer: TRUE Terms: Audit report considerations Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 10) AICPA reporting standards do not require the communication of key audit matters, but do provide guidance for how to communicate these matters if the terms of the engagement require such disclosure. Answer: TRUE Terms: Audit report considerations Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking 11) List the four principal purposes of the required communication with the audit committee regarding certain additional information obtained during the audit. Answer: • To communicate auditor responsibilities in the audit of financial statements • To provide an overview of the scope and timing of the audit • To provide those charged with governance with significant findings arising during the audit • To obtain from those charged with governance information relevant to the audit Terms: Other communications with audit committee Difficulty: Moderate Objective: LO 24-7 AACSB: Reflective thinking

24.8 Learning Objective 24-8 1) The audit firm issues an audit report for its client. The auditors have no obligation to make further inquiries with respect to the client's audited financial statements unless A) a development occurs that may affect the company's long-term viability. B) final resolution was made on disclosed contingency for which no liability needed to be accrued. C) new information comes to the auditor's attention concerning an event that occurred prior to the date of the audit report that, if known, would have impacted the audit opinion. D) a lawsuit, in which the risk of loss was considered remote, was resolved in the company's favor. Answer: C Terms: Audit report; Further inquiries Difficulty: Moderate Objective: LO 24-8 AACSB: Analytic thinking 2) If an auditor discovers that previously issued financial statements are misleading, the most desirable approach to follow is to request that the client issue an immediate revision of the financial statements containing an explanation of the reasons for the revision. Answer: TRUE Terms: Auditor discovers that previously issued financial statements are misleading Difficulty: Easy Objective: LO 24-8 AACSB: Reflective thinking 3) Subsequent discoveries of facts requiring the reissuance of financial statements arise from events occurring after the date of the auditor's report. Answer: FALSE Terms: Events that occur after the date of the auditor's report Difficulty: Moderate Objective: LO 24-8 AACSB: Reflective thinking

4) The fieldwork for the December 31, 2016 audit of Treble Corporation ended on March 17, 2017. The financial statements and auditor's report were issued and mailed to stockholders on March 29, 2017. In each of the material situations (1 through 5) below, indicate the appropriate action (a, b, c, d, or e). The possible actions are as follows: a. Adjust the December 31, 2016 financial statements. b. Disclose the information in a footnote in the December 31, 2016 financial statements. c. Request the client revise and reissue the December 31, 2016 financial statements. The revision should involve an adjustment to the December 31, 2016 financial statements. d. Request the client revise and reissue the December 31, 2016 financial statements. The revision should involve the addition of a footnote, but no adjustment, to the December 31, 2016 financial statements. e. No action is required. The situations are as follows: ________ 1. On January 16, 2017 a lawsuit was filed against Treble for a patent infringement action that allegedly took place in early 2014. In the opinion of Treble's attorneys, there is a reasonable (but not probable) danger of a significant loss to Treble. ________ 2. On February 19, 2017, Treble settled a lawsuit out of court that had originated in 2015 and is currently listed as a contingent liability. ________ 3. On March 30, 2017, Treble settled a lawsuit out of court that had originated in 2014 and is currently listed as a contingent liability. ________ 4. On February 2, 2017, you discovered an uninsured lawsuit against Treble that had originated on August 30, 2013. There is a reasonable (but not probable) danger of a significant loss to Treble. ________ 5. On April 7, 2017, you discovered that a debtor of Treble went bankrupt on January 22, 2017, due to a major uninsured fire that occurred on January 2, 2017. Answer: 1. b 2. a 3. e 4. b 5. d Terms: Actions for subsequent events Difficulty: Challenging Objective: LO 24-8 AACSB: Analytic thinking

Auditing and Assurance Services, 18e (Arens) Chapter 25 Other Assurance Services 25.1 Learning Objective 25-1 1) The standards for preparation, compilation, and review engagements of financial statements are the A) AICPA's Code of Professional Conduct. B) Statements on Auditing Standards (SASs). C) Statements of Standards on Attestation Engagements (SSAEs). D) Statements on Standards for Accounting and Review Services (SSARS). Answer: D Terms: Review, compilation, and preparation services Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 2) Two of the types of services provided in connection with the Statements on Standards for Accounting and Review Services are A) audit and examination services. B) compilation and review services. C) examination and review services. D) management advisory services and compilations. Answer: B Terms: Statements on Standards for Accounting and Review Services (SSARS) Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 3) Practitioners who perform preparation, compilation, or review engagements are referred to in the Statements on Standards for Accounting and Review Services (SSARS) standards as A) bookkeepers. B) accountants. C) auditors. D) CPAs. Answer: B Terms: Preparation, compilation, and review engagements; SSARS standards Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking

4) Compilation reports may be of all except which of the following types? A) compilation with limited independence B) compilation with full disclosure C) compilation without independence D) compilation that omits substantially all disclosures Answer: A Terms: Compilation reports Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 5) A CPA firm can issue a compilation report A) only if the partners are independent. B) only if all the partners and the staff in the office performing the engagement are independent. C) if the partners have no material or direct immaterial interest in the client. D) even if it is not independent. Answer: D Terms: Compilation reports Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 6) Which of the following would not be included in a CPA's report based upon a review of the financial statements of a nonpublic entity? A) a statement that the review was in accordance with generally accepted auditing standards B) a statement that all information included in the financial statements is the representation of management C) a statement that the review primarily consists of analytical procedures and inquiries D) a statement that the accountant has conducted a review Answer: A Terms: CPA's report; Review of financial statements; Nonpublic entity Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 7) The statement that "We are not aware of any material modifications that should be made to the accompanying financial statements" expresses which of the following? A) disclaimer of an opinion B) negative assurance C) negative confirmation D) shared opinion Answer: B Terms: Negative assurance Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 2 Copyright © 2023 Pearson Education, Inc.

8) For compilations, an accountant does which of the following? A) Obtain an Perform tests of Perform tests of understanding of controls. transactions. system of internal control. Yes Yes No B) Obtain an understanding of system of internal control. Yes

Perform tests of controls.

Perform tests of transactions.

Yes

Obtain an understanding of system of internal control. No

Perform tests of controls.

Perform tests of transactions.

Yes

Obtain an understanding of system of internal control. No

Perform tests of controls.

Perform tests of transactions.

Answer: D Terms: Compilation Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 9) The concept of limited assurance is provided for in which of the following engagements? A) audit B) review C) compilation D) agreed-upon procedures Answer: B Terms: Limited assurance; Engagements Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking

10) Evidence for a review engagement consists primarily of A) Inquiries Analytical procedures Tests of details No Yes No B) Inquiries Yes

Analytical procedures Yes

Tests of details No

Inquiries No

Analytical procedures No

Tests of details Yes

Inquiries Yes

Analytical procedures No

Tests of details Yes

Answer: B Terms: Evidence for review engagement Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 11) When the accountant has performed a review and has determined that no material changes to the financial statements are needed, the first paragraph of the review report A) expresses positive assurance about the financial statements. B) notes the accountant's responsibility to conduct the review. C) identifies the entity and the period of financial statements subject to the review. D) specifies that management is responsible for the financial statements. Answer: C Terms: Review of financial statement; Report Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 12) The highest level of assurance is provided for in which one of the following engagements? A) review B) compilation C) audit D) preparation service Answer: C Terms: Concept of reasonable assurance Difficulty: Moderate Objective: LO 25-1 AACSB: Analytic thinking

13) You are preparing to issue a report on the compilation of financial statements for a nonpublic company. Prior to issuing the report you should A) read the financial statements to determine if they are free from obvious material errors. B) perform analytical procedures to determine if they are free from material misstatements. C) perform tests of balances on selected accounts to determine if they are free from material misstatements. D) perform limited control tests to determine if there are any material misstatements. Answer: A Terms: Report on the compilation of financial statements for nonpublic company Difficulty: Moderate Objective: LO 25-1 AACSB: Analytic thinking 14) Which of the following statements is true regarding review and audit services? A) A review requires more substantive evidence than an audit. B) An audit requires less evidence related to system of internal control than a review. C) A review requires less evidence than an audit. D) None of the above statements is true. Answer: C Terms: Assurance; Review Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 15) An accountant who reviews the financial statements of a nonpublic entity should issue a report stating that a review A) is substantially equivalent in scope to an audit. B) is substantially more in scope than a compilation. C) is substantially less in scope than an audit. D) provides only minimal assurance that the financial statements are fairly presented. Answer: C Terms: Review of financial statement; Report Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 16) An accountant has accepted an engagement in which the audit procedures of inquiry and analytical procedures will be employed. These procedures will form the basis for issuance of A) a compilation report. B) an audit report on supplemental information issued by the client. C) a management advisory report requested by the audit committee. D) a review report on financial statements for a nonpublic company. Answer: D Terms: Engagement with audit procedures of inquiry and analytically procedures Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 5 Copyright © 2023 Pearson Education, Inc.

17) All of the following are steps that should be performed in a review engagement except for A) understand the company's ownership structure. B) read the company's financial statements. C) perform analytical procedures. D) assess fraud risk. Answer: D Terms: Review of a nonpublic entity's financial statements Difficulty: Moderate Objective: LO 25-1 AACSB: Analytic thinking 18) In a review service where the client has failed to follow applicable accounting standards, the accountant is A) not required to determine the effect of a departure if management has not done so, but that fact must be disclosed in the report. B) required to determine the effect of a departure if management has not done so, and that fact must be disclosed in the report. C) not required to determine the effect of a departure if management has not done so, and that fact need not be disclosed in the report. D) required to determine the effect of a departure if management has not done so, and that fact need not be disclosed in the report. Answer: A Terms: Review service where client failed to follow applicable accounting standards Difficulty: Challenging Objective: LO 25-1 AACSB: Reflective thinking 19) Your accounting firm has accepted a compilation engagement from a client in which your firm is not independent. In that case you A) may not accept the engagement. B) may accept the engagement and disclose the lack of independence. C) may accept the engagement and not disclose the lack of independence. D) may accept the engagement and disclose the lack of independence and the reason for the lack of independence. Answer: B Terms: Compilation engagement; Firm not independent Difficulty: Challenging Objective: LO 25-1 AACSB: Analytic thinking

20) One of the first steps that should be performed for a review of a nonpublic entity's financial statements is to A) read the financial statements. B) obtain knowledge of the accounting principles and practices of the client's industry. C) inquire whether management has omitted substantially all of the disclosures required by applicable accounting standards. D) apply analytical procedures to provide limited assurance that no material modifications should be made to the financial statements. Answer: B Terms: Review of a nonpublic entity's financial statements Difficulty: Challenging Objective: LO 25-1 AACSB: Reflective thinking 21) Each page of the financial statements reviewed for a nonpublic entity should include the reference A) "These financial statements are unaudited." B) "We express no assurance on these financial statements." C) "See independent accountant's review report." D) "See the audit opinion for the review procedures performed." Answer: C Terms: Review of financial statement; Report Difficulty: Moderate Objective: LO 25-1 AACSB: Analytic thinking 22) The last paragraph of the accountant's review report A) details the responsibilities of management. B) details the responsibilities of the accountant. C) expresses limited assurance in the form of negative assurance. D) lists the analytical procedures performed. Answer: C Terms: Review of financial statement; Report Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking

23) Which of the following is a correct statement regarding review, compilation, and preparation services? A) A written engagement letter is not needed for a review, compilation, or preparation service. B) The Statements on Standards for Accounting and Review Services (SSARS) clarity project used international standards as the base standard when revising the SSARS. C) CPAs must be independent of the client in a review service engagement and for an audit engagement. D) The amount of evidence accumulated in a review is minimal. Answer: C Terms: Preparation, compilation, and review engagements; SSARS standards Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 24) When performing a review service, auditors must make inquiries of management. Which of the following inquiries are typically made of management? A) Is each account on the financial statements prepared in conformity with accounting standards and consistently applied? B) What unusual or significant transactions occurred this year? C) Do you have knowledge of an actual or suspected fraud? D) All of the above are inquiries typically made of management. Answer: D Terms: Review of a nonpublic entity's financial statements Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 25) In a preparation service engagement, A) the CPA's responsibilities are similar to those performed during a review. B) the CPA does not provide any assurance of the financial statements. C) the CPA must issue a preparation service engagement report. D) the CPA must be independent. Answer: B Terms: Preparation services Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 26) When performing a review service and the accountant becomes aware that fraud may have occurred, the accountant must withdraw from the engagement. Answer: FALSE Terms: Review services Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking

27) If an auditor performs a compilation but lacks independence, an additional paragraph must be added which states that: "We are not independent with respect to XYZ Company." Answer: TRUE Terms: Compilation engagement; Firm not independent Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 28) Review reports are normally dated as of the client's balance sheet date. Answer: FALSE Terms: Review reports dated Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 29) Statements on Standards for Accounting and Review Services (SSARS) are issued by the SEC. Answer: FALSE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 30) A nonaudit engagement in which the accountant undertakes to present, in the form of financial statements, information that is the representation of management, without undertaking to express any assurance on the statements is called a review engagement. Answer: FALSE Terms: Nonaudit engagement; review engagement Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 31) CPAs must be independent to issue a compilation report. Answer: FALSE Terms: Compilation report; Independence Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 32) CPAs must be independent to issue a review report. Answer: TRUE Terms: Review report; Independence Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking

33) A financial statement review conducted in compliance with Statements on Standards for Accounting and Review Services (SSARS) includes obtaining an understanding of system of internal control. Answer: FALSE Terms: Financial statement review; SSARS; Internal control Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 34) Statements on Standards for Accounting and Review Services (SSARS) govern the CPA's association with unaudited financial statements of nonpublic companies. Answer: TRUE Terms: Statements on Standards for Accounting and Review Services (SSARS) Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 35) When performing a review (SSARS review) of financial statements, the accountant is required to obtain a letter of representation from management. Answer: TRUE Terms: Review of financial statements; Letter of representation from management Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 36) When performing compilation services, the accountant is not required to obtain an understanding of the client's system of internal control. Answer: TRUE Terms: Compilation services; Client system of internal control Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 37) A CPA firm can issue a compilation report even if it is not independent with respect to the client. Answer: TRUE Terms: Compilation report; Independence Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking

38) When performing a preparation service, the CPA must issue a report and must be independent. Answer: FALSE Terms: Preparation services Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 39) For a preparation service, each page of the financial statements should indicate, at a minimum, that "no assurance is provided" on the financial statements. Answer: TRUE Terms: Preparation services Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 40) In a preparation service, if the financial statements are expected to be used by a third party, the accountant must provide at least minimal assurance on the financial statements. Answer: FALSE Terms: Preparation services Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 41) Statements on Standards for Accounting and Review Services (SSARS) are issued by the Accounting and Review Services Committee of the AICPA. Answer: TRUE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 42) A review provides limited assurance on the financial statements, whereas a compilation report provides no expressed assurance. Answer: TRUE Terms: A review compared to a compilation report Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking

43) The SSARS include a section on general principles for all engagements and separate sections on preparation of financial statements, compilation engagements, and reviews of financial statements. Answer: TRUE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 44) SSARS refers to CPAs performing reviews, compilations, and preparation services as auditors, not accountants. Answer: FALSE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 45) The assurance provided in a preparation, compilation, or review engagement is considerably below that of audits. As a result, less evidence is required for these services and they are provided at the same amount of fees as an audit. Answer: FALSE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 46) The amount of evidence and assurance needed for each engagement is defined by the profession, reducing the need for the accountant to make judgments for these engagements. Answer: FALSE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 47) Because reviews, compilations, and preparation services provide the accountant with less assurance than audits, the accountant should establish an understanding with the client about the services to be performed through a written engagement letter. Answer: TRUE Terms: SSARS Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking

48) Each page of the financial statements reviewed by the auditor should include the reference "See independent auditor's review report." Answer: FALSE Terms: Review Report Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 49) For all three types of compilation reports, each page of the financial statements compiled by the auditor should state "See Auditor's Compilation Report." Answer: FALSE Terms: Compilation report Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 50) For compilation reports, if the client fails to follow accounting standards, the accountant must include the same modifications in the compilation report that are used in the review report. Answer: TRUE Terms: Compilation report Difficulty: Easy Objective: LO 25-1 AACSB: Reflective thinking 51) A financial statement review conducted in compliance with Statements on Standards for Accounting and Review Services (SSARS) requires the accountant to obtain evidence to express negative assurance. One of these procedures is to "perform analytical procedures." List three other procedures the accountant must perform. Answer: • Obtain agreement on engagement terms. • Obtain knowledge of the accounting principles and practices of the client's industry. • Obtain knowledge of the client; that is, understand the nature of the client's business transactions, its accounting records and employees, the ownership structure, the key personnel, the accounting principles and practices used by the client, and the content of the financial statements. • Make inquiries of management to determine whether the financial statements are fairly presented. • Read the financial statements to determine whether they conform with the financial reporting framework. • Reconcile the financial statements to the underlying accounting records. • Obtain a letter of representation from members of management who are knowledgeable about financial matters. • Prepare documentation that is sufficient in detail to provide a clear understanding of the work performed; the review evidence obtained and its source; and the conclusions reached. Terms: SSARS; Financial statement review activities Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 13 Copyright © 2023 Pearson Education, Inc.

52) Discuss each of the three types of compilation reports and the circumstances in which each should be used. Answer: • Compilation with full disclosure. This report is used when the financial statements include all disclosures required by accounting standards. • Compilation that omits substantially all disclosures. This type of report is used when the financial statements are compiled without disclosures. This type of report is acceptable if the report indicates the lack of disclosures and the absence of disclosures is not, to the CPA's knowledge, undertaken with the intent to mislead users. Typically, this type of statement is used primarily for management purposes. Appropriate wording is added after the conclusion paragraph of the standard compilation report. • Compilation without independence. A CPA firm can issue a compilation report with full or omitted disclosures even if it is not independent of the client. If the accountant is not independent with respect to the client, the compilation report should include, as a separate last paragraph, a statement to that effect. Terms: Compilation reports Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking 53) Draft a report that would be appropriate when an independent accountant has performed a compilation of financial statements with disclosures in accordance with accounting principles generally accepted in the United States of America. Answer: Management is responsible for the accompanying financial statements of XYZ Company, which comprise the balance sheet as of December 31, 201X, and the related statements of income, changes in stockholders' equity and cash flows for the year then ended, and the related notes to the financial statements in accordance with accounting principles generally accepted in the United States of America. We have performed the compilation engagement in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. We did not audit or review the financial statements nor were we required to perform any procedures to verify the accuracy or completeness of the information provided by management. Accordingly, we do not express an opinion, a conclusion, nor provide any form of assurance on these financial statements. Terms: Report on compilation of financial statements with disclosures in accordance with GAAP Difficulty: Challenging Objective: LO 25-1 AACSB: Analytic thinking

54) Discuss the six Statements on Standards for Accounting and Review Services (SSARS) requirements that must be met when an accountant is performing a compilation of financial statements. Answer: The preparer of the statements must: • Establish an understanding with the client in a written engagement letter or other suitable form of written agreement about the objectives of the compilation engagement, type and limitations of the services to be provided, including acknowledgement that the accountant does not provide any assurance about the financial statements, and a description of the report, if a report is to be issued. • Possess knowledge about the accounting principles and practices of the client's industry. • Know the client, including a general understanding of the client's organization, the nature of its business transactions, the accounting principles and practices used by the client, and the content of its financial statements. • Make inquiries to determine whether the client's information is satisfactory. • Read the compiled financial statements and be alert for any obvious omissions or errors in arithmetic and in the application of accounting standards. • Request management to provide additional or corrected information if the accountant becomes aware that the records, documents, explanations, or other information, including significant judgments by management, is incomplete, inaccurate, or otherwise unsatisfactory. • Prepare documentation in sufficient detail to provide a clear understanding of the work performed and any findings or issues that are significant, including any communications with management regarding fraud or illegal acts that came to the accountant's attention. Terms: SSARS requirements for compilation of financial statements Difficulty: Challenging Objective: LO 25-1 AACSB: Reflective thinking 55) If a client has failed to follow applicable accounting standards in a review engagement, the report must be modified. Prepare an example of the suggested wording in a separate paragraph covering known departures from accounting principles generally accepted in the United States of America. Answer: Known Departures from Accounting Principles Generally Accepted in the United States of America As disclosed in note X to the financial statements, accounting principles generally accepted in the United States of America require that land be stated at cost. Management has informed us that the company has stated its land at appraised value and that, if accounting principles generally accepted in the United States of America had been followed, the land account and stockholders' equity would have been decreased by $500,000. Terms: Modified review report Difficulty: Moderate Objective: LO 25-1 AACSB: Reflective thinking

25.2 Learning Objective 25-2 1) An interim review of the financial information for public companies is performed following standards of the A) American Institute of Certified Public Accountants (AICPA). B) Public Company Accounting Oversight Board (PCAOB). C) Securities and Exchange Commission (SEC). D) Statements on Standards for Accounting and Review Services (SSARS). Answer: B Terms: Review of interim information of public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 2) The Securities and Exchange Commission requires quarterly financial information as a part of the A) 10-K report. B) 10-Q report. C) 8-K report. D) auditor's report. Answer: B Terms: Securities and Exchange Commission; Quarterly financial information Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 3) The quarterly reports submitted to the SEC by the client A) have to be audited, and the CPA firm must be identified. B) do not have to be audited, but the CPA firm which does the annual audit must be identified. C) have to be audited, but the CPA firm does not have to be identified. D) do not have to be audited, but the CPA firm which does the annual audit must review the quarterly statements before they are submitted to the SEC. Answer: D Terms: Quarterly reports; SEC Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 4) When performing a review of interim information for a public company, the accountant ordinarily does not perform tests of the accounting records, independent confirmations, or physical examinations. Answer: TRUE Terms: Review of interim information of public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

5) The auditor must obtain evidence that the interim financial information agrees or reconciles with the accounting records for a public company interim review. Answer: TRUE Terms: Review of interim information of public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 6) A public company interim review is performed following standards of the PCAOB and the review report refers to SSARS. Answer: FALSE Terms: Review of interim information of public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 7) A public company interim review includes five requirements for review service engagements. Name these five requirements. Answer: Obtain knowledge of the accounting principles of the client's industry; obtain knowledge of the client; make inquiries of management; perform analytical procedures; and obtain letter of representation. Terms: Review of interim information of a public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking 8) Like SSARS reviews, reviews for public companies do not provide a basis for expressing positive opinion level assurance. However, these two types of reviews differ in several areas. Name three of the four differences. Answer: • Because an annual audit is also performed for the public company client, the auditor must obtain sufficient information about the client's system of internal control for both annual and interim financial information. • Similarly, because the client is audited annually, the auditor's knowledge of the results of these audit procedures is used in considering the scope and results of the inquiries and analytical procedures for the review. • Under SSARS, the auditor makes inquiries about actions taken at directors' and stockholders' meetings; for a public company, the auditor reads the minutes of those meetings. • The auditor must also obtain evidence that the interim financial information agrees or reconciles with the accounting records for a public company interim review. For example, the auditor might compare the interim financial information to the general ledger. Terms: Review of interim information of a public company Difficulty: Moderate Objective: LO 25-2 AACSB: Reflective thinking

25.3 Learning Objective 25-3 1) Statements on Standards for Attestation Engagements are established by the A) Securities and Exchange Commission. B) Public Company Accounting Oversight Board. C) Auditing Standards Board of the AICPA. D) Accounting and Review Services Committee. Answer: C Terms: Statements on Standards for Attestation Engagements Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 2) As a CPA, you have been engaged to perform an attestation engagement. You would typically A) express a conclusion about an assertion. B) provide management consulting services. C) prepare financial forecasts to secure in preparation for receiving debt funding. D) compile financial statements for the client. Answer: A Terms: CPA; Attestation engagement Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 3) Which of the following attestation engagements result in a conclusion that represents positive assurance? A) review B) compilation C) examination D) agreed-upon procedure engagement Answer: C Terms: Positive assurance Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 4) A review results in a conclusion that represents ________ assurance. A) limited B) negative C) positive D) unequivocal Answer: B Terms: Negative assurance Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

5) The distribution of which of the following types of reports is unrestricted? A) examinations and reviews B) reviews and agreed-upon procedures C) examinations and agreed-upon procedures D) examinations, reviews, and agreed-upon procedures Answer: A Terms: Restricted distribution of reports Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 6) Reports on agreed-upon procedures are intended to be distributed A) to only the involved parties, who would have the requisite knowledge about those procedures and the level of assurance resulting from them. B) to only the involved parties, who would have the requisite knowledge about those procedures but not the level of assurance resulting from them. C) to any party to whom the client wishes. D) only to the stockholders of the client. Answer: A Terms: Reports on agreed-upon procedures Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 7) Distribution of which of the following types of reports is limited? A) audit B) review C) agreed-upon procedures D) examination Answer: C Terms: Distribution of reports limited Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 8) Which of the following is not a standard contained in both the Attestation Standards and Generally Accepted Auditing Standards? A) The examination is to be performed by a person having adequate technical training. B) An independence in mental attitude is to be maintained. C) Sufficient evidence is to be obtained. D) The practitioner must obtain a sufficient understanding of the client's system of internal control. Answer: D Terms: Attestation standard; Standards of fieldwork Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 19 Copyright © 2023 Pearson Education, Inc.

9) Which of the following is not one of the types of engagements and related forms of conclusions that are defined by the attestation standards? A) reviews B) compilations C) examinations D) agreed-upon procedures Answer: B Terms: Attestations; Conclusions; Attestation standards Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 10) Which of the following types of engagement reports would provide positive assurance? A) an examination B) a review C) an agreed-upon procedures engagement D) a compilation Answer: A Terms: Engagement reports; Positive assurance Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 11) An agreed-upon procedures engagement is one in which A) the CPA and management agree that procedures will be applied to all accounts and circumstances. B) the CPA and management agree that procedures will not be applied to all accounts and circumstances. C) the CPA, the responsible party making the assertions, and the specific persons who are the intended users of the CPA's report agree to all the procedures the CPA will perform. D) the CPA, the responsible party making the assertions, and the specific persons who are the intended users of the CPA's report agree that the CPA will apply his judgment to determine the procedures to be performed. Answer: C Terms: Agreed-upon procedures engagement Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking

12) When a CPA performs an examination engagement under the attestation standards, the amount of evidence gathered is ________ and the level of assurance is ________. A) extensive; varying B) significant; high C) extensive; high D) significant; moderate Answer: C Terms: Agreed-upon procedures engagement Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 13) Statements on Standards for Attestation Engagements (SSAEs) are issued by the Auditing Standards Board of the AICPA. Answer: TRUE Terms: SSAEs Difficulty: Easy Objective: LO 25-3 AACSB: Reflective thinking 14) Auditors of the financial statements of public companies must follow the guidelines in the SSAEs. Answer: FALSE Terms: Attestation engagement; Statements on Standards for Attestation Engagements Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 15) The use of positive assurance is appropriate in a review attestation report. Answer: FALSE Terms: Positive assurance; Review reports Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 16) Of the three types of attestation engagements, examination engagements provide a higher level of assurance than agreed-upon procedures engagements but less than review engagements. Answer: FALSE Terms: Attestation engagements; Examination engagements; Agree-upon procedure engagements Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking

17) Examination attestation engagements result in a conclusion that is in a positive form, whereas review attestation engagements result in a conclusion in the form of a negative assurance. Answer: TRUE Terms: Examination attestation engagements; Review attestation engagements Difficulty: Moderate Objective: LO 25-3 AACSB: Reflective thinking 18) The AICPA has made changes to the clarified Statements on Standards for Attestation Engagements effective for reports dated on or after May 1, 2020. Summarize those changes. Answer: The changes modify the wording of the purpose of an attestation engagement to state that the purpose is to provide users of information with an opinion, conclusion, or findings regarding a subject matter or an assertion about the subject matter as measured against suitable and available criteria. The important distinction here is that the practitioner is no longer required to request a written assertion from the party responsible for the subject matter if the practitioner is reporting directly on the subject matter. The change also replaced the word "review" with "limited assurance" engagement. The statement emphasizes that an examination results in an opinion, a limited assurance engagement results in a conclusion, and an agreed-upon procedures engagement results in findings. These changes are designed to converge the U.S. standards with the international standards on attestation engagements. Under the standard, practitioners have more flexibility when conducting agreed-upon procedures in that the procedures would not necessarily have to be "agreed-upon" by all parties but rather could be "specific" procedures performed to meet the needs of the users of the report and deemed appropriate by the party responsible for engaging the practitioner. This type of engagement is somewhat similar to a consulting engagement but would still be considered an attestation engagement in that the practitioner would issue a report on the findings. One other significant change related to this type of agreed-upon procedures engagement is that the report does not necessarily have to be for limited use as was the case under the existing standards; however, the standard does still allow for engagements with prescribed procedures and limited use reports. Terms: Attestation engagement; Statements on Standards for Attestation Engagements Difficulty: Challenging Objective: LO 25-3 AACSB: Reflective thinking

25.4 Learning Objective 25-4 1) Which of the following services is performed under the attestation standards? A) WebTrust SysTrust Yes Yes B) WebTrust No

SysTrust No

C) WebTrust Yes

SysTrust No

D) WebTrust No

SysTrust Yes

Answer: C Terms: Services performed under attestation standards Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 2) The WebTrust service requires that a CPA update its testing of the e-commerce aspects of an entity's website at least every A) ninety days. B) month. C) six months. D) twelve months. Answer: D Terms: WebTrust; Update testing of e-commerce aspects Difficulty: Easy Objective: LO 25-4 AACSB: Reflective thinking

3) In a WebTrust attestation engagement, the client engages a CPA to provide what level of assurance that the company's website complies with Trust Services categories? A) absolute B) reasonable C) limited D) moderate Answer: B Terms: WebTrust Difficulty: Easy Objective: LO 25-4 AACSB: Reflective thinking 4) The service auditor's Type 2 report contains A) an opinion on the reasonableness of the financial statements. B) the two opinions about the description and suitability of the design of controls that are issued in a Type 1 report plus an additional opinion about the operating effectiveness of controls throughout the period. C) an opinion only on the operating effectiveness of the controls. D) an opinion on the service company's website. Answer: B Terms: Report on controls at service organizations Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 5) What type of SOC report is intended to meet the needs of entities that use service organizations and their auditors, who are responsible for understanding system of internal controls over financial reporting at service organizations? A) SOC 1 report B) SOC 2 report C) SOC 3 report D) none of the above Answer: A Terms: Report on controls at service organizations Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking

6) What type of SOC report is intended to meet the needs of a broad range of users who need information and assurance about controls at a service organization that affect the security, availability, and processing integrity of the systems the service organization uses to process users' data and the confidentiality and privacy of the information processed by these systems? A) SOC 1 report B) SOC 2 report C) SOC 3 report D) none of the above Answer: B Terms: Report on controls at service organizations Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 7) Which of the following is not one of the five Trust Services categories? A) security B) confidentiality C) completeness D) availability Answer: C Terms: Trust Services categories Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 8) WebTrust services are performed under the direction of the SSARS. Answer: FALSE Terms: WebTrust services; SSARS Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 9) There are five Trust Service categories, including security and viability. Answer: FALSE Terms: Trust Services categories Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 10) SOC 3 reports are prepared using the Trust Services Criteria. Answer: TRUE Terms: Trust Services categories Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking

11) The guidance for service auditors has been moved to the attestation standards. Answer: TRUE Terms: Report on controls at service organizations Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 12) In a Type 2 engagement, the service auditor performs tests of the operating effectiveness of the controls, but does not have to perform any of the procedures performed in a Type 1 engagement. Answer: FALSE Terms: Report on controls at service organizations Difficulty: Moderate Objective: LO 25-4 AACSB: Reflective thinking 13) Who developed the WebTrust service? Briefly explain this service. Answer: WebTrust was developed jointly by the AICPA and CPA Canada. In a WebTrust engagement, a client engages a CPA to provide reasonable assurance that the client's website complies with certain Trust Services categories and criteria for one or more aspects of ecommerce activities. A site that meets the Trust Service principles is eligible to display the WebTrust electronic seal on its transaction or order page. Terms: WebTrust Difficulty: Easy Objective: LO 25-4 AACSB: Reflective thinking 14) Briefly describe each of the five Trust Services Categories. Answer: The five Trust Services categories are: 1. Security — Information and systems are protected against unauthorized access, unauthorized disclosure of information, and damage to systems that could compromise the availability, integrity, confidentiality, and privacy of information or systems and affect the entity's ability to meet its objectives. 2. Availability — Information and systems are available for operation and used to meet the entity's objectives. 3. Processing integrity — System processing is complete, valid, accurate, timely, and authorized to meet the entity's objectives. 4. Confidentiality — Information designated as confidential is protected to meet the entity's objectives. 5. Privacy — Personal information is collected, used, retained, disclosed, and disposed to meet the entity's objectives. Terms: Trust Services categories Difficulty: Challenging Objective: LO 25-4 AACSB: Reflective thinking 26 Copyright © 2023 Pearson Education, Inc.

25.5 Learning Objective 25-5 1) As a CPA, you have been asked to examine an entity's financial projections. Acceptance of the engagement would be appropriate if distribution is limited to A) stockholders of record as of the date of the report. B) potential investors and creditors by posting on the company's website. C) general public by posting on the company's website. D) a financial institution for which the company is negotiating a loan. Answer: D Terms: Examine financial projections; Distribution limited to Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 2) Which of the following is a type of prospective financial statement as defined by the AICPA attestation standards? A) Forecasts Projections Earnings estimates No No Yes B) Forecasts No

Projections Yes

Earnings estimates No

Forecasts Yes

Projections Yes

Earnings estimates No

Forecasts Yes

Projections No

Earnings estimates Yes

Answer: C Terms: General types of prospective financial statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking

3) Which of the following are prospective financial statements that present an entity's expected financial position, results of operations, and cash flows, to the best of the responsible party's knowledge and belief? A) Forecasts Projections Yes Yes B) Forecasts No

Projections No

Forecasts Yes

Projections No

Forecasts No

Projections Yes

Answer: C Terms: Prospective financial statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking

4) Which of the following are prospective financial statements that present an entity's financial position, results of operations, and cash flows, to the best of the responsible party's knowledge and belief, given one or more hypothetical assumptions? A) Forecasts Projections Yes Yes B) Forecasts No

Projections No

Forecasts Yes

Projections No

Forecasts No

Projections Yes

Answer: D Terms: Prospective financial statements; one or more hypothetical assumptions Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 5) Professional standards prohibit which one of the following types of engagements for prospective financial statements from being undertaken? A) a compilation B) a review C) an examination D) an agreed-upon procedures engagement Answer: B Terms: Professional standards prohibit engagement for prospective financial statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 6) General use statements are prepared for use by A) known contractual parties. B) any third party. C) regulators. D) internal auditors. Answer: B Terms: General use statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 29 Copyright © 2023 Pearson Education, Inc.

7) Which of the following statements regarding prospective financial statements is most correct? A) CPAs are not attesting to the accuracy of the prospective financial statements. B) CPAs are attesting to the accuracy of the prospective financial statements. C) CPAs are performing a review on the company's assumptions and hypotheticals that underlie the prospective financial statements. D) CPAs are performing a review on the achievability of the prospective financial statements. Answer: A Terms: Examination of prospective financial statements Difficulty: Challenging Objective: LO 25-5 AACSB: Reflective thinking 8) What is the best reason that standards prohibit accepting an engagement on a projection for general use? A) The CPA's procedures would violate SSARS. B) Reports on projections are not well understood by the general public. C) Underlying hypothetical assumptions are difficult to interpret without obtaining additional information. D) The CPA is not qualified to report on the use of GAAP in the projected financial statement. Answer: C Terms: Standards for engagement on projection for general use Difficulty: Challenging Objective: LO 25-5 AACSB: Reflective thinking 9) Which of the following is not an element of the examination of prospective financial statements? A) evaluating the preparation of the prospective financial statements B) understanding system of internal controls C) evaluating the support underlying the assumptions D) issuing an examination report Answer: B Terms: Element of examining prospective financial statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking

10) Which of the following statements is not correct? A) Forecasts can be provided for general use. B) Forecasts can be provided for limited use. C) Projections can be provided for general use. D) Projections can be provided for limited use. Answer: C Terms: Prospective financial statements; General use and limited use Difficulty: Challenging Objective: LO 25-5 AACSB: Reflective thinking 11) Attestation standards allow a CPA to perform all but which of the following services for a forecast or projection? A) compilation B) review C) examination D) agreed-upon procedures Answer: B Terms: Attestation standards; Services for a forecast or projection Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 12) In an examination engagement for prospective financial statements, the CPA obtains satisfaction as to the completeness and reasonableness of all the assumptions. Answer: TRUE Terms: Professional standards for performing engagements to review forecasts or projections Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 13) Current professional standards prohibit accountants from performing engagements to review forecasts or projections. Answer: TRUE Terms: Professional standards for performing engagements to review forecasts or projections Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 14) Considerable guidance is provided by the AICPA's Prospective Financial Information Guide. which includes criteria against which an attestation engagement can be compared. Answer: TRUE Terms: AICPA Guide Prospective Financial Statements Difficulty: Moderate Objective: LO 25-5 AACSB: Reflective thinking 31 Copyright © 2023 Pearson Education, Inc.

15) Define forecast and projection. Answer: Forecasts are prospective financial statements that present an entity's expected financial position, results of operations, and cash flows, to the best of the responsible party's knowledge and belief. Projections are prospective financial statements that present an entity's financial position, results of operations, and cash flows, to the best of the responsible party's knowledge and belief, given one or more hypothetical assumptions. Terms: Forecast and projection Difficulty: Easy Objective: LO 25-5 AACSB: Reflective thinking 16) The examination of prospective financial statements contains four elements that comprise the examination. List the four elements below. Answer: 1. Evaluate the preparation of the prospective financial statements. 2. Evaluate the support underlying the assumptions. 3. Evaluate the presentation of the prospective financial statements for conformity with AICPA presentation guidelines. 4. Issue the examination report. Terms: Examination of prospective financial statements Difficulty: Easy Objective: LO 25-5 AACSB: Reflective thinking

25.6 Learning Objective 25-6 1) Which of the following is not an accurate statement regarding agreed-upon procedures engagements? A) These engagements are also known as procedures and findings engagements. B) A report for such an engagement describes the findings resulting from the procedures, but cannot describe the procedures agreed upon. C) All agreed-upon procedure engagements are now under the scope of attestation standards. D) Agreed-upon procedures engagements appeal to CPAs because management, or a third-party user, specifies the procedures they want done. Answer: B Terms: Agreed-upon procedures to prospective financial statements Difficulty: Moderate Objective: LO 25-6 AACSB: Reflective thinking 2) An agreed-upon procedures engagement cannot be undertaken for a federal government agency. Answer: FALSE Terms: Agreed-upon procedures engagement Difficulty: Easy Objective: LO 25-6 AACSB: Reflective thinking

25.7 Learning Objective 25-7 1) One of the bases other than GAAP or IFRS is the financial reporting framework for small- and medium-sized businesses. This basis A) has not yet been approved by the AICPA. B) is the same as the income tax basis. C) draws upon a blend of traditional accounting principles and accrual income tax methods of accounting. D) must be used by a business with sales under $1 million. Answer: C Terms: Other comprehensive basis of accounting Difficulty: Easy Objective: LO 25-7 AACSB: Reflective thinking 2) Clients occasionally enter into loan agreements that require them to provide the ________ with a report from a CPA about the existence or nonexistence of some condition. A) underwriters of securities B) audit committee C) lender D) Securities and Exchange Commission Answer: C Terms: Debt compliance letters Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking 3) When CPAs do audits for specified elements, accounts, or items, A) materiality is defined in terms of the overall financial statements. B) materiality is defined in terms of the elements, accounts, or items being audited. C) auditors do not need to extend their audit efforts to include other elements, accounts, or items that are interrelated with those being audited. D) the authority for auditing specified elements, accounts, or items is in the review and compilation standards. Answer: B Terms: Other audits or limited assurance engagements Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking

4) A CPA who has been engaged to audit financial statements that were prepared on a cash basis A) must ascertain that there is proper disclosure of the fact that the cash basis has been used. B) may not be associated with such statements which are not in accordance with generally accepted accounting principles. C) must render a qualified report explaining the departure from generally accepted accounting principles in the opinion paragraph. D) must restate the financial statements on an accrual basis and then render the standard (shortform) report. Answer: A Terms: Engaged to audit financial statements prepared on a cash basis Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking 5) The engagement and report on debt compliance letters should be limited to compliance matters that the auditor is qualified to evaluate. Which of the following engagements would be inappropriate for the CPA to attempt to evaluate? A) determining whether the client has properly restricted its business activities to the requirements of an agreement B) determining whether principal and interest payments were made when due C) determining whether the proper limitations were maintained on dividends, working capital, and debt ratios D) determining whether the accounting records were adequate for conducting an ordinary audit Answer: A Terms: Engagement and report on debt compliance letters Difficulty: Challenging Objective: LO 25-7 AACSB: Analytic thinking 6) A primary concern in reporting on a comprehensive basis is to make sure that the statements clearly indicate that they are prepared on a basis other than GAAP. Answer: TRUE Terms: Reporting on a comprehensive basis Difficulty: Easy Objective: LO 25-7 AACSB: Reflective thinking 7) When issuing a debt compliance letter, the auditor's opinion should be in the form of a negative assurance. Answer: TRUE Terms: Debt compliance letter; Negative assurance Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking

8) Auditors should provide debt compliance letters only for clients for whom the auditor has done an audit of the overall financial statements. Answer: TRUE Terms: Debt compliance letters Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking 9) State three types of assurance services that fall within the auditing standards but are not audits, reviews, or compilations of financial statements in accordance with GAAP. Answer: • other comprehensive bases of accounting • specified elements, accounts, or items • debt compliance letters and similar reports Terms: Types of assurance services which fall within auditing standards but are not audits, reviews, or compilations Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking 10) Auditors frequently audit statements prepared on bases other than GAAP. Discuss four commonly used bases other than GAAP. Answer: • Cash or modified cash basis. With the cash basis, only cash receipts and disbursements are recorded; there are no accruals. Under the modified cash basis, the cash basis is followed except for certain items, such as fixed assets and depreciation. • Basis used to comply with the requirements of a regulatory agency. This includes the uniform system of accounts required of railroads, utilities, and some insurance companies. • Contractual basis. A basis of accounting a business uses to comply with an agreement between the business and a third party. • Income tax basis. The same measurement rules used for filing tax returns are often used for financial statement preparation, even though this is not in accordance with generally accepted accounting principles (GAAP) or IFRS. • Financial reporting framework for small-and medium-sized businesses. A framework developed by the AICPA for small- and medium-sized businesses that is a self-contained framework not based on accounting principles generally accepted in the United States of America (GAAP). The framework draws upon a blend of traditional accounting principles and accrual income tax methods of accounting. • A definite set of criteria having substantial support. For example, the price-level basis of accounting could be applied to all material items in the financial statements. Terms: Audit statements prepared on bases other than GAAP Difficulty: Moderate Objective: LO 25-7 AACSB: Reflective thinking

Auditing and Assurance Services, 18e (Arens) Chapter 26 Internal and Governmental Financial Auditing and Operational Auditing 26.1 Learning Objective 26-1 1) Internal auditors are expected to add value to the organization through improved operational effectiveness. In addition, their responsibilities include all the following except A) reviewing the reliability and integrity of information. B) ensuring compliance with the company's policies and regulations. C) verifying accounting information for external users. D) safeguarding assets. Answer: C Terms: Internal auditors' responsibilities Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 2) Statements on Internal Auditing Standards are issued by the A) AICPA. B) SEC. C) Internal Auditing Standards Board. D) Auditing Standards Boards. Answer: C Terms: Statements on Internal Auditing Standards Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 3) Internal auditors are responsible to A) the board of directors. B) management. C) both A and B. D) neither A nor B. Answer: C Terms: Internal auditors' responsibilities Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking

4) Which of the following is not a similarity between external and internal auditors? A) Both must be independent of the company. B) Both must be competent. C) Both follow a similar methodology in performing their audits. D) Both consider risk and materiality deciding the extent of their tests and evaluating results. Answer: A Terms: Similarities between internal and external auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 5) External auditors would consider internal auditors effective if they A) are independent of the operating units being evaluated. B) are competent and well trained. C) apply a systematic and disciplined approach, including quality control. D) all of the above. Answer: D Terms: External auditors; Internal auditors effective Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 6) Which of the following is most correct regarding external auditors use of internal auditors directly on the audit engagement? A) discourage B) prohibit C) require D) permit Answer: D Terms: External auditor reliance on internal auditors' work Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 7) The International Standards for the Professional Practice of Internal Auditing include which two categories of standards? A) attribute and performance B) competency and professional skepticism C) performance and integrity D) ethics and rules of conduct Answer: A Terms: International standards; Internal auditing Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking

8) The professional organization which is responsible for providing guidance for internal auditors is the A) Association of Private Auditors. B) Institute of Internal Auditors. C) American Bar Association. D) Association of Internal Auditors. Answer: B Terms: Professional organization responsible for guidance for internal auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 9) External financial statement auditors must obtain evidence regarding what attributes of an internal audit department if the external auditors intend to rely on the internal auditor's work? A) If they have performed relevant audit Competence tests of the system of internal controls and financial statements Yes Yes B) If they have performed relevant audit tests of the system of internal controls and financial statements No

Competence

C) If they have performed relevant audit tests of the system of internal controls and financial statements Yes

Competence

D) If they have performed relevant audit tests of the system of internal controls and financial statements No

Competence

Yes

Answer: A Terms: External auditor reliance on internal auditors' work Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking

10) Which of the following is a performance standard under the International Standards for the Professional Practice of Internal Auditing? A) proficiency and due professional care B) independence and objectivity C) requirement that the internal auditor must be a CPA D) engagement planning Answer: D Terms: International standards; Internal auditing Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 11) Which of the following is an attribute standard under the International Standards for the Professional Practice of Internal Auditing? A) proficiency and due professional care B) communicating results C) requirement that the internal auditor must be a CPA D) engagement planning Answer: A Terms: International standards; Internal auditing Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 12) Independence is a fundamental ethical principle for internal auditors. Answer: FALSE Terms: Independence; Ethical principle Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 13) Current professional auditing standards prohibit external auditors from using internal auditors for direct assistance on external audits. Answer: FALSE Terms: Current professional auditing standards Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 14) Internal auditors are expected to provide value to the organization through improved operational effectiveness. Answer: TRUE Terms: Internal auditors' responsibilities Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 4 Copyright © 2023 Pearson Education, Inc.

15) The objectives of internal auditors are considerably broader than the objectives of external auditors. Answer: TRUE Terms: Objectives of internal auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 16) Integrity is one of the Institute of Internal Auditors' ethical principles. Answer: TRUE Terms: Integrity; IIA ethical principles Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 17) Internal auditing standards are included in the Blue Book. Answer: FALSE Terms: Internal auditing standards Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 18) Professional guidelines for performing internal audits for companies are not as well-defined as for external audits. Answer: TRUE Terms: Professional guidelines for internal audits Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 19) The Internal Auditing Standards Board issues Statements on Internal Auditing Standards. Answer: TRUE Terms: Internal Auditing Standards Board; Statements on Internal Auditing Standards Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 20) Because they spend all their time within one company, internal auditors have much greater knowledge about the company's operations and system of internal controls then external auditors. Answer: TRUE Terms: Internal auditors Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking

21) Under the International Standards for the Professional Practice of Internal Auditing, the performance standards deal with the education requirements of the internal auditor. Answer: FALSE Terms: International Standards for the Professional Practice; Performance standards Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 22) Internal auditors and government auditors perform a significant amount of financial auditing, similar to that done by external CPA firms. Answer: TRUE Terms: Roles of internal and government auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 23) Internal auditors can have a significant impact on a company's operational efficiency and effectiveness, but not on earnings and cash flow. Answer: FALSE Terms: Roles of internal auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 24) Companies employ their own internal auditors to perform operational auditing, but not financial auditing. Answer: FALSE Terms: Roles of internal auditors Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 25) The New York Stock Exchange requires its registrants to have an internal audit function. Answer: TRUE Terms: Internal audit function requirement of New York Stock Exchange registrants Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 26) Internal auditors do not have the same amount of knowledge about system of internal controls and the company's operations as the external auditors do. Answer: FALSE Terms: Internal audit knowledge of operations and system of internal controls Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 6 Copyright © 2023 Pearson Education, Inc.

27) The role of internal auditors in an organization has not expanded significantly in the last two decades. Answer: FALSE Terms: Expansion of internal auditor roles Difficulty: Easy Objective: LO 26-1 AACSB: Reflective thinking 28) Internal audit reports are standardized, as the reporting needs are standardized from company to company. Answer: FALSE Terms: Internal audit reports Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 29) Internal audit reports are relied on by both internal and external users. Answer: FALSE Terms: Internal audit reports Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 30) The American Institute of Certified Public Accountants (AICPA) has established a highly regarded certification program resulting in the designation of Certified Internal Auditor (CIA). Answer: FALSE Terms: Certified Internal Auditor (CIA) Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 31) Statements on Internal Auditing Standards (SIASs) are issued by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA). Answer: FALSE Terms: SIASs issued by the Internal Auditing Standards Board Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 32) Recent research shows the board of directors is delegating oversight of management's enterprise risk management (ERM) responsibilities to the internal audit department in place of a board level committee. Answer: FALSE Terms: Enterprise Risk Management (ERM) oversight responsibilities Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 7 Copyright © 2023 Pearson Education, Inc.

33) The International Standards for the Professional Practice of Auditing list seven performance standards. List three. Answer: 1. managing the internal audit activity 2. nature of work 3. engagement planning 4. performing the engagement 5. communicating results 6. monitoring progress 7. communicating the acceptance of risks Terms: International Standards for the Professional Practice; Performance standards Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 34) What are three similarities between internal and external auditors? Answer: • Both must be competent as auditors and remain objective in performing their work and reporting their results. • Both follow a similar methodology in performing their audits, including planning and performing tests of controls and substantive tests. • Both consider risk and materiality in deciding the extent of their tests and evaluating results. However, their decisions about materiality and risks may differ because external users may have different needs than management or the board. Terms: Similarities between internal and external auditors Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 35) External auditors typically consider internal auditors effective if they meet three criteria. What are these criteria? Answer: External auditors typically consider internal auditors effective if they: • are independent of the operating units being evaluated • are competent and well trained • apply a systematic and disciplined approach, including quality control Terms: Internal auditors effective if they meet three criteria Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking

36) The Institute of Internal Auditors has established Ethical Principles for its members. List each of the principles. Answer: The Institute of Internal Auditors' ethical principles are: • integrity • objectivity • confidentiality • competency Terms: Institute of Internal Auditors established Ethical Principles Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 37) What is the Institute of Internal Auditors Professional Practices Framework definition of internal auditing? Answer: Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. Terms: Definition of internal auditing Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 38) Name three expectations of today's internal auditors. Answer: Providing value through improved operational effectiveness; reviewing the reliability and the integrity of information; ensuring compliance with policies and regulations; safeguarding company assets. Terms: Expectations of today's internal auditor Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking 39) The Institute of Internal Auditors' Position Paper, "The Role of Internal Auditing in Enterprise-Wide Risk Management," and another paper "The State of Risk Oversight: An Overview of Enterprise Risk Management Practices," highlight tasks internal audit should and should not undertake within a company related to ERM activities. Name two roles internal audit should and should not undertake. Answer: Should undertake: giving assurance on the risk management processes; evaluating the reporting of key risks. Should not undertake: setting the company's risk appetite; implementing risk responses on management's behalf. Terms: Roles internal audit should not undertake in Enterprise-wide Risk Management Difficulty: Moderate Objective: LO 26-1 AACSB: Reflective thinking

26.2 Learning Objective 26-2 1) The primary source of authoritative literature for doing government audits is the A) Purple Book. B) Yellow Book. C) Green Book. D) Red Book. Answer: B Terms: Authoritative literature for doing government audits Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 2) When a state or local government agency receives federal funds, it is subject to the audit requirements of A) Yellow Book Single Audit Act OMB Circular A-133 Yes Yes No B) Yellow Book No

Single Audit Act No

OMB Circular A-133 Yes

Yellow Book Yes

Single Audit Act Yes

OMB Circular A-133 Yes

Yellow Book Yes

Single Audit Act No

OMB Circular A-133 No

Answer: C Terms: Local government agency receives federal funds; Audit requirements Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking

3) Which of the following is most correct with regard to the comparison of the financial auditing standards of the Yellow Book with the principles of the AICPA auditing standards? A) the same as B) quite different from C) incompatible with D) consistent with Answer: D Terms: Financial auditing standards of Yellow Book; General Auditing Standards Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 4) The correct title of the Yellow Book is A) Government Auditing Standards. B) Institute of Internal Auditors (IIA) Practice Standards. C) Statement of Responsibilities of Internal Auditing. D) Statement of Standards on Accounting and Review Services. Answer: A Terms: Yellow Book Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 5) Government Auditing Standards recognize that because of public accountability over governmental activities, the acceptable tolerable misstatement as compared to commercial businesses may be A) equal. B) lower. C) higher. D) indeterminable. Answer: B Terms: Government auditing standards; Tolerable misstatement Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 6) The Single Audit Act requires that a single audit be conducted for recipients who receive total federal funds in any fiscal year of more than A) $1,000,000. B) $750,000. C) $500,000. D) $100,000. Answer: B Terms: Single Audit Act Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 11 Copyright © 2023 Pearson Education, Inc.

7) An audit designed to provide reasonable assurance of detecting material misstatements resulting from noncompliance with provisions of contracts or grant agreements that have a material and direct effect on the financial statements would be called a(n) A) performance audit. B) management audit. C) operational audit. D) compliance audit. Answer: D Terms: Material misstatements from noncompliance with provisions of contracts or grant agreements Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 8) Auditors involved in planning, performing, or reporting on audits under Generally Accepted Government Auditing Standards (GAGAS) must complete ________ hours of continuing professional education in each two-year period. A) 20 B) 40 C) 60 D) 80 Answer: D Terms: Auditors involved in planning, performing, or reporting on audits under GAGAS Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 9) An audit conducted in accordance with the Yellow Book must include an audit report that states the audit was performed in accordance with A) Generally Accepted Auditing Standards (GAAS). B) Generally Accepted Government Auditing Standards (GAGAS). C) Generally Accepted Standards on Auditing (GASA). D) Statements on Auditing Standards (SAS). Answer: B Terms: Yellow Book; Audit report; Audit performed in accordance with Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 10) Government auditing standards are included in the Yellow Book. Answer: TRUE Terms: Government auditing standards; Yellow Book Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 12 Copyright © 2023 Pearson Education, Inc.

11) The formal name of the Yellow Book is Government Auditing Standards. Answer: TRUE Terms: Yellow Book; Government Auditing Standards Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 12) The Single Audit Act applies only to audits of state and local governments. Answer: FALSE Terms: Single Audit Act Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking 13) Extensive professional development is necessary for auditors doing governmental audits. Answer: TRUE Terms: Government auditing Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 14) At least 24 of the 80 hours of continuing professional education required under GAGAS must be in subjects related to governmental auditing or the governmental environment. Answer: TRUE Terms: Government auditing Difficulty: Easy Objective: LO 26-2 AACSB: Reflective thinking 15) How do the risk and materiality thresholds change in a government audit compared to a financial statement audit of a public company? Answer: The Yellow Book recognizes that in government audits the thresholds of acceptable audit risk and materiality may be lower than in an audit of a commercial enterprise. This is because of the sensitivity of government activities and their public accountability. Terms: Risk and materiality thresholds change in a government audit Difficulty: Moderate Objective: LO 26-2 AACSB: Reflective thinking

16) In addition to an opinion on whether the financial statements are in accordance with GAAP, identify four other reports required by the OMB Circular A-133/2 CFR 200 subpart F. Answer: The following reports are required: • an opinion as to whether the schedule of federal awards is presented fairly in all material respects in relation to the financial statements as a whole. • a report on system of internal control related to the financial statements and major programs. • a report on compliance with laws, regulations, and the provisions of contracts or grant agreements, where noncompliance could have a material effect on the financial statements. This report can be combined with the report on system of internal control. • a schedule of findings and questioned costs. Terms: Reports required by OMB Circular A-133 Difficulty: Challenging Objective: LO 26-2 AACSB: Reflective thinking 17) The auditing standards of the Yellow Book are consistent with the ten generally accepted auditing standards of the AICPA. There are, however, important additions/modifications in the Yellow Book. For example, the Yellow Book recognizes that materiality and risk are lower due to the nature of the government enterprise. Discuss the other additions/modifications. Answer: • Quality control. CPA firms and other organizations that audit government entities must have an appropriate system of internal quality control and participate in an external quality control review program. • Compliance auditing. The audit should be designed to provide reasonable assurance of detecting material misstatements resulting from noncompliance with provisions of contracts or grant agreements that have a material and direct effect on the financial statements. • Reporting. The audit report must state that the audit was made in accordance with generally accepted government auditing standards (GAGAS). The report on financial statements must describe the scope of the auditors' tests of compliance with laws and regulations and system of internal controls and present the results of those tests or refer to a separate report that includes the information. Terms: Auditing standards of Yellow Book; Additions and modifications to auditing standards of the AICPA Difficulty: Challenging Objective: LO 26-2 AACSB: Reflective thinking

26.3 Learning Objective 26-3 1) Which one of the following is not a major difference between operational and financial auditing? A) purpose of the audit B) distribution of the report C) testing the effectiveness of system of internal controls D) inclusion of nonfinancial areas Answer: C Terms: Operational and financial auditing Difficulty: Easy Objective: LO 26-3 AACSB: Reflective thinking 2) Which of the following is not one of the major differences between financial and operational auditing? A) The financial audit is oriented to the past, but an operational audit concerns performance for the future. B) The financial audit report has widespread distribution, but the operational audit report has limited distribution. C) Financial audits deal with the information on the financial statements, but operational audits are concerned with the information in the ledgers. D) Financial audits are limited to matters that directly affect the fairness of the financial statement presentation, but operational audits cover any aspect of efficiency and effectiveness. Answer: C Terms: Difference between financial and operational auditing Difficulty: Moderate Objective: LO 26-3 AACSB: Reflective thinking 3) Which of the following is not a difference between operational auditing and financial auditing? A) Both must be performed by a CPA. B) Operational audit reports are usually of a restricted distribution while financial audit reports are widely distributed. C) Operational audits often cover nonfinancial issues while financial audits do not. D) None of the above is a difference. Answer: A Terms: Difference between operational auditing and financial auditing Difficulty: Moderate Objective: LO 26-3 AACSB: Reflective thinking

4) A typical objective of an operational audit is to determine whether an entity's A) system of internal control is adequately operating as designed. B) financial statements present fairly the results of operations. C) specific operating units are functioning efficiently and effectively. D) operational information is in accordance with generally accepted government auditing standards. Answer: C Terms: Objective of operational audit Difficulty: Moderate Objective: LO 26-3 AACSB: Reflective thinking 5) Operational audits are primarily geared towards improving a company's operational efficiency and effectiveness. Answer: TRUE Terms: Operational auditing; Effectiveness and efficiency Difficulty: Easy Objective: LO 26-3 AACSB: Reflective thinking 6) For financial auditing, the audit report typically goes to many users of financial statements, whereas operational audit reports are intended primarily for management. Answer: TRUE Terms: Financial audit reports; Operational audit reports Difficulty: Easy Objective: LO 26-3 AACSB: Reflective thinking 7) Discuss three major differences between operational and financial auditing. Answer: • Purpose of the audit. Financial auditing emphasizes whether historical information was correctly recorded, whereas operational auditing emphasizes effectiveness and efficiency. Financial auditing is oriented to the past, while operational auditing focuses on improving future performance. • Distribution of the reports. For financial auditing, the report typically goes to many external users of financial statements, such as stockholders and bankers, whereas operational audit reports are intended primarily for management. The widespread distribution of financial auditing reports requires a well-defined structure and wording. For operational audits, the reports have limited distribution and the reports vary from audit to audit. • Inclusion of nonfinancial areas in operational auditing. Operational audits cover any aspect of efficiency and effectiveness in an organization, whereas financial audits are limited to matters that directly affect the fairness of financial statement presentations. Terms: Differences between operational and financial audits Difficulty: Moderate Objective: LO 26-3 AACSB: Reflective thinking 16 Copyright © 2023 Pearson Education, Inc.

26.4 Learning Objective 26-4 1) Which of the following groups could be involved in an operational audit? A) CPA firms B) internal auditors C) government auditors D) All of the above could be involved. Answer: D Terms: Operational audits Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking 2) Which of the following statements regarding types of operational audits is likely incorrect? A) A functional audit has the advantage of permitting specialization by auditors. B) An advantage of functional auditing is its ability to evaluate interrelated functions. C) The emphasis in an organizational audit is on how efficiently and effectively functions interact. D) Special operational auditing assignments arise at the request of management. Answer: B Terms: Operational audits Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 3) The two most important qualities for an operational auditor are A) personality and appearance. B) independence and competence. C) competence and technical training. D) academic background and sufficient experience. Answer: B Terms: Qualities for an operational auditor Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking

4) Which of the following can affect the independence of operational auditors? A) Responsibilities Reporting Structure Yes No B) Responsibilities No

Reporting Structure No

Responsibilities No

Reporting Structure Yes

Responsibilities Yes

Reporting Structure Yes

Answer: D Terms: Affect independence of operational auditors Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 5) Effective system of internal controls are designed to help organizations achieve which of the following objectives? A) reliability of financial reporting B) efficiency and effectiveness of operations C) compliance with applicable laws and regulations D) all of the above Answer: D Terms: Internal control objectives Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 6) Which of the following best describes an audit that emphasizes how efficiently and effectively functions interact? A) operational B) compliance C) financial D) organizational Answer: D Terms: Audit that emphasizes how efficiently and effectively functions interact Difficulty: Challenging Objective: LO 26-4 AACSB: Reflective thinking 18 Copyright © 2023 Pearson Education, Inc.

7) Which of the following is not a purpose of a program audit as performed by government auditors? A) determination of the extent to which the desired results established by the legislature are being achieved B) determination of the causes of inefficiencies in sponsored programs C) determination of the effectiveness of organizations, programs, activities, or functions D) determination as to whether the entity has complied with laws and regulations applicable to the program Answer: B Terms: Purpose of program audit performed by government auditors Difficulty: Challenging Objective: LO 26-4 AACSB: Reflective thinking 8) What distinguishes system of internal control evaluation and testing for financial and operational auditing? A) purpose of the work B) scope of the work C) both A and B D) neither A nor B Answer: C Terms: Internal control evaluation and testing for financial and operational auditing Difficulty: Challenging Objective: LO 26-4 AACSB: Reflective thinking 9) ________ is the degree to which the organization's objectives are accomplished. A) Effectiveness B) Efficiency C) Goal optimization D) Performance Answer: A Terms: Operational audit; Activities as represented by functions Difficulty: Challenging Objective: LO 26-4 AACSB: Reflective thinking 10) Effectiveness refers to the degree to which costs are reduced without reducing efficiency. Answer: FALSE Terms: Effectiveness; Costs reduced without reducing efficiency Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking

11) Efficiency refers to the degree to which costs are reduced without changing effectiveness. Answer: TRUE Terms: Efficiency; Costs are reduced without reducing effectiveness. Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking 12) Effectiveness is concerned with whether defined goals are achieved, whereas efficiency is concerned with whether the goals are achieved with a minimum use of resources. Answer: TRUE Terms: Effectiveness and efficiency Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking 13) Operational audits may be performed by internal auditors and government auditors, but not by external auditors. Answer: FALSE Terms: Operational audits; Internal auditors; Government auditors Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking 14) The two most important qualities for an operational auditor to possess are independence and competence. Answer: TRUE Terms: Internal auditors; Independence and competence Difficulty: Easy Objective: LO 26-4 AACSB: Reflective thinking 15) Auditors can insist that the changes that they recommend as the result of an operational audit be implemented by the company. Answer: FALSE Terms: Operational audits Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 16) Operational audits are often categorized as functional, organizational, or special assignments. Answer: TRUE Terms: Operational audits; Functional, organizational or special assignments Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking

17) One disadvantage of functional auditing is the failure to evaluate interrelated functions. Answer: TRUE Terms: Functional auditing Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 18) Unlike financial statement auditors, operational auditors cannot benefit from the use of data analytical tools to identify opportunities for improvements in operational efficiency and effectiveness. Answer: FALSE Terms: Operational auditing and data analytics Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 19) List the three purposes of a program audit. Answer: The purposes of a program audit are to determine: 1. The extent to which the desired results or benefits established by the legislature or other authorizing body are achieved 2. The effectiveness of organizations, programs, activities, or functions 3. Whether the entity has complied with laws and regulation applicable to the program Terms: Yellow Book; Defines and sets standards for performance audits Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 20) Discuss each of the three broad categories (types) of operational audits. Answer: • Functional. A functional audit deals with auditing one or more functions (e.g., purchasing) in an organization. • Organizational. An organizational audit deals with an entire organizational unit, such as a department, branch, or subsidiary. It emphasizes how efficiently and effectively functions interact. • Special assignments. Special assignment audits arise at the request of management when there is a need to investigate a particular area, such as investigating the possibility of fraud in a division, determining the cause of an ineffective IT system, or making recommendations for reducing the cost of a manufactured product. Terms: Categories of operational audits Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking

21) Operational auditing is the review of an organization for efficiency and effectiveness. Discuss what is meant by the terms "effectiveness" and "efficiency." Answer: • Effectiveness refers to the degree to which the organization's objectives and goals are accomplished. • Efficiency refers to the degree to which costs are reduced without reducing effectiveness. Terms: Operational auditing; Effectiveness and efficiency Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking

22) Match seven of the terms (a-o) with the descriptions/definitions provided below (1-7). a. compliance audit b. economy and efficiency audit c. effectiveness d. efficiency e. functional audit f. Government Auditing Standards g. government audit h. Institute of Internal Auditors i. operational auditing j. organizational audit k. program audit l. Single Audit Act m. special assignment n. IIA Practice Standards o. Statements on Internal Auditing Standards ________ 1. the official title of the Yellow Book ________ 2. a management request for an operational audit for a specific purpose, such as investigating the possibility of fraud in a division or making recommendations for reducing the cost of a manufactured product ________ 3. a government audit to determine whether an entity is acquiring, protecting, and using its resources economically and efficiently and whether the entity has complied with laws and regulations concerning such matters ________ 4. the degree to which the organization's objectives are accomplished ________ 5. the review of an organization for efficiency and effectiveness ________ 6. federal legislation that provides for a single coordinated audit to satisfy the audit requirements of all federal funding agencies ________ 7. statements issued by the Internal Auditing Standards Board of the Institute of Internal Auditors (IIA) to provide authoritative interpretation of the Institute of Internal Auditors' Practice Standards

Answer: 1. f 2. m 3. b 4. c 5. i 6. l 7. o Terms: Types of audits; Standards Difficulty: Moderate Objective: LO 26-4 AACSB: Reflective thinking 26.5 Learning Objective 26-5 1) Which of the following is not one of the three phases in an operational audit? A) planning B) training and supervising employees C) evidence accumulation and evaluation D) reporting and follow-up Answer: B Terms: Phases of operational audit Difficulty: Easy Objective: LO 26-5 AACSB: Reflective thinking 2) When performing an operational audit, the internal audit team must first determine that A) a financial audit has been performed by an independent auditor. B) a financial audit has been performed by an internal auditor. C) a review was performed by either an independent or an internal auditor. D) specific criteria are developed to define effectiveness. Answer: D Terms: Operational audits Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking

3) As compared to a financial audit, an operational audit: A) Requires the auditors to Makes staffing more spend more time with the complicated interested parties Yes Yes B) Requires the auditors to spend more time with the interested parties No

Makes staffing more complicated No

C) Requires the auditors to spend more time with the interested parties Yes D) Requires the auditors to spend more time with the interested parties No

Makes staffing more complicated No

Makes staffing more complicated Yes

Answer: A Terms: Operational compared to financial audit Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking 4) Benchmarking is one source of evaluation criteria for completing an operational audit. Answer: TRUE Terms: Benchmarking; Operational audit Difficulty: Easy Objective: LO 26-5 AACSB: Reflective thinking 5) Operational auditors must accumulate sufficient appropriate evidence to provide a basis for a conclusion about the objectives being tested. Answer: TRUE Terms: Operational audits Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking

6) An operational auditor may use "engineered standards" as an evaluation criterion. Answer: TRUE Terms: Operational auditor; Engineered standards Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking 7) In operational audits, the audit report is usually sent only to management, with a copy to the unit being audited. This increases the need for standardized wording in operational audit reports. Answer: FALSE Terms: Operational audits Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking 8) Discuss each of the three phases of an operational audit. Answer: • Planning. In the planning phase, the auditor must determine the scope of the engagement and communicate it to the organizational unit. It is also necessary to staff the engagement properly, obtain background information about the organizational unit, understand system of internal control, and decide on the appropriate evidence to accumulate. • Evidence accumulation and evaluation. In operational auditing, it is common to use inspection, client inquiry, analytical procedures and observation extensively, while confirmation, reperformance, and recalculation are used less extensively for most operational audits than for financial audits. Operational auditors must accumulate sufficient appropriate evidence to provide a basis for a conclusion about the objectives being tested. • Reporting and follow-up. The audit report is tailored to address the scope of the audit, findings, and recommendations and is typically sent only to management, with a copy to the unit being audited. The lack of third-party users reduces the need for standardized wording in operational auditing reports. When recommendations are made to management, follow-up is done to determine whether the recommended changes were made, and if not, why not. Terms: Phases of operational audit Difficulty: Moderate Objective: LO 26-5 AACSB: Reflective thinking