TEST BANK Auditing and Assurance Services, 15 Edition by Arens. All Chapter 1-24 (Complete Download) by StudyGuide

Auditing and Assurance Services, 15e (Arens) Chapter 1 The Demand for Audit and Other Assurance Services Learning Objective 1-1 1) The Sarbanes-Oxley Act applies to which of the following companies? A) All companies B) Privately held companies C) Public companies D) All public companies and privately held companies with assets greater than $500 million Answer: C Terms: Sarbanes-Oxley Act Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills Topic: SOX 2) Which of the following is considered audit evidence? A) Oral statements Written Auditor made by management Communications Observation Y N N B) Oral statements made by management N

Written Communications Y

Auditor Observation Y

Written Communications Y

Auditor Observation Y

Written Communications N

Auditor Observation Y

C) Oral statements made by management Y D) Oral statements made by management N

Answer: C Terms: Audit evidence Diff: Moderate Objective: LO 1-1 AACSB: Reflective thinking skills

3) 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 Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills 4) The criteria by which an auditor evaluates the information under audit may vary with the information being audited. A) True B) False Answer: A Terms: Criteria which an auditor evaluates information Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills 5) The criteria used by an external auditor to evaluate published financial statements are known as generally accepted auditing standards. A) True B) False Answer: B Terms: Criteria used by external auditor to evaluate published financial statements Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills 6) The Sarbanes-Oxley Act establishes standards related to the audits of privately held companies. A) True B) False Answer: B Terms: Sarbanes-Oxley Act Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills Topic: SOX

7) The Sarbanes-Oxley Act is widely viewed as having ushered in sweeping changes to auditing and financial reporting. A) True B) False Answer: A Terms: Sarbanes-Oxley Act Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills Topic: SOX 8) An auditor must be competent and have an independent mental attitude. A) True B) False Answer: A Terms: Competence and independent mental attitude Diff: Easy Objective: LO 1-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 1-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 1-2 AACSB: Reflective thinking skills

3) In "auditing" financial accounting data, the primary concern is with: 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 Diff: Moderate Objective: LO 1-2 AACSB: Reflective thinking skills 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 accumulation and interpretation of evidence related to a company's financial statements. Answer: D Terms: Distinguishes auditors from accountants Diff: Challenging Objective: LO 1-2 AACSB: Reflective thinking skills 5) 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 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 Diff: Moderate Objective: LO 1-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 1-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 1-4 AACSB: Reflective thinking skills 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: Reducing information risk Diff: Moderate Objective: LO 1-4 AACSB: Reflective thinking skills

3) 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 Diff: Easy Objective: LO 1-3 and LO 1-4 AACSB: Reflective thinking skills Learning Objective 1-5 1) In the audit of historical financial statements, what accounting criteria is most common? A) Regulatory accounting principles B) Applicable international accounting standards C) Applicable U.S. accounting standards D) B and C E) All of the above Answer: D Terms: Most common accounting criteria Diff: Easy Objective: LO 1-5 AACSB: Reflective thinking skills 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: Strengthen internal controls over accounting for materials used in production Diff: Easy Objective: LO 1-5 AACSB: Reflective thinking skills

3) Three common types of attestation services are: A) audits of historical financial statements, reviews of historical financial statements, and audits of internal control over financial reporting. B) audits of historical financial information, verifications of historical financial information, and attestations regarding internal controls. C) reviews of historical financial information, verifications of future financial information, and attestations regarding 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 Diff: Easy Objective: LO 1-5 AACSB: Reflective thinking skills 4) Which of the following services provides the lowest level of assurance on a financial statement? A) A review B) An 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 Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills 5) Which of the following is not a SysTrust Services principle as defined by the AICPA? A) Online privacy B) Availability C) Processing integrity D) Operational integrity Answer: D Terms: SysTrust Services principles defined by AICPA Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills

6) The Sarbanes-Oxley Act prohibits a CPA firm that audits a public company from providing which of the following types of services to that company? A) Reviews of quarterly financial statements B) Preparation of corporate tax returns C) Most consulting services D) Tax services Answer: C Terms: Sarbanes-Oxley Act Diff: Challenging Objective: LO 1-5 AACSB: Reflective thinking skills Topic: SOX 7) Attestation services on information technology include WebTrust services and SysTrust services. Which of the following statements most accurately describes SysTrust services? A) SysTrust services provide assurance on business processes, transaction integrity and information processes. B) SysTrust services provide assurance on system reliability in critical areas such as security and data integrity. C) SysTrust services provide assurance on internal control over financial reporting. D) SysTrust services provide assurance as to whether accounting personnel are following procedures prescribed by the company controller. Answer: B Terms: Attestation services on information technology; WebTrust and Systrust services Diff: Challenging Objective: LO 1-5 AACSB: Reflective thinking skills 8) 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 auditor fees. Terms: Attestation services; Audits and reviews of historical financial statements Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills

9) What is an engagement to attest on internal control over financial reporting? Answer: For an audit of internal control over financial reporting, management asserts that 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 internal control over financial reporting. The Act also requires auditors for larger public companies to attest to the effectiveness 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 internal controls reduce the likelihood of future misstatements in the financial statements. Terms: Engagement to attest on internal control over financial reporting Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills Topic: SOX 10) What are the five categories of attestation services? Answer: The five categories of attestation services include: • Audit of historical financial statements • Audit of internal control over financial reporting • Review of historical financial statements • Attestation services on information technology • Other attestation services that may be applied to a broad range of subject matter Terms: Categories of attestation services Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills 11) What is a WebTrust engagement? What is a SysTrust engagement? How do they differ? Answer: WebTrust is a service provided by a CPA where the CPA provides assurance that the Web Site owner has met established criteria related to business practices, transaction integrity, and information processes. SysTrust is a service provided by a CPA to evaluate and test a system reliability in areas such as security and data integrity. There are five principles that must be addressed on a SysTrust engagement: security, availability, processing integrity, online privacy, and confidentiality. WebTrust is primarily designed to provide assurance to third party users of a Web site. SysTrust provides assurance to management, the board of directors or third parties about the reliability of information systems used to generate real-time information. Terms: WebTrust and SysTrust engagements Diff: Challenging Objective: LO 1-5 AACSB: Reflective thinking skills

12) CPA firms are never allowed to provide bookkeeping services for clients. A) True B) False Answer: B Terms: CPA services provided to clients Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills 13) Section 404 of the Sarbanes-Oxley Act requires public companies to have an external auditor attest to their internal control over financial reporting. A) True B) False Answer: A Terms: Section 404 of the Sarbanes-Oxley Act Diff: Moderate Objective: LO 1-5 AACSB: Reflective thinking skills Topic: SOX 14) Most public companies' audited financial statements are available on the SEC's EDGAR database. A) True B) False Answer: A Terms: Public companies' audited financial statements: SEC's EDGAR database Diff: Challenging Objective: LO 1-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 1-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 1-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 1-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 1-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 1-6 AACSB: Reflective thinking skills 11

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 Engagement Y

Assurance Engagement N

Operational Audit Y

Compliance Audit Y

Attestation Engagement N

Assurance Engagement N

Operational Audit N

Compliance Audit N

Attestation Engagement Y

Assurance Engagement Y

C) Financial Statement Audit Y D) Financial Statement Audit N

Answer: B Terms: Required to have a written report Diff: Challenging Objective: LO 1-6 AACSB: Reflective thinking skills

7) 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. 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. 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 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 Diff: Challenging Objective: LO 1-6 AACSB: Analytic skills

8) 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. generally accepted accounting standards or International Financial Reporting Standards (IFRS). (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 Diff: Easy Objective: LO 1-1 and LO 1-6 AACSB: Reflective thinking skills 9) The primary purpose of a compliance audit is to determine whether the financial statements are prepared in compliance with generally accepted accounting principles. A) True B) False Answer: B Terms: Compliance audit Diff: Moderate Objective: LO 1-6 AACSB: Reflective thinking skills 10) Results of compliance audits are typically reported to the company's management rather than to a broad spectrum of outside users. A) True B) False Answer: A Terms: Compliance audit Diff: Moderate Objective: LO 1-6 AACSB: Reflective thinking skills

Learning Objective 1-7 1) Match the engagement described to the (A) type of audit and (B) auditor that would 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. 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 Diff: Challenging Objective: LO 1-6 and LO 1-7 AACSB: Analytic skills

2) 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 Diff: Moderate Objective: LO 1-7 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Primary role of United States General Accounting Office Diff: Moderate Objective: LO 1-7 AACSB: Reflective thinking skills 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) Educational requirements C) Character requirements D) Experience requirement Answer: C Terms: Requirements for becoming a CPA Diff: Moderate Objective: LO 1-8 AACSB: Reflective thinking skills

2) The use of the Certified Public Accountant title is regulated by: A) the federal government. B) state law through a licensing department or agency 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 Diff: Moderate Objective: LO 1-8 AACSB: Reflective thinking skills 3) List and discuss the three primary requirements to become a CPA. Answer: The three primary requirements for becoming a CPA are: • Educational requirement. An undergraduate degree or a graduate degree with a major in accounting is required. Most states now require 150 semester hours for licensure and some states require 150 semester hours before taking the CPA exam. • Uniform CPA examination requirement. This is a four-part, computer-based examination with components on auditing and attestation, financial accounting and reporting, regulation, and business environment and concepts. Some states also require a separate ethics requirement. • 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. Terms: Primary requirements to become CPA Diff: Easy Objective: LO 1-8 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 2 The CPA Profession 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 Audit Standards Board. Answer: A Terms: Legal rights to perform audits Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills 2) The four categories for describing the size of audit firms include: the Big Four international firms; national firms; regional and local firms; and small firms. Which of the following is not a characteristic of a small firm? A) Most have fewer than 25 professionals. B) They perform audits on small and not-for-profit businesses. C) Tax services are more important to their practice than auditing. D) They do not audit publicly traded companies. Answer: D Terms: Four categories for describing size of audit firms Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills 3) Sarbanes-Oxley and the Securities 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 or II Answer: B Terms: Sarbanes-Oxley and Securities Exchange Commission restrictions Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills Topic: SOX

4) 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 Diff: Challenging Objective: LO 2-1 AACSB: Reflective thinking skills 5) 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. Independence from clients. Independence is important as it allows the auditors to remain unbiased in drawing conclusions on client financial statements. 2. Auditor Competency. Competency allows auditors to conduct audits and perform services effectively and efficiently. 3. Litigation. The increased litigation risk faced by auditors increases audit firm business risk. Certain organizational structures allow a degree of personal protection to individual firm members. Common forms of audit firm organization include: • Limited Liability Partnerships • Limited Liability Companies • Professional Corporations • General Corporations • General Partnerships • Sole Proprietorship Terms: Factors that influence that influence the organizational structure of CPA firms Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills

6) 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. Unlike a general partnership, 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. Professional corporations can have 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 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 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 Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills 7) Many small, local accounting firms do not perform audits as their primary services to their clients include accounting and tax. A) True B) False Answer: A Terms: Small accounting firms do not perform audits Diff: Easy Objective: LO 2-1 AACSB: Reflective thinking skills 8) All of the Big Four accounting firms and many of the smaller CPA firms now operate as Limited Liability Partnerships. A) True B) False Answer: A Terms: Limited liability partnerships Diff: Easy Objective: LO 2-1 AACSB: Reflective thinking skills

9) Sarbanes-Oxley and the Securities Exchange Commission restrict auditors from providing many consulting services to their publicly traded audit clients. A) True B) False Answer: A Terms: Sarbanes-Oxley and Securities Exchange Commission restrict auditors Diff: Easy Objective: LO 2-1 AACSB: Reflective thinking skills Topic: SOX 10) 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. A) True B) False Answer: A Terms: Limited liability companies Diff: Moderate Objective: LO 2-1 AACSB: Reflective thinking skills Learning Objective 2-2 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 Diff: Easy Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX 2) Members of the Public Company Accounting Oversight Board are appointed and overseen by: A) the U.S. Congress. B) the American Institute of Certified Public Accountants. C) the Auditing Standards Board. D) the Securities and Exchange Commission. Answer: D Terms: Members of Public Company Accounting Oversight Board Diff: Easy Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX 4

3) The Public Company Accounting Oversight Board: A) performs inspections of the quality controls of audit 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 any of the above functions. Answer: A Terms: Public Company Accounting Oversight Board Diff: Moderate Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX

4) Assume the Public Company Accounting Oversight Board (PCAOB) identifies a violation during its inspection of a registered accounting firm. The PCAOB: A) can enforce report the matter to disciplinary action the Securities and suspend the license to against the accounting Exchange practice of the CPA firm Commission guilty of the violation Yes Yes Yes B) can enforce report the matter to disciplinary action the Securities and suspend the license to against the accounting Exchange practice of the CPA firm Commission guilty of the violation Yes Yes No C) can enforce report the matter to disciplinary action the Securities and suspend the license to against the accounting Exchange practice of the CPA firm Commission guilty of the violation Yes No No D) can enforce report the matter to disciplinary action the Securities and suspend the license to against the accounting Exchange practice of the CPA firm Commission guilty of the violation No No No Answer: B Terms: Public Company Accounting Oversight Board inspection violations Diff: Moderate Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX 5) The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). What are the PCAOB's primary functions? Answer: The PCAOB has responsibility for providing oversight to auditors of public companies, establishing auditing and quality control standards for public company audits and performing inspections of the quality controls at audit firms performing those audits. Terms: Sarbanes-Oxley Act; Public Company Accounting Oversight Board primary functions Diff: Moderate Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX 6

6) The Public Company Accounting Oversight Board (PCAOB) provides oversight to auditors of publicly traded and private companies. A) True B) False Answer: B Terms: Public Company Accounting Oversight Board Diff: Easy Objective: LO 2-2 AACSB: Reflective thinking skills 7) All CPA firms registered with the PCAOB are required to undergo a peer review annually. A) True B) False Answer: B Terms: PCAOB requirement for peer review Diff: Moderate Objective: LO 2-2 AACSB: Reflective thinking skills Topic: SOX Learning Objective 2-3 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 Diff: Moderate Objective: LO 2-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 2-3 AACSB: Reflective thinking skills 7

3) The AICPA has authority to establish standards and rules in all but which of the following areas? A) Auditing standards applicable to financial statements of private companies B) Compilation and review standards C) Professional conduct D) Auditing standards applicable to financial statements of private and public companies Answer: D Terms: AICPA has authority to establish standards and rules Diff: Challenging Objective: LO 2-3 AACSB: Reflective thinking skills 4) 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 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 power to establish rules for any CPA associated with audited financial statements submitted to the commission. The SEC's attitude is generally considered in any major change proposed by the FASB, the independent organization that establishes U.S. GAAP. Terms: Securities and Exchange Commission influence on setting generally accepted accounting principles Diff: Moderate Objective: LO 2-3 AACSB: Reflective thinking skills 5) The difference between the Securities Act of 1933 and the Securities Act of 1934 is that only the 1934 act requires audited financial statements. A) True B) False Answer: B Terms: Securities Acts of 1933 and 1934 Diff: Easy Objective: LO 2-3 AACSB: Reflective thinking skills 6) Form 10-K must be filed with the SEC whenever a public company experiences a significant event. A) True B) False Answer: B Terms: Form 10-K; SEC Diff: Moderate Objective: LO 2-3 AACSB: Reflective thinking skills 8

7) The overall purpose of the Securities and Exchange Commission is to assist in providing investors with reliable information upon which to make investment decisions. A) True B) False Answer: A Terms: Securities and Exchange Commission Diff: Moderate Objective: LO 2-3 AACSB: Reflective thinking skills Learning Objective 2-4 1) Statements on Standards for Accounting and Review Services 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) Diff: Moderate Objective: LO 2-4 AACSB: Reflective thinking skills 2) What are the major functions of the AICPA? Answer: Major functions of the AICPA include: • Establishing standards and rules that 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, 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. • 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 for its members. Terms: Major functions of AICPA Diff: Moderate Objective: LO 2-4 AACSB: Reflective thinking skills

3) Membership in the AICPA is restricted to CPAs who are currently practicing as independent auditors. A) True B) False Answer: B Terms: Membership in AICPA Diff: Easy Objective: LO 2-4 AACSB: Reflective thinking skills 4) Membership in the AICPA is mandatory for all licensed practicing CPAs. A) True B) False Answer: B Terms: Membership in AICPA Diff: Easy Objective: LO 2-4 AACSB: Reflective thinking skills 5) Any public accounting firm can be a member of the AICPA if the firm meets the membership requirements. A) True B) False Answer: A Terms: Membership in AICPA Diff: Easy Objective: LO 2-4 AACSB: Reflective thinking skills

Learning Objective 2-5 1) Which of the following are audit standards used in professional practice by audit firms? A) International U.S. Generally PCAOB Auditing Standards Accepted Auditing Standards on Auditing Standards Yes No No B) International Standards on Auditing Yes

U.S. Generally Accepted Auditing Standards Yes

PCAOB Auditing Standards

International Standards on Auditing Yes

U.S. Generally Accepted Auditing Standards Yes

PCAOB Auditing Standards

International Standards on Auditing No

U.S. Generally Accepted Auditing Standards Yes

PCAOB Auditing Standards

Yes

Answer: C Terms: Standards used in professional practice Diff: Easy Objective: LO 2-5 AACSB: Reflective thinking skills 2) For privately held companies who is responsible for establishing auditing standards? 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 Diff: Easy Objective: LO 2-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 2-5 AACSB: Reflective thinking skills Topic: SOX 4) The International Standards on Auditing (ISAs): 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 Diff: Moderate Objective: LO 2-5 AACSB: Reflective thinking skills 5) If an auditor of a public company cannot find guidance issued by the PCAOB on a particular audit matter, the auditor should generally seek guidance from which of the following sources? A) Statements on Auditing Standards B) Statements on Standards for Accounting and Review Services C) Regulations issued by the Securities and Exchange Commission D) The AICPA Code of Professional Conduct Answer: A Terms: Guidance issued by PCAOB Diff: Challenging Objective: LO 2-5 AACSB: Reflective thinking skills Topic: SOX

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 United States and International Standards of Auditing Diff: Easy Objective: LO 2-5 AACSB: Reflective thinking skills 7) The PCAOB considers International Standards on Auditing (ISAs) when developing its standards. A) True B) False Answer: A Terms: Public Company Accounting Oversight Board Standards Diff: Easy Objective: LO 2-5 AACSB: Reflective thinking skills Topic: SOX 8) International Standards on Auditing are issued by the International Auditing and Assurance Standards Board. A) True B) False Answer: A Terms: International Standards on Auditing; International Auditing and Assurance Standards Board Diff: Easy Objective: LO 2-5 AACSB: Reflective thinking skills Learning Objective 2-6 1) Historically auditing standards have been organized into three categories, including: A) Standards of field work. B) Purpose of an audit. C) Responsibilities of the auditor. D) Proper planning and supervision. Answer: A Terms: GAAS, general standards Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills 13

2) The "Principles Underlying an Audit in Accordance with Generally Accepted Auditing Principles" provides 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 Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills 3) Which of the following is not one of the responsibilities of an auditor under the principles underlying an audit? A) Possess appropriate competence and capabilities B) Comply with ethical requirements C) Plan work and supervise assistants D) Maintain professional skepticism and exercise professional judgment Answer: C Terms: New principles underlying an audit Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills 4) 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 Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills

5) The Statements on Auditing Standards issued by the Auditing Standards Board: A) are regarded as authoritative literature. B) are the equivalent of laws for audit practitioners. 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: General accepted auditing standards; Performance Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 6) 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) any of the above three are correct. Answer: A Terms: Auditor need not abide by a particular auditing standard Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 7) When assessing the risk of material misstatements in the financial statements, A) inadequate 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 have an understanding of the client's business and industry. Answer: D Terms: General accepted auditing standards; Performance Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 8) 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 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 Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills

9) Which of the following statements best describes the primary purpose of Statements on Auditing Standards? A) They are guides intended to set forth auditing procedures that are applicable to a variety of situations. B) They are procedural outlines that are intended to narrow the areas of inconsistency and divergence of auditor opinion. C) They are authoritative statements, enforced through the Code of Professional Conduct, and are intended to limit the degree of auditor judgment. D) They are interpretations that are intended to clarify the meaning of "generally accepted auditing standards." Answer: D Terms: Purpose of Statements on Auditing Standards Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 10) Hansen Corporation's stock is listed on a national stock exchange and registered with the Securities and Exchange Commission. Hansen's management hires a CPA to perform an independent audit of Hansen's financial statements. The primary objective of this audit is to provide assurance to the: A) investors in Hansen Corporation's stock. B) stock exchange. C) Securities and Exchange Commission. D) management of Hansen Corporation. Answer: A Terms: Primary objective of audit to provide assurance Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 11) 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 any 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 Audit Standards Diff: Challenging Objective: LO 2-6 AACSB: Reflective thinking skills

12) Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards (SAS) should be looked upon 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) Diff: Challenging Objective: LO 2-6 AACSB: Reflective thinking skills 13) Statements on Auditing Standards issued by the AICPA's Auditing Standards Board are: A) part of the generally accepted auditing standards under the AICPA Code of Professional Conduct. B) interpretations of generally accepted auditing standards and departures from such statements must be justified. C) interpretations of generally accepted auditing standards and such standards must be followed in every engagement. D) generally accepted auditing procedures that are not covered by the AICPA Code of Professional Conduct. Answer: B Terms: Statements on Auditing Standards Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills 14) List the four principles underlying an audit. Answer: • Purpose of an audit • Responsibilities • Performance • Reporting Terms: GAAS; New principles underlying GAAS Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills

15) Distinguish between generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP). What professional organization establishes GAAS? What professional organization establishes GAAP? Answer: Generally accepted auditing standards are general guidelines to help auditors meet their professional responsibilities in the audit of historical financial statements. The general standards stress the important personal qualities that the auditor should possess. The standards of field work concern evidence accumulation and other activities during the actual conduct of the audit. The reporting standards require the auditor to prepare a report on the financial statements taken as a whole, stating whether the statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP). They are considered to be the minimum standards of performance for auditors to follow and are established by the Auditing Standards Board of the American Institute of Certified Public Accountants for private companies and by the Public Company Accounting Oversight Board for public companies. Generally accepted accounting principles are the guidelines which an entity's management normally follows when preparing historical financial statements. GAAP is established by the Financial Accounting Standards Board. Terms: Generally Accepted Auditing Standards Diff: Easy Objective: LO 2-5 and LO 2-6 AACSB: Reflective thinking skills 16) Professional skepticism must be maintained only if the auditor suspects fraud. A) True B) False Answer: B Terms: Generally Accepted Auditing Standards; Responsibilities Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills 17) Statements on Auditing Standards (SASs) are issued by the Public Company Accounting Oversight Board. A) True B) False Answer: B Terms: Statements on Auditing Standards (SAS); Public Company Accounting Oversight Board Diff: Easy Objective: LO 2-6 AACSB: Reflective thinking skills

18) The SAS number identifies the order in which it was issued in relation to all other SASs. A) True B) False Answer: A Terms: Statements on Auditing Standards (SAS); Generally accepted auditing standards Diff: Moderate Objective: LO 2-6 AACSB: Reflective thinking skills Learning Objective 2-7 1) Which of the following is not true for audit firms who audit publicly traded companies? A) They must undergo a PCAOB inspection on an annual basis if they audit more than 100 issuers. B) They must have an AICPA peer review on all audit clients. C) They must have an AICPA peer review on all non-publicly traded clients. D) The audit firm can choose which CPA firm they wish to conduct their AICPA peer review. Answer: B Terms: Audit firms who audit publicly traded companies Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills 2) The methods used by a CPA firm to ensure that the firm meets is 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 Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills 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 personnel to engagements D) Complying with laws and regulations Answer: C Terms: Quality control policies and procedures Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 2-7 AACSB: Reflective thinking skills 8) Discuss the relationship between quality control and generally accepted auditing standards. Answer: For a CPA firm, quality control encompasses the methods used to make sure that the firm meets its professional responsibilities to clients. Quality control is closely related to, but distinct from, GAAS. 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 GAAS are followed on every audit. Quality controls are the procedures used by the entire CPA firm that help it meet requirements demanded by GAAS on every engagement in a consistent manner. Terms: Relationship between quality control and generally accepted auditing standards Diff: Easy Objective: LO 2-7 AACSB: Reflective thinking skills

9) List and describe the six elements of quality control. Who establishes the standards for quality control? Answer: • Leadership responsibilities for quality within the firm - 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 - Personnel on engagements should maintain independence in fact and in appearance, perform all professional responsibilities with integrity and maintain objectivity in performing their professional responsibilities. • 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, work is assigned to personnel who have adequate training, and personnel should participate in continuing professional education. • Acceptance and continuation of clients and engagements - Policies and procedures should be established for deciding whether to accept or continue a client relationship. These policies should minimize the risk of associating with a client whose management lacks integrity. • Engagement performance - Policies and procedures should exist to ensure that engagement personnel perform work that meets applicable professional standards 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 Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills

10) 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 a Generally Accepted Audit Standard (GAAS) or a Quality Control Standard. Audit firm Policy or Procedure 1. Determination on whether to accept or reject a new client. Standards Category 2. A client evaluation form. a. GAAS 3. All personnel participate in continuing b. Quality Control 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. a 2. b 3. b 4. a 5. b 6. a 7. b 8. a Terms: Generally Accepted Audit Standards (GAAS) and Quality Control Standards Diff: Moderate Objective: LO 2-6 and LO 2-7 AACSB: Reflective thinking skills

11) 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 1. An organizational structure where professional services are provided by one or more shareholders. 2. The grantor of the right to practice public accounting. Audit Term 3. A report filed to indicate a significant event. a. AICPA 4. Sets professional standards and rules for auditors. b. PCAOB 5. Oversees accounting firms who audit public c. Securities Exchange companies. Commission 6. An organizational structure where the owners are d. Form 10-k taxed like a partnership and have limited personal e. IAASB liability. f. Form S-1 7. A report that is filed when a company wishes to g. Due professional care issue new securities. h. Limited Liability Partnership 8. The methods used to ensure the firm meets its i. Professional Corporation professional responsibilities to clients and others. j. Limited Liability Company 9. Assists in providing investors with reliable k. Peer review information. l. 1933 Securities Act 10. Requires annual inspections of accounting firms m. 1934 Securities Act auditing > 100 issuers. n. Form 8-k 11. Practice monitoring by a CPA firm for another o. State Regulation CPA firm. p. Code of Professional Conduct 12. Fulfilling duties diligently and carefully. q. Quality Control Standards 13. Requires a registration statement. r. GAAS Standards 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 Diff: Moderate Objective: LO 2-1, LO 2-2, LO 2-3, LO 2-6, and LO 2-7 AACSB: Reflective thinking skills 24

12) Quality controls are established for the entire CPA firm whereas GAAS are applicable to the individual engagement. A) True B) False Answer: A Terms: Quality controls and GAAS Diff: Moderate Objective: LO 2-7 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 3 Audit Reports Learning Objective 3-1 1) 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 Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 4) The auditor's responsibility section of the standard unqualified 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: Scope paragraph of standard unqualified audit report states Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

5) The audit report date on a standard unqualified 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 client or 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 Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 6) The standard audit report for non-public entities refers to GAAS and GAAP in which sections? A) GAAS GAAP Auditor's responsibility Auditor's responsibility B) GAAS Auditor's responsibility

GAAP Introductory paragraph

C) GAAS GAAP Management's responsibility Management's responsibility and Opinion paragraph and Introductory paragraph D) GAAS Auditor's responsibility

GAAP Management's responsibility and Opinion paragraph

Answer: D Terms: Standard unqualified audit report for non-public entities; GAAS and GAAP Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills

7) Which of the following is not explicitly stated in the standard unqualified 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 unqualified audit report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 8) The standard unqualified audit report for a non-public 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 non-public entity;eight parts of the report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills Topic: Public 9) The management's responsibility section of the standard audit report for a non-public 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 non-public entity;eight parts of the report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

10) The introductory paragraph of the standard audit report for a non-public company performs which functions? I. It states the CPA has performed an audit. II. It lists the financial statements being audited. III. It states the financial statements are the responsibility of the auditor. A) I and II B) I and III C) II and III D) I, II and III Answer: A Terms: Introductory paragraph of standard audit report Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 11) Which of the following statements are true for the audit report of a non-public entity? I. The introductory paragraph states that management is responsible for the preparation and content of the financial statements. II. The scope paragraph states that the auditor evaluates the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management. A) I only B) II only C) I and II D) Neither I nor II Answer: B Terms: Introductory paragraph and scope paragraph Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 12) The auditor's responsibility section of the standard 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) responsible for the opinion on the financial statements. D) jointly responsible for the financial statements with management. Answer: C Terms: Standard unqualified audit report for a non-public entity;eight parts of the report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

13) If the balance sheet of a private company is dated December 31, 2011, the audit report is dated February 8, 2012, and both are released on February 15, 2012, this indicates that the auditor has searched for subsequent events that occurred up to: A) December 31, 2011. B) January 1, 2012. C) February 8, 2012. D) February 15, 2012. Answer: C Terms: Audit report subsequent event dating Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 14) The appropriate audit report date for a standard nonqualified audit report for a non-public entity should be the: A) date the financial statements are given to the Board of Directors. B) date of the financial statements. C) 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 non-public entity;eight parts of the report Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-1 AACSB: Reflective thinking skills

16) An audit report prepared by Garrett and Brown, CPAs, is provided below. The audit for the year ended December 31, 2012 was completed on March 1, 2013, and the report was issued to Javlin Corporation, a private company, on March 13, 2013. List any deficiencies in this report. Do not rewrite the report. We have examined the accompanying financial statements of Dalton Corporation as of December 31, 2012. These financial statements are the responsibility of the company's management. Management's Responsibility for the Financial Statements: Management is responsible for the preparation and fair presentation of the financial statements in accordance with generally accepted auditing standards; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from all misstatement, whether due to fraud or error. Auditor's Responsibility Our responsibility is to give an opinion on these financial statements based on our audit. We conducted our audits in accordance with auditing standards generally accepted throughout the world.Those standards require that we plan and perform the audit to obtain absolute assurance about whether the financial statements are free of misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on management's judgment, including the assessment of the risks of material misstatement of the income statement, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the auditor's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also includes evaluating the appropriateness of accounting policies and the accuracy of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present accurately the financial position of Javlin Corporation as of December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Garrett and Brown, CPAs March, 2013 7

Answer: The audit report contains the following deficiencies: • The report title is missing. The title must include the word independent. • The audit report address is missing.The report should be addressed to shareholders and the board of directors. • The introductory paragraph should refer to an "audit," not an "examination." • The introductory paragraph should list the financial statements that were audited. • The introductory paragraph refers to the wrong company. • The introductory paragraph should not state that the financial statements are the responsibility of management. This belongs in the next section- management's responsibility. • The management's responsibility section should state that the financial statements are in accordance with "accounting principles generally accepted in the Unites States of America" not in accordance with generally accepted auditing standards." • The auditor's responsibility section should state that our responsibility is to "express" an opinion, not "give" an opinion. • The auditor's responsibility section should state the audit was conducted in accordance with "auditing standards generally accepted in the United States of America", not "throughout the world." • The auditor's responsibility section should state that the audit was planned and performed to obtain "reasonable" assurance, not "absolute "assurance. • The auditor's responsibility section should state that the financial statements are free of "material misstatements," not simply "misstatement." • The scope paragraph of the auditor's responsibility section should state that the procedures selected depend on the "auditor's" judgment, not "management's" judgment. • The scope paragraph of the auditor's responsibility section should state risk of material misstatement in the "financial statements," not the "income statement." • The scope paragraph of the auditor's responsibility section should state the auditor considers internal control relevant to management's preparation , not the entity's preparation. • The scope paragraph of the auditor's responsibility section is missing the sentence "Accordingly, we express no such opinion." This should be placed right after the second sentence. • The scope paragraph of the auditor's responsibility section should state " reasonableness" of significant accounting estimates," not "accurate." • The scope paragraph should contain the following phrase: "An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation." • The auditor's opinion section should state that the financial statements present "fairly, in all material respects," not present accurately. • The auditor's opinion section should include "and the results of their operations and cash flows for the year then ended." • The audit report should be dated March 1, 2013. Terms: Audit report deficiencies Diff: Challenging Objective: LO 3-1 AACSB: Analytic skills

17) Describe the standard unqualified report to be issued for an audit of a private company. Begin by specifying the eight parts of the report, and then discuss the contents of each part. Answer: The parts of the standard unqualified report are as follows: • Report title. The title must include the word "independent." Examples of appropriate titles are "independent auditor's report," or "report of independent accountant." • Report address. The report is usually addressed to the company's stockholders or board of directors. It should not be addressed to company management. • Introductory paragraph. 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 those used by management on the financial statements. • Management's Responsibility section. This section states that the statements are the responsibility of management. This responsibility includes selecting the appropriate accounting principles and maintaining internal control over financial reporting sufficient for preparation of financial statements that are free of material misstatements due to fraud or error. •

Auditor's Responsibility section. This section contains three paragraphs:

The first paragraph states that (1) the audit was conducted in accordance with auditing standards generally accepted in the United States of America, (2) the audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement. The second paragraph is called the scope paragraph and describes the scope of the audit and the evidence accumulated. This paragraph indicates that the procedures depend on the auditor's 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 and is not sufficient to express an opinion on the effectiveness of the entity's internal control. The last sentence of the paragraph indicates that the audit includes evaluating the accounting policies selected, the reasonableness of accounting estimates, and the overall financial statement presentation. The third paragraph indicates the auditor believes that sufficient appropriate evidence has been obtained to support the auditor's opinion. • Opinion paragraph. This paragraph states the auditor's conclusions based on the results of the audit. It states that in the auditor's opinion the financial statements present fairly, in all material respects, the financial position of the company as of a certain date, and the results of their operations and cash flows for the the year(s) then ended, in accordance with accounting principles generally accepted in the United States of America. 9

• Name of CPA firm. Typically, the name of the CPA firm, and not the name of an individual auditor, is used. •

Audit report date. The audit report is normally dated as of the last day of fieldwork.

Terms: Standard unqualified audit report for a non-public entity; eight parts of the report Diff: Challenging Objective: LO 3-1 AACSB: Reflective thinking skills

18) EPM, Inc., is a private 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, audited the 2011 and 2012 financial statements. The auditors completed all significant fieldwork on March 5, 2013 and issued the audit report on March 16, 2013. Required: Consider all the facts given and write the standard unqualified auditor's report, including all eight sections of the report. Answer: Independent Auditor's Report To the Board of Directors and Shareholders of EPM, Inc. We have audited the accompanying balance sheets of EPM, Inc., as of December 31, 2012 and 2011, and the related statements of income, changes in stockholders' equity, and cash flows for the years then ended, and the related notes to the financial statements. Management's Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor's Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. 11

Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of EPM, Inc., as of December 31, 2012 and 2011, and the results of their operations and cash flows for the years then ended, in accordance with accounting principles generally accepted in the United States of America. Harrington and Perry, LLP March 5, 2013 Terms: Audit report format for private company Diff: Challenging Objective: LO 3-1 AACSB: Analytic skills 19) An audit provides a high level of assurance, but is not a guarantee that a material misstatement will exist in the financial statements. A) True B) False Answer: A Terms: Audit and reasonable assurance Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 20) AICPA auditing standards provide uniform wording for the auditor's report to enable users of the financial statements to understand the audit report. A) True B) False Answer: A Terms: Uniform wording for auditor's report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 21) Users of the financial statements rely on the auditor's report because of the absolute assurance the report provides. A) True B) False Answer: B Terms: Users of financial statements rely on auditor's report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

22) The introductory paragraph of the auditor's report states that the auditor is responsible for the preparation, presentation and opinion on financial statements. A) True B) False Answer: B Terms: Introductory paragraph of auditor's report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 23) The audit report date is the date the auditor completed audit procedures in the field. A) True B) False Answer: A Terms: Audit report date Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 24) The scope paragraph of the auditor's responsibility section of the audit report issued for financial statements of a non-public company should refer to generally accepted auditing standards . A) True B) False Answer: A Terms: Audit reports issued for financial statements of private company; Scope paragraph; Generally accepted auditing standards Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills Topic: Public 25) In the scope paragraph of the audit report issued for financial statements of a non-public company, the auditor expresses an opinion about the internal controls of the company. A) True B) False Answer: B Terms: Audit reports issued for financial statements of private company; Scope paragraph; Generally accepted auditing standards Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills

26) The audit report is normally addressed to the company's president or chief executive officer. A) True B) False Answer: B Terms: Audit report normally addressed Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 27) The phrase "generally accepted accounting principles" can be found in the opinion paragraph of a standard unqualified report. A) True B) False Answer: A Terms: Generally accepted accounting principles; Opinion paragraph of standard unqualified report Diff: Easy Objective: LO 3-1 AACSB: Reflective thinking skills 28) 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. A) True B) False Answer: A Terms: Date of auditor's report indicates auditor's responsibility Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills 29) The phrase "auditing standards generally accepted in the United States of America" can be found in the opinion paragraph of a standard, unqualified audit report for a non-public company. A) True B) False Answer: B Terms: Auditing standards generally accepted in the United States; Opinion paragraph in standard unqualified report for public company Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills Topic: Public

30) 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. A) True B) False Answer: B Terms: Standard unqualified audit report for a non-public entity;eight parts of the report Diff: Moderate Objective: LO 3-1 AACSB: Reflective thinking skills Learning Objective 3-2 1) In which of the following situations would the auditor most likely issue an unqualified report? A) The client valued ending inventory by using the replacement cost method. B) The client valued ending inventory by using the Next-In-First-Out (NIFO) method. C) The client valued ending inventory at selling price rather than historical cost. D) The client valued ending inventory by using the First-In-First-Out (FIFO) method, but showed the replacement cost of inventory in the Notes to the Financial Statements. Answer: D Terms: Issued audit report; further audit tests or inquiries Diff: Challenging Objective: LO 3-2 AACSB: Reflective thinking skills 2) The standard unqualified 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 unqualified audit report Diff: Easy Objective: LO 3-2 AACSB: Reflective thinking skills

3) There are four conditions that must be met before an auditor can issue a standard unqualified report for the audit of a private company. Please discuss each of these five conditions. Answer: The four conditions that justify issuing a standard unqualified 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 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 Diff: Moderate Objective: LO 3-2 AACSB: Reflective thinking skills 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 internal control over financial reporting II. Separate reports on financial statements and 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 internal control over financial reporting Diff: Easy Objective: LO 3-3 AACSB: Reflective thinking skills Topic: Public

2) The standard unqualified audit report for public entities includes the following three paragraphs: A) introductory, scope and management's responsibility. B) materiality, scope and report. C) introductory, scope and opinion. D) scope, fieldwork and conclusion. Answer: C Terms: Standard unqualified audit report for public entities Diff: Easy Objective: LO 3-3 AACSB: Reflective thinking skills Topic: Public 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 Diff: Easy Objective: LO 3-3 AACSB: Reflective thinking skills Topic: Public 4) 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 internal controls over financial reporting. A) True B) False Answer: B Terms: Section 404(b) of Sarbanes-Oxley Act; Internal controls over financial reporting Diff: Moderate Objective: LO 3-3 AACSB: Reflective thinking skills Topic: Public 5) Auditors of public company financial statements must issue separate reports on internal control over financial reporting. A) True B) False Answer: B Terms: Auditors issue separate reports on internal control Diff: Moderate Objective: LO 3-3 AACSB: Reflective thinking skills Topic: Public

Learning Objective 3-4 1) Examples of unqualified opinions which contain modified wording (without adding an explanatory paragraph) include: A) the use of other auditors. B) material uncertainties. 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 Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills 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: Unqualified opinion with emphasis on specific matters regarding the financial statements Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills 3) All of the following are causes for the addition of an explanatory 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 modified wording Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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 unqualified opinion 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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 explanatory paragraph that appears before the opinion paragraph. C) the opinion paragraph. D) an explanatory paragraph after the opinion paragraph. Answer: D Terms: Justified Departure Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

10) William Gregory, CPA, is the principal auditor for a multi-national 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 off consolidated assets and revenue that they audited. Answer: C Terms: Reports involving other auditors Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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 an other auditor. Answer: D Terms: Shared opinions Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

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 principle auditor. III. The principle 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 14) When an auditor is trying to determine how changes can affect consistency and and/or comparability, he 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 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: Unqualified opinion with emphasis on specific matters regarding the financial statements Diff: Easy Objective: LO 3-4 AACSB: Analytic skills

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 Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-4 AACSB: Reflective thinking skills

19) Indicate which changes would require an explanatory paragraph in the audit report. A) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Change from LIFO to FIFO 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

Change from LIFO to FIFO No

C) Correction of an error by changing from an accounting principle that is not generally acceptable to one that is generally acceptable Yes

Change from LIFO to FIFO No

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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

20) Indicate which changes 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 Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

21) Indicate which changes would require an explanatory paragraph in the audit report. A) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern Change from FIFO to LIFO Yes Yes B) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern Change from FIFO to LIFO No No C) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern Change from FIFO to LIFO Yes No D) The CPA concludes there is substantial doubt about the entity's ability to continue as a going concern Change from FIFO to LIFO No Yes Answer: A Terms: Changes that would require an explanatory paragraph in audit report Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

22) Indicate which changes would require an explanatory paragraph in the audit report. A) A departure from GAAP The CPA makes reference to which, due to unusual the work of another auditor circumstances, does not to indicate shared require a qualified or adverse responsibility in an opinion. unqualified opinion. Yes Yes B) A departure from GAAP The CPA makes reference to which, due to unusual the work of another auditor circumstances, does not to indicate shared require a qualified or adverse responsibility in an opinion. unqualified opinion. No No C) A departure from GAAP The CPA makes reference to which, due to unusual the work of another auditor circumstances, does not to indicate shared require a qualified or adverse responsibility in an opinion. unqualified opinion. Yes No D) A departure from GAAP The CPA makes reference to which, due to unusual the work of another auditor circumstances, does not to indicate shared require a qualified or adverse responsibility in an opinion. unqualified opinion. No Yes Answer: C Terms: Changes that would require an explanatory paragraph in audit report Diff: Challenging Objective: LO 3-4 AACSB: Reflective thinking skills

23) Discuss each of the five circumstances when an auditor would issue an unqualified audit report with an explanatory paragraph or modified wording. Answer: An unqualified report with an explanatory paragraph or modified wording is 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 unqualified opinion 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 unqualified opinion 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 unqualified opinion 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 unqualified 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 unqualified report. Terms: Circumstances where an auditor will issue modified unqualified report with explanatory paragraph or modified wording Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 24) A modified unqualified audit report arises when the auditor believes the financials are fairly stated but also believes additional information should be provided. A) True B) False Answer: A Terms: Modified unqualified audit report Diff: Easy Objective: LO 3-4 AACSB: Reflective thinking skills 25) Changes in accounting estimates requires the auditor to issue a modified unqualified audit report with a consistency paragraph inserted after the opinion paragraph. A) True B) False Answer: B Terms: Changes of accounting estimates; Modified unqualified audit report Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills

26) The only modified unqualified opinion that does not include an explanatory paragraph is when other auditors are involved. In this case only the introductory paragraph is modified. A) True B) False Answer: B Terms: Modified unqualified opinion Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 27) Items that materially affect the comparability of the financial statements generally require disclosure in the footnotes. A) True B) False Answer: A Terms: Items that materially affect comparability of financial statements Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 28) 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. A) True B) False Answer: B Terms: Comparability vs. consistency Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 29) 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. A) True B) False Answer: B Terms: Comparability and consistency Diff: Challenging Objective: LO 3-4 AACSB: Reflective thinking skills

30) 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. A) True B) False Answer: B Terms: Auditor reliance on different CPA firm to perform part of audit; Shared opinion Diff: Moderate Objective: LO 3-4 AACSB: Reflective thinking skills 31) 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. A) True B) False Answer: A Terms: Shared responsibility Diff: Challenging Objective: LO 3-4 AACSB: Reflective thinking skills 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 unqualified 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 unqualified audit report; Management refusal to permit the auditor to physically examine inventory Diff: Easy Objective: LO 3-5 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 3-5 AACSB: Reflective thinking skills 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

Departure from GAAP Yes

Lack of Consistency Yes

Lack of Sufficient Evidence Yes

Answer: C Terms: Qualified opinions Diff: Easy Objective: LO 3-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills

6) In which situation would the auditor be choosing between "except for" qualified opinion and an adverse opinion? A) The auditor lacks 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills

10) A client has changed their method of valuing inventory from FIFO to LIFO and the change has a material effect on the financial statements. If the auditor does not concur with the appropriateness of the change, the auditor should issue a(n): A) disclaimer. B) adverse opinion. C) unqualified opinion. D) qualified opinion. Answer: D Terms: Change in valuing inventory and auditor does not concur with change Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 internal control structure is so poor that the auditor has to assess control risk at the maximum. Answer: B Terms: Adverse opinion circumstances Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-5 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-5 AACSB: Reflective thinking skills 18) 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 Rule 101 of the rules of the 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 Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills

19) A qualified 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. A) True B) False Answer: B Terms: Qualified report Diff: Easy Objective: LO 3-5 AACSB: Reflective thinking skills 20) Auditors should issue a disclaimer of opinion when there is a highly material client-imposed scope restriction. A) True B) False Answer: A Terms: Disclaimer of opinion; Client-imposed scope restriction Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 21) Whenever an auditor issues a qualified report, he or she must use the term "except for " in the opinion paragraph. A) True B) False Answer: A Terms: Qualified report; Except for in opinion paragraph Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 22) A qualified report can take the form of a qualification of both the scope and the opinion or of the opinion alone. A) True B) False Answer: A Terms: Qualified report; Scope limitation Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills

23) 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. A) True B) False Answer: B Terms: Disclaimer of opinion; Highly material GAAP violation in the financial statements and client refuses to correct it Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 24) Client imposed restrictions on the audit always require a disclaimer of opinion. A) True B) False Answer: B Terms: Disclaimer of opinion; Client imposed restrictions on audit Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 25) An auditor should issue a qualified opinion with an explanatory paragraph whenever there is a material uncertainty affecting the financial statements. A) True B) False Answer: B Terms: Qualified opinion with explanatory paragraph Diff: Moderate Objective: LO 3-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills 6) When a client fails to follow GAAP, the audit report can be unqualified, 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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-6 AACSB: Reflective thinking skills

8) 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 unqualified, qualified, or adverse opinion is issued. For conditions involving a scope restriction, the materiality of the restriction influences whether an unqualified report, a qualified scope and opinion report, or a disclaimer of opinion is issued. Terms: Materiality affect on audit reporting decisions Diff: Easy Objective: LO 3-6 AACSB: Reflective thinking skills 9) Materiality is essential when an auditor considers his/her determination of the appropriate report for a given set of circumstances. A) True B) False Answer: A Terms: Materiality; Appropriate report Diff: Easy Objective: LO 3-6 AACSB: Reflective thinking skills 10) A pervasive exception is one that affects different parts of the financial statements. A) True B) False Answer: A Terms: Pervasive exception Diff: Easy Objective: LO 3-6 AACSB: Reflective thinking skills 11) An item with a "psychic" effect (e.g., where the item maintains an increasing earnings trend) is a qualitative factor that may affect the auditors decision regarding materiality. A) True B) False Answer: A Terms: Psychic effect; Materiality Diff: Challenging Objective: LO 3-6 AACSB: Reflective thinking skills

Learning Objective 3-7 1) The explanatory paragraph for a qualified opinion would: A) precede the scope paragraph. B) follow the scope paragraph. C) follow the opinion paragraph. D) either precede or follow the opinion paragraph depending on the materiality. Answer: B Terms: Explanatory paragraph for qualified opinion Diff: Easy Objective: LO 3-7 AACSB: Reflective thinking skills 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) Notes to the financial Scope paragraph Opinion paragraph statements Yes No Yes B) Scope paragraph No

Opinion paragraph Yes

Notes to the financial statements Yes

Scope paragraph No

Opinion paragraph Yes

Notes to the financial statements No

Scope paragraph Yes

Notes to the financial Opinion paragraph statements Yes No

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

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 Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 4) When a qualified or adverse opinion is issued, the qualifying paragraph is inserted: A) between the introductory and scope paragraphs. B) between the scope and opinion paragraphs. 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 Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills

5) The independent auditor must issue a qualified opinion when which of the financial(s) are missing? I. Balance Sheet II. Income Statement III. Statement of Cash Flows A) I only B) II only C) III only D) I, II, and III Answer: C Terms: Qualified opinion issued when which financial statement is missing Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills

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) a unqualified opinion may still be issued depending on the materiality of the scope limitation. Answer: D Terms: Scope limitation Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 10) When there is a scope restriction, what type of audit report can be issued? A) Unqualified opinion B) Qualification of scope and opinion C) Disclaimer of opinion D) Any of the above Answer: D Terms: Audit reports in various situations Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills

11) Subsequent to the close of Spacely Sprockets fiscal year ending October 31, 2012, 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 Diff: Challenging Objective: LO 3-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 3-7 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 3-1 and LO 3-7 AACSB: Reflective thinking skills

15) 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 internal control over financial reporting.) Independent Auditor's Report To the shareholders of Wallace Corporation We have audited the accompanying balance sheet of Wallace Corporation as of December 31, 2012, 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 conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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, 2012, 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 preceding paragraph, the financial statements referred to above do not present fairly the financial position of Wallace Corporation as of December 31, 2012, or the results of its operations and its cash flows for the year then ended. Terms: Adverse audit report Diff: Challenging Objective: LO 3-7 AACSB: Analytic skills Topic: Public

16) The following is the introductory paragraph, and the Basis for Qualified Opinion paragraph for Fast Times Corporation, a non-public company. Independent Auditor's Report To the shareholders of Fast Times Corporation We have audited the accompanying balance sheet of Fast Times Corporation as of September 30, 2012, 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, 2012, 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 Diff: Challenging Objective: LO 3-7 AACSB: Analytic skills Topic: Public 17) Your CPA firm has completed the fieldwork for the 2012 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, 2012, 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 Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 49

18) Assume you are the partner in charge of the 2012 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 a standard unqualified report. b. Qualify both the scope and opinion paragraphs. c. Qualify the opinion paragraph. d. Issue an unqualified opinion with an explanatory paragraph. e. Issue an unqualified opinion with modified 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 2012. 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 Diff: Challenging Objective: LO 3-1, LO 2-4, LO 3-5, and LO 3-7 AACSB: Analytic skills

19) 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, 2012 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, 2012, 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, 2012. 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 2012 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 rase 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, 2012, and the related consolidated statements of income, changes in stockholders 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, 2012 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 52

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, 2012 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, 2012 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 is required 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. 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. 53

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 Diff: Challenging Objective: LO 3-1, LO 3-4, and LO 3-7 AACSB: Analytic skills

20) 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 Unqualified 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

Terms: Circumstances and required audit reports Diff: Challenging Objective: LO 3-1, LO 3-4, and LO 3-7 AACSB: Analytic skills

Scope Opinion Exp1

21) 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 unqualified 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 unqualified 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 F/S 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 F/S 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 F/S that present financial position and results of operations but omits the related statement of cash flows. Management discloses in the notes to the F/S that it does not believe the statement of cash flows to be useful. 6. An entity changes its depreciation method for production equipment from SL 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 F/S. 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 F/S. 8. An entity discloses certain lease obligations in the notes to the F/S. The auditor believes that the failure to capitalize these leases is a departure from GAAP. 9. The entity wishes to show comparative F/S and include the prior year. However, the prior year F/S 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 F/S and include the prior year. However, the prior year F/S were audited by another auditor who refuses to reissue his opinion. 56

List A Opinion Choices

A Qualified

B Unqualified

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 explanatory paragraph preceding the opinion paragraph w/o modifying the three standard paragraphs. I Describe the circumstances in the opinion paragraph w/o adding an explanatory paragraph. J Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the opinion paragraph. K Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the opinion paragraph. L Describe the circumstances in an explanatory paragraph preceding the opinion paragraph and modify the scope & opinion paragraph. M Describe the circumstances in an explanatory paragraph following the opinion paragraph and modify the scope & opinion paragraph. N Describe the circumstances in the scope paragraph w/o adding an explanatory paragraph. O Describe the circumstances in an explanatory paragraph following the opinion paragraph w/o modifying the three standard paragraphs. P Describe the circumstances in the introductory paragraph w/o adding an explanatory paragraph. Q Describe the circumstances in the introductory paragraph w/o adding an explanatory 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 Diff: Challenging Objective: LO 3-1, LO 3-4, LO 3-5, and LO 3-7 AACSB: Analytic skills 22) Financial statement users are typically more concerned with an unqualified report with explanatory paragraphs than they are with a disclaimer of opinion. A) True B) False Answer: B Terms: Financial statement users; Unqualified report with explanatory paragraphs; Disclaimer of opinion Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 23) A lack of independence will override any other scope limitations and requires a disclaimer of opinion. A) True B) False Answer: A Terms: Lack of independence; Disclaimer of opinion Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: B Terms: Qualified opinion explanatory paragraph and opinion paragraph Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills

25) In the case of a disclaimer due to lack of independence, the entire scope paragraph is excluded from the report. A) True B) False Answer: A Terms: Disclaimer of opinion Diff: Moderate Objective: LO 3-7 AACSB: Reflective thinking skills 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) unqualified opinion. B) unqualified opinion with an explanatory paragraph. C) adverse opinion. D) disclaimer opinion. Answer: A Terms: Audit report and different levels of materiality Diff: Moderate Objective: LO 3-8 AACSB: Analytic skills 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 exists requiring a departure from a standard unqualified report. D) decide the materiality for each condition. Answer: C Terms: Auditor's decision process for audit reports Diff: Moderate Objective: LO 3-8 AACSB: Reflective thinking skills 3) In most audits, the auditor issues a: A) qualified audit report. B) unqualified audit report. C) scope limited audit report. D) adverse audit report. Answer: B Terms: Standard unqualified audit report Diff: Challenging Objective: LO 3-8 AACSB: Reflective thinking skills 59

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 Diff: Moderate Objective: LO 3-8 AACSB: Reflective thinking skills 5) When there is a justified departure from GAAP which is considered material, the auditor should issue a(n): A) standard unqualified audit report. B) disclaimer of opinion. C) unqualified audit report with an explanatory paragraph. D) adverse opinion. Answer: C Terms: Audit report and different levels of materiality Diff: Moderate Objective: LO 3-8 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 3-8 AACSB: Reflective thinking skills

7) After the auditor determines whether any conditions exist which require a departure from a standard unqualified report, the next step in the decision process for audit reports 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 Diff: Easy Objective: LO 3-8 AACSB: Reflective thinking skills 8) The final step in the auditor's decision process for audit reports is to write the audit report. A) True B) False Answer: A Terms: Auditor's decision process for audit reports Diff: Easy Objective: LO 3-8 AACSB: Reflective thinking skills 9) Academic research is underway to study the effectiveness of communications provided by auditors in the audit report. A) True B) False Answer: A Terms: Research underway on audit report Diff: Moderate Objective: LO 3-8 AACSB: Reflective thinking skills Learning Objective 3-9 1) Auditing standards in the United States allow an auditor to perform an audit of a U.S. entity in accordance with both generally accepted auditing standards in the U.S. and the ISAs. A) True B) False Answer: A Terms: Auditing standards of United States and International Standards of Auditing Diff: Moderate Objective: LO 3-9 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 4 Professional Ethics 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 Diff: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning abilities 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 Diff: Moderate Objective: LO 4-1 AACSB: Ethical understanding and reasoning abilities 3) One of the main reasons people act unethically is that they choose to act selfishly. A) True B) False Answer: A Terms: Ethical Principles Diff: Easy Objective: LO 4-1 AACSB: Ethical understanding and reasoning abilities

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 Diff: Moderate Objective: LO 4-2 AACSB: Ethical understanding and reasoning abilities 2) 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 shortand long-term effects of each alternative. 6. Decide the appropriate action. Terms: Ethical dilemma Diff: Challenging Objective: LO 4-2 AACSB: Ethical understanding and reasoning abilities 3) A rationalization method that can easily result in unethical behavior is the argument that "everybody does it." A) True B) False Answer: A Terms: Ethical Principles Diff: Easy Objective: LO 4-2 AACSB: Ethical understanding and reasoning abilities

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 Diff: Easy Objective: LO 4-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 4-3 AACSB: Reflective thinking skills 3) 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 Diff: Easy Objective: LO 4-3 AACSB: Ethical understanding and reasoning abilities

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 Diff: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 2) Which of the following is not one of the four parts of the AICPA's Code of Professional Conduct? A) Principles B) Rules of Conduct C) Interpretations D) Definitions Answer: D Terms: AICPA Code of Professional Conduct Diff: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

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 Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 4) According to the Principles section of the Code of Professional Conduct, all members: A) should be independent in fact and in appearance at all times. B) in public practice should be independent in fact and in appearance at all times. C) in public practice should be independent in fact and in appearance when providing auditing and other attestations services. D) in public practice should be independent in fact and in appearance when providing auditing, tax, and other attestation services. Answer: C Terms: Principles section of the Code of Professional Conduct Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

5) Which of the following statements best describes the enforceability of the Interpretations of the Rules of Conduct? A) The Interpretations are not enforceable. B) The Interpretations are enforceable. C) The Interpretations may be enforceable if they have been reviewed and approved by the AICPA's Division of Professional Ethics. D) The Interpretations are not enforceable, but a practitioner must justify departure from them. Answer: D Terms: Enforceability of Interpretations of the Rules of Conduct Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 6) Of the four parts of the AICPA's Code of Professional Conduct, which part is enforceable? A) Ethical Rulings B) Rules of Conduct C) Principles D) Interpretations Answer: B Terms: AICPA Code of Professional Conduct; Enforceable Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 7) Ethical Rulings are: I. explanations relating to broad hypothetical circumstances. II. not enforceable, but one must justify departure. III. explanations relating to specific factual circumstances. A) I and II B) I and III C) II and III D) I, II, and III Answer: C Terms: Ethical Rulings Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

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 Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 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 Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 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 Diff: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 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 Diff: Challenging Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 7

12) Identify and describe each of the four parts to the AICPA's Code of Professional Conduct. Also discuss which parts are officially enforceable and which are not. Answer: The four parts to the Code are: • Principles. These establish ideal standards of ethical conduct stated in philosophical terms. They are not officially enforceable. • Rules of conduct. These are the minimum standards of ethical conduct stated as explicit rules that must be followed by every CPA in the practice of public accounting. They are officially enforceable. • Interpretations. Interpretations of rules are intended to clarify the rules of conduct when there are questions from practitioners about a specific rule. They are not officially enforceable, but a practitioner must justify any departure. • Ethical rulings. These are explanations by the executive committee of the professional ethics division of specific factual circumstances. They are not enforceable, but a practitioner must justify any departure. Terms: Four parts of AICPA Code of Professional Conduct Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 13) Briefly describe the advantages and disadvantages of a code of conduct based on general statements of ideal conduct as opposed to specific rules that define unacceptable behavior. Answer: Advantages Disadvantages General statements

Emphasis on positive activities encouraging a high level of performance.

Difficult to enforce.

Specific rules

Enforceability of Tendency for rules to be minimum behavior and regarded as maximum rather performance standards. than minimum standards. Terms: Code of conduct general statements vs. specific rules Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

14) 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 Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 15) An advantage of specific rules in the Code of Professional Conduct is the enforceability of minimum behavior and performance standards. A) True B) False Answer: A Terms: Code of Professional Conduct Diff: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 16) The AICPA Code of Professional Conduct permits the auditor to perform a wide variety of non-audit services for audit clients. A) True B) False Answer: B Terms: Code of Professional Conduct Diff: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

17) 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. A) True B) False Answer: B Terms: Code of Professional Conduct Diff: Easy Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 18) In the AICPA Code of Professional Conduct, ethical rulings are less specific than rules of conduct. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Ethical rulings Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 19) Interpretations of rules of conduct in the Code of Professional Conduct are not officially enforceable and practitioners need not justify departure from them. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Interpretation of rules Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 20) In the AICPA Code of Professional Conduct, interpretations of rules are more specific than ethical rulings. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Ethical rulings; Interpretations of rules Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

21) In the AICPA 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. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Public Interest principle Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 22) In the AICPA 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. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Scope and nature of services principle Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 23) The Conceptual Framework for AICPA Independence Standards can be used when making decisions on ethical matters not explicitly addressed in the Code. A) True B) False Answer: A Terms: AICPA Code of Professional Conduct Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities 24) Each state also has rules of conduct that are required for licensing by the state. A) True B) False Answer: A Terms: AICPA Code of Professional Conduct Diff: Moderate Objective: LO 4-4 AACSB: Ethical understanding and reasoning abilities

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 three of the above Answer: B Terms: Independence Diff: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 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 Diff: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 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 Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 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 Diff: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 12

5) 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 Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities Topic: SOX 6) 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 Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 7) The provisions of the Sarbanes-Oxley Act of 2002 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 of 2002; Allowed non-audit services Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 13

8) 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 internal control over financial reporting Answer: D Terms: Services allowed by SEC when CPA audits company Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 9) 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: Services allowed by SEC when CPA audits company Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 10) 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 Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 11) 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 Diff: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities Topic: SOX 14

12) In determining independence with respect to any audit engagement, the ultimate decision as to whether or not the auditor is independent must be made by the: A) auditor. B) client. C) audit committee. D) public. Answer: A Terms: Auditor independence Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 13) 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 Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 14) 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 Diff: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 15) Interpretations of the AICPA 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 dominated by Diff: Challenging Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 15

16) A public company may obtain internal audit services from their financial statement auditor if it is approved by the company's audit committee. A) True B) False Answer: B Terms: Public company; Non-audit services purchased Diff: Easy Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities Topic: SOX 17) The audit committee of a private company need not approve all non-audit services provided by the company's financial statement auditor. A) True B) False Answer: A Terms: Private company; Non-audit services purchased Diff: Moderate Objective: LO 4-5 AACSB: Ethical understanding and reasoning abilities 18) 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. A) True B) False Answer: A Terms: Sarbanes-Oxley Act; Audit committee Diff: Moderate Objective: LO 4-5 AACSB: Reflective thinking skills Topic: SOX

Learning Objective 4-6 1) Interpretations of Independence Rule 101 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 engagement office even if they have no engagement Individuals on the attest The firm and its employee responsibility engagement benefit plans Yes Yes Yes B) All partners in the engagement office even if they have no engagement responsibility Yes

Individuals on the attest engagement No

The firm and its employee benefit plans No

Individuals on the attest engagement Yes

The firm and its employee benefit plans Yes

Individuals on the attest engagement No

The firm and its employee benefit plans No

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 101; Direct investment; Covered members Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

2) In some situations, the interpretations of the Rules of Conduct permit former partners to have relationships with a client of the firm without affecting the firm's independence. Which of the following situations would cause a loss of independence? A) The former partner works in the maintenance department of an audit client of his former firm. B) The former partner's grandson works in the warehouse of an audit client of his former firm. C) The former partner was held out as an associate of the firm. D) The former partner purchased 5% of the stock of an audit client of his former firm. Answer: C Terms: Independence ramifications on auditor and CPA firm Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 3) 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 Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 4) 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 Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 5) Independence is required of a CPA when performing: A) external audits. B) all attestation services. C) all attestation and tax services. D) all professional services. Answer: B Terms: Independence Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

6) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 7) An example of an "indirect ownership interest in a client" would be ownership of a client's stock by a member's: A) dependent child. B) spouse. C) non-dependent grandfather. D) All of the above are examples of indirect ownership. Answer: C Terms: Indirect ownership interest in a client Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 8) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

9) 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 brother, sister, or in-laws are employed by the client Answer: A Terms: Direct financial interest, independence Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 10) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 11) 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 25% of the company. C) Lisa is the marketing manager. D) all of the above. Answer: A Terms: Financial interest and independence Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

12) 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, and employee of another local accounting firm, prepares the tax return of Capital Trust's CEO. C) Oehlers and Capital Trust's 401K plan 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 13) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 14) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

15) 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 16) 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

17) The Code of Conduct rule on independence indicates that materiality must be considered when: A) Evaluating direct investments Evaluating indirect made by the 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 18) 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

19) 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. D) when 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 20) 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 21) 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

22) Which of the following statements is true? 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 Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 23) 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: Services allowed by SEC when CPA audits company Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 24) 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 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 Diff: Challenging Objective: LO 4-6 AACSB: Reflective thinking skills

25) 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 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 Diff: Challenging Objective: LO 4-6 AACSB: Reflective thinking skills

26) 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. 27

c. No violation. The AICPA does not prohibit CPA firms from providing bookkeeping, tax, and audit services to the same non-public 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 Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 27) 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 they either move: a. Don to an office that does not participate on the engagement or b. the audit engagement to an office in which Don is not employed. Terms: Independence ramifications on auditor and CPA firm Diff: Challenging Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 28) Rule 101, Independence, prohibits a CPA from performing both audit services and bookkeeping services for the same public company in the same year. A) True B) False Answer: A Terms: Rule 101, Independence Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

29) Under Rule 101, Independence, 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. A) True B) False Answer: B Terms: Rule 101, Independence Diff: Easy Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 30) 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. A) True B) False Answer: A Terms: Indirect financial interest; Immaterial Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 31) Rule 101, Independence, applies to members of the AICPA when performing any professional service. A) True B) False Answer: B Terms: Rule 101, Independence Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities 32) Rule 101, Independence, applies to covered members in a position to influence an attest engagement. A) True B) False Answer: A Terms: Rule 101, Independence Diff: Moderate Objective: LO 4-6 AACSB: Ethical understanding and reasoning abilities

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 Diff: Easy Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 2) Which of the following would be a violation of the rule requiring "objectivity" by the CPA? I. The auditor accepts management's opinion regarding the collection of accounts receivable without an independent evaluation. II. In preparing a client's tax return, the CPA encourages a client to take a deduction for which there is no support. A) I only B) II only C) I and II D) Neither I nor II Answer: C Terms: Violation of rule requiring CPA objectivity Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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. She 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities

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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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. Are commissions 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities

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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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 partners must be a member of the AICPA. B) All partners must be members of the AICPA. C) The partners whose names appear in the firm name must be members of the AICPA. D) A majority of the partners must be members of the AICPA. Answer: B Terms: Members of the AICPA requirements Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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 Diff: Challenging Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 9) Which of the following would be considered a violation of the AICPA Code of 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 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 32

10) Rule 301 of 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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: Rule 503, Commissions and Referral Fees Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities

13) Which of the following represents all of the ways a CPA firm can be organized under Rule 505? 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: Rule 505, AICPA Code of Professional Conduct; CPA firm form of organization Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 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) 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 Diff: Moderate Objective: LO 4-7 AACSB: Ethical understanding and reasoning abilities 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 Diff: Challenging Objective: LO 4-7 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 4-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 4-7 AACSB: Analytic skills 18) Rule 201 - General Standards requires members to comply with certain standards and interpretations. Which of the following is not a standard specifically addressed in Rule 201? A) Professional integrity B) Due professional care C) Planning and supervision D) Sufficient relevant data Answer: A Terms: Rule 201, General Standards Diff: Challenging Objective: LO 4-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 35

20) Discuss Rule 301–Confidential Client Information, including the four exceptions to the rule. Answer: Rule 301 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; i.e., when Rule 202 or Rule 203 requires the disclosure. • In response to a valid subpoena or summons and compliance with laws and regulations. • A peer review is being conducted under AICPA, state CPA Society, or State Board of Accountancy authorization. • The CPA is initiating or responding to an inquiry from a recognized investigative body or the professional ethics division. Terms: Rule 301, Confidential Client Information and exceptions Diff: Challenging Objective: LO 4-7 AACSB: Reflective thinking skills

21) 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 2013, Freeman and Johnson, both CPAs, decided to form a CPA practice. In 2015, 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, unqualified 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: ________ Violation? Yes No Explanation: Answer: a. Violation of the rule on Form of Organization and Name (Rule 505). 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 (Rule 503). A CPA may pay a referral fee to a non-CPA as long as the payment is disclosed to the client. 37

c. Violation of the Contingent Fees rule (Rule 302). This is a contingent fee agreement and is prohibited by Rule 302. d. Violation of the Independence rule (Rule 101). Don is a covered member for purposes of Rule 101. 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 (Rule 101). 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 Diff: Challenging Objective: LO 4-5, LO 4-6 and LO 4-7 AACSB: Analytic skills

22) 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, 20x6, Hank Anderson, CPA and partner, was offered and accepted the engagement to audit the annual financial statements of Jernigan Corporation for the year ended December 31, 20x6. Preliminary work began on the audit on September 15, 20x6 and the engagement ended on March 7, 20x7. Jernigan is regulated by the SEC. Hank served as controller of Jernigan Corporation from December 1, 20x2, until April 10, 20x6, at which time he terminated his 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. 39

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 Hank had an employment relationship with the client during part of the period covered by the financial statements, his independence is impaired. Terms: Violations of Rules of AICPA Code of Professional Conduct Diff: Challenging Objective: LO 4-5, LO 4-6 and LO 4-7 AACSB: Analytic skills

23) The scenarios below all involve a possible violation of the AICPA's Cod of Professional Conduct. 1. Using the list below, indicate which of the Code of Conduct Rules applies to the scenario. a. 101: Independence b. 102: Integrity and Objectivity c. 302: Contingent Fees d. 501: Acts Discreditable e. 503: Commissions and Referral Fees f. 505: 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 share 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 ne 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. 9. Brad Barns, CPA, was traveling from Las Vegas to the Grand Canyon when he was pulled 41

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 Diff: Challenging Objective: LO 4-5, LO 4-6 and LO 4-7 AACSB: Ethical understanding and reasoning abilities 24) Imprisonment for a period of six months or longer will result in automatic expulsion from the AICPA. A) True B) False Answer: B Terms: Imprisonment; Expulsion Diff: Easy Objective: LO 4-7 AACSB: Reflective thinking skills 25) Rule 505, Form of Organization and Name, prohibits CPA firms from practicing as limited liability partnerships. A) True B) False Answer: B Terms: Rule 505, Form of Organization and Name Diff: Easy Objective: LO 4-7 AACSB: Reflective thinking skills

26) Under Rule 505, Form of Organization and Name, a CPA firm may use any name as long as it is not misleading. A) True B) False Answer: A Terms: Rule 505, Form of Organization and Name Diff: Easy Objective: LO 4-7 AACSB: Reflective thinking skills 27) A CPA firm may practice public accounting only in a form of organization permitted by federal law or regulation. A) True B) False Answer: B Terms: Form of Organization Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 28) Under Rule 301, Confidential Client Information, 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. A) True B) False Answer: A Terms: Rule 301, Confidential Client Information Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 29) Information obtained by a CPA from a client is legally privileged in federal court. A) True B) False Answer: B Terms: Legally privileged information Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills

30) Rule 502, Advertising and Other Forms of Solicitation, prohibits members of the AICPA in public practice from performing comparative advertising. A) True B) False Answer: B Terms: Rule 502, Advertising and Other Forms of Solicitation Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 31) Under Rule 505, Form of Organization and Name, 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. A) True B) False Answer: B Terms: Rule 505, Form of Organization and Name Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 32) 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. A) True B) False Answer: B Terms: AICPA Code of Professional Conduct; Offer audit clients a discount Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills 33) All owners of a CPA firm must be CPAs who are qualified to practice. A) True B) False Answer: B Terms: CPA qualified to practice Diff: Moderate Objective: LO 4-7 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 4-8 AACSB: Reflective thinking skills 2) 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 Boards' rules of conduct is punishable by loss of the violator's CPA certificate and license to practice. Terms: Methods to enforce the rules conduct Diff: Moderate Objective: LO 4-8 AACSB: Reflective thinking skills 3) Expulsion from the AICPA for failing to follow the rules of conduct is, by itself, sufficient to prevent a CPA from practicing public accounting. A) True B) False Answer: B Terms: Expulsion from AICPA for failing to follow rules of conduct Diff: Moderate Objective: LO 4-8 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 5 Legal Liability Learning Objective 5-1 1) Discuss 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. • An increased consciousness on the part of the Securities and Exchange Commission regarding its responsibility for protecting investors' interests. • The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations. • Large civil court judgments against CPA firms. • 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 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. • The global recession and tough economic times result in business failures, which prompt stakeholders to seek restitution from others, including external auditors. Terms: Major factors that have contributed to the recent increase in the number of lawsuits against auditors Diff: Moderate Objective: LO 5-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 5-2 AACSB: Reflective thinking skills 3) 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 Diff: Easy Objective: LO 5-2 AACSB: Reflective thinking skills 4) Audit risk is the risk there will be an audit failure for a given audit engagement. A) True B) False Answer: B Terms: Audit risk Diff: Moderate Objective: LO 5-2 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Audit failure; Followed audit standards and fail to discover material misstatement Diff: Moderate Objective: LO 5-2 AACSB: Reflective thinking skills

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: Performance of an audit Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 3) Recklessness in the case of an audit 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 description is the legal term for: A) ordinary negligence. B) gross negligence. C) constructive fraud. D) fraud. Answer: C Terms: Legal term for reckless in an audit with not intent to deceive Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills

4) The standard of due care to which the auditor is expected to adhere to 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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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: Laws of agency. Partners of CPA firm liable for work of others on whom they rely Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 4

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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills

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, but who is known Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 state legislatures Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 6

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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 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: Describes constructive fraud Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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: Describes fraud Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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: Support a finding of constructive fraud Diff: Moderate Objective: LO 5-3 AACSB: Analytic skills

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

All fraud should be detected during audit No

C) Gross negligence may constitute Fraud requires the constructive fraud intent to deceive Yes No

All fraud should be detected during audit Yes

D) Gross negligence may constitute Fraud requires the constructive fraud intent to deceive No No

All fraud should be detected during audit No

Answer: A Terms: Gross negligence, fraud, and constructive fraud Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills

22) Gregory & Hedrick, a medium-sized CPA firm, employed Elise as a staff accountant. Elise was negligent while auditing several of the firm's clients. Under these circumstances, which of the following statements is true? A) Elise would have no personal liability for negligence. B) Gregory & Hedrick is not liable for Elise's negligence because CPAs are generally considered to be independent contractors. C) Gregory & Hedrick would not be liable for Elise's negligence if Elise disobeyed specific instructions in the performance of the audits. D) Gregory & Hedrick can recover against its insurer on its malpractice policy even if one of the partners was also negligent in reviewing Elise's work. Answer: D Terms: Auditor negligent while auditing Diff: Challenging Objective: LO 5-3 AACSB: Reflective thinking skills 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: Failure of party to meet its obligations, causing injury to another party Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 24) 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. 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 reckless, in the case of an audit 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills

25) 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 Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 26) 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 and fraud Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 27) 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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills

28) 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 Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills

29) The standard of due care to which the auditor is expected to be held is referred to as the prudent person concept. A) True B) False Answer: A Terms: Standard of due care; Prudent person concept Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 30) 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. A) True B) False Answer: A Terms: CPA firm operating as a limited liability partnership Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 31) In a CPA firm operating as a limited liability partnership (LLP), the liability for one partner's actions extends to the firm's assets. A) True B) False Answer: A Terms: CPA firm operating as a limited liability partnership Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills 32) Statutory laws are laws that have been developed through court decisions rather than through the U.S. Congress and other governmental units. A) True B) False Answer: B Terms: Statutory laws Diff: Easy Objective: LO 5-3 AACSB: Reflective thinking skills

33) The doctrine of joint and several liability is one factor that has contributed to the recent increase in the number of lawsuits against auditors and the size of awards to plaintiffs. A) True B) False Answer: A Terms: Doctrine of joint and several liability; Contributed to increase in lawsuits Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 34) 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. A) True B) False Answer: B Terms: CPA and privileged communication Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills 35) Gross negligence is the existence of extreme or unusual negligence with the intent to deceive. A) True B) False Answer: B Terms: Gross negligence; Extreme or unusual negligence; Intent to deceive Diff: Moderate Objective: LO 5-3 AACSB: Reflective thinking skills Learning Objective 5-4 1) The principal issue in cases involving alleged negligence is usually: A) if an 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 Diff: Easy Objective: LO 5-4 AACSB: Reflective thinking skills

2) In third-party suits, which of the auditor's defenses 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: Third-party suits; Auditor defenses contends lack of privity contract Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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 internal controls. Answer: B Terms: Independent auditor could be responsible for failure to detect material fraud Diff: Easy Objective: LO 5-4 AACSB: Reflective thinking skills 4) Which of the following is an illustration of liability to clients under common law? A) Client sues auditor for not discovering a theft of assets by an employee. B) Bank sues auditor for not discovering that borrower's financial statements are misstated. C) Combined group of stockholders sue 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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills

5) Which of the following is an illustration of liability under the federal securities acts? 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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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: Defenses when there are legal claims Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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 are more common than breach of contract Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 10) A common way for a CPA firm to demonstrate a lack of duty 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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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 behavior and the damages suffered by the client. Answer: D Terms: To succeed in an action against the auditor, client must show that Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 12) Matthews & Co., CPAs, issued an unqualified opinion on Dodgers Corporation. Millennium Bank, which relied on the audited financial statements, granted a loan of $200,00,000 to Dodgers Corporation. Dodgers subsequently defaulted on the loan. To succeed in an action against Matthews & Co., Millennium Bank must prove that the bank was: A) in privity of contract with Dodgers. B) in privity of contract with Millennium. C) free from contributory negligence. D) justified in relying on the financial statements in granting the loan. Answer: D Terms: Legal action where bank relied audited financial statements, granted loan on which customer defaulted Diff: Challenging Objective: LO 5-4 AACSB: Analytic skills 17

13) One of the changes in auditing procedure 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 Diff: Challenging Objective: LO 5-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 5-4 AACSB: Analytic skills 15) 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 Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills

16) Discuss each of the four defenses a CPA firm can normally use when facing legal claims by clients. Which of these defenses is ordinarily not available against third-party suits? 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: Four defenses a CPA firm can normally use when facing legal claims by clients Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Legal liability to third parties under common law Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 18) The 1136 Tenants case was a criminal case concerning a CPA's failure to uncover fraud during a financial statement audit. A) True B) False Answer: B Terms: 1136 Tenants case Diff: Moderate Objective: LO 5-4 AACSB: Reflective thinking skills 19) Many litigation experts believe that a well written engagement letter significantly reduces the likelihood of adverse legal actions. A) True B) False Answer: A Terms: Engagement letter Diff: Easy Objective: LO 5-4 AACSB: Reflective thinking skills 19

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: Legal liability in audit of financial statements that are materially misstated Diff: Easy Objective: LO 5-5 AACSB: Reflective thinking skills 2) Which of the following auditor's defenses usually means nonreliance on the financial statements by the user? A) Lack of duty B) Nonnegligent performance C) Absence of causal connections D) Contributory negligence Answer: C Terms: Auditor defenses which means non-reliance on the financial statements Diff: Easy Objective: LO 5-5 AACSB: Analytic skills

3) 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

Employees of client Yes

Answer: A Terms: Third-parties in common law Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 4) 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 Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills

5) 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

A primary beneficiary No

A known third party Yes

Answer: A Terms: Foreseen user under common law treated the same as Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 6) A broad interpretation of the rights of third-party beneficiaries holds that users that 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 Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 7) 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) Non-negligent performance D) Lack of duty Answer: B Terms: Auditor defenses not available when lawsuits filed by a third party Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 22

8) According to the principle established by the Restatement of Torts case, 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; Foreseen users must be members Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 9) In an action against a CPA in a jurisdiction that follows the Ultramares doctrine, lack of privity is a viable defense provided the plaintiff: A) is the client's creditor who sued the CPA for negligence. B) can prove gross negligence. C) violated the Securities Act of 1933. D) violated the Securities Act of 1934. Answer: A Terms: Ultramares doctrine; Lack of privity is viable defense Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 10) 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 Diff: Challenging Objective: LO 5-5 AACSB: Analytic skills

11) The basic legal concept which was affirmed in the 1985 New York case, Credit Alliance, was that: A) the auditor's defense of privity of contract is still valid against third parties. 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 1985 case, Credit Alliance Diff: Challenging Objective: LO 5-5 AACSB: Analytic skills 12) 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 Diff: Challenging Objective: LO 5-5 AACSB: Analytic skills 13) The preferred defense in third party suits 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 Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills

14) 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; Credit Alliance approach; Restatement of torts approach; foreseeable user approach Diff: Challenging Objective: LO 5-5 AACSB: Reflective thinking skills 15) 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. A) True B) False Answer: A Terms: Credit Alliance approach; Restatement of torts approach; Foreseeable user approach Diff: Moderate Objective: LO 5-5 AACSB: Reflective thinking skills 16) The restatement of torts approach to the concept of foreseen users states that any users that the auditor should have reasonably been able to foresee as being likely users of financial statements have the same rights as those with privity of contract. A) True B) False Answer: B Terms: Restatement of torts approach; Foreseen users; Privity of contract Diff: Challenging Objective: LO 5-5 AACSB: Reflective thinking skills

17) 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. A) True B) False Answer: A Terms: Credit Alliance approach; Foreseen users; Liability to third parties Diff: Challenging Objective: LO 5-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 5-6 AACSB: Reflective thinking skills

2) The increased litigation under the federal securities laws has resulted from: A) The strict liability standards The availability of class- imposed on CPAs by the action litigation securities laws An excess of attorneys Yes Yes Yes B) The strict liability standards The availability of class- imposed on CPAs by the action litigation securities laws Yes No

An excess of attorneys No

C) The availability of classaction litigation Yes

The strict liability standards imposed on CPAs by the securities laws Yes

An excess of attorneys No

The strict liability standards imposed on CPAs by the securities laws No

An excess of attorneys No

D) The availability of classaction litigation No

Answer: C Terms: Increased litigation under federal securities law resulted from Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 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; Auditor responsibility for making sure financial statements were fairly stated extends Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 6) The Foreign Corrupt Practices Act (FCPA) of 1977: A) requires auditors to review and evaluate systems 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills

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) The Sarbanes-Oxley Act of 2002 B) The Racketeer Influenced and Corrupt Organization Act C) The Federal False Statements Statute D) The Federal Mail Fraud Statute Answer: A Terms: Foreign Corrupt Practices Act of 1977; Internal control provisions Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills Topic: SOX 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 bas 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills

10) The 2012 news of a massive alleged bribery scheme involving Wal-Mart has 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 5-6 AACSB: Analytic skills 12) The most significant audit issue that came as a result of the court decision in the Escott et al. v. Bar Chris 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 the increased auditor's responsibility when performing an S-1 review, a review of events subsequent to the balance sheet, 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. Bar Chris Construction Corporation case in 1968 Diff: Challenging Objective: LO 5-6 AACSB: Reflective thinking skills

13) Under the federal securities acts, one significant result occurring directly due to the Escott et al. v. Bar Chris Construction Corporation case was that SAS was changed to require: A) greater emphasis on subsequent events procedures. B) new standards for unaudited statements. C) a broader definition of third party beneficiaries. D) more companies to file annual reports with the SEC. Answer: A Terms: Significant result from Escott et al v. Bar Chris Construction Corporation case Diff: Challenging Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 5-6 AACSB: Reflective thinking skills

16) In a leading securities law and CPA liabilities case, 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, what would be required to be shown to the court was the auditor's: 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 Diff: Challenging Objective: LO 5-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 18) The partnership of Booth & Haynes, CPAs, has been engaged to examine the financial statements of Paul, Inc., in connection with the registration of Paul's securities with the Securities and Exchange Commission. Under these circumstances, which of the following statements is true? A) Booth & Haynes is assuming much greater third-party liability than it assumes on engagements under common law. B) If its examination is not fraudulent, Booth & Haynes may issue an appropriate disclaimer to the financial statements and thereby avoid liability. C) Booth & Haynes must incorporate if they wish to practice before the SEC. D) Booth & Haynes must be a large interstate firm if they wish to practice before the SEC. Answer: A Terms: CPAs engaged to examine financial statements in connection with registration of securities with the Securities and Exchange Commission Diff: Moderate Objective: LO 5-6 AACSB: Analytic skills

19) 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: Sanctions the Securities and Exchange Commission can impose on auditors Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 20) One result from the Escott et al. v. Bar Chris case was a greater emphasis being placed on audit staff understanding the client's business and industry. A) True B) False Answer: A Terms: Result from Escott et al. v. Bar Chris Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 21) The only parties who can recover from auditors under the Securities Act of 1933 are original purchasers of securities. A) True B) False Answer: A Terms: Securities Act of 1933 Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills

22) 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. A) True B) False Answer: A Terms: Securities Act of 1933; Burden of proof Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 23) 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. A) True B) False Answer: B Terms: Securities Act Commission; Securities traded on national exchanges Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: A Terms: Securities Act of 1934; Defenses available to auditors in common law suits by third parties Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 25) The United States Supreme Court has ruled that outside professionals such as accountants who don't help run corrupt businesses cannot be sued under the provisions of the Foreign Corrupt Practices Act. A) True B) False Answer: B Terms: United States Supreme Court; Foreign Corrupt Practices Act Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills

26) 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. A) True B) False Answer: B Terms: Sarbanes-Oxley Act Diff: Moderate Objective: LO 5-6 AACSB: Reflective thinking skills 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. Bar Chris D) ESM Government Securities v. Alexander Grant & Co. Answer: B Terms: Case where auditors were prosecuted for filing false financial statements Diff: Moderate Objective: LO 5-7 AACSB: Reflective thinking skills 2) A CPA is subject to criminal liability 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 Diff: Moderate Objective: LO 5-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 5-7 AACSB: Reflective thinking skills 35

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: Similarity between United States v. Natelli case (i.e., the National Student Marketing case of 1975), and the ESM Government Securities v. Alexander Grant & Co. case of 1986 Diff: Moderate Objective: LO 5-7 AACSB: Analytic skills 5) CPAs can be held liable for criminal activity under both state and federal laws. Infamous cases have involved United States vs. Natelli and ESM Government Securities v. Alexander Grant and Co. Discuss what occurred and prepare a summary of the court findings. 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 Diff: Moderate Objective: LO 5-7 AACSB: Reflective thinking skills 6) The Sarbanes-Oxley Act of 2002 makes destruction of audit documentation punishable by up to 10 years in prison. A) True B) False Answer: B Terms: Sarbanes-Oxley Act of 2002; Destruction of audit documentation punishable Diff: Challenging Objective: LO 5-7 AACSB: Reflective thinking skills Topic: SOX

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 Diff: Challenging Objective: LO 5-8 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 5-8 AACSB: Reflective thinking skills 3) Discuss at least 3 steps the AICPA and the accounting profession as a whole can and 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 the meet the changing needs of auditing. • Oppose lawsuits. • Educate investors and other users of financial statements as to the meaning of the opinion of the auditors and the 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 Diff: Moderate Objective: LO 5-8 AACSB: Reflective thinking skills

4) 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. Private Securities Litigation Reform Act n. 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. n 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 Diff: Moderate Objective: LO 5-2, LO 5-4, LO 5-5, LO 5-6 and LO 5-8 AACSB: Reflective thinking skills 5) Discuss some of the steps individual 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. • Hire qualified personnel and train and supervise them properly. • Follow the standards of the profession. • Maintain independence. • Understand the client's business. • Perform quality audits. • Document the work properly. • Obtain an engagement letter and a representation letter. • Maintain confidential relations. • Carry adequate insurance. • Consult with experienced legal counsel. • Choose a form of organization that provides some form of legal liability protection to owners. • Exercise professional skepticism. Terms: Steps auditors can take to minimize legal liability Diff: Easy Objective: LO 5-3 and LO 5-8 AACSB: Reflective thinking skills

6) The Private Securities Litigation Reform Act of 1995 capped damage awards against auditors to the amount of the audit fees charged. A) True B) False Answer: B Terms: Private Securities Litigation Reform Act of 1995 Diff: Easy Objective: LO 5-8 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 6 Audit Responsibilities and Objectives 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 Diff: Easy Objective: LO 6-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-1 AACSB: Reflective thinking skills

Learning Objective 6-2 1) The responsibility for adopting sound accounting policies and maintaining adequate 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 internal controls Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills 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 audit report Issue a qualified audit report Yes Yes B) Issue an adverse audit report No

Issue a qualified audit report No

Issue an adverse audit report Yes

Issue a qualified audit report No

Issue an adverse audit report No

Issue a qualified audit report Yes

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

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 Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills Topic: Public 4) Which of the following statements is true of a public company's financial statements? A) Sarbanes-Oxley requires the CEO only to certify the financial statements. B) Sarbanes-Oxley requires the CFO only to certify the financial statements. C) Sarbanes-Oxley requires 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 Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills Topic: SOX 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 Diff: Moderate Objective: LO 6-2 AACSB: Reflective thinking skills 6) 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. A) True B) False Answer: A Terms: Responsibility for fair presentation of financial statements Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills 3

7) The annual reports of many public companies include a statement about management's responsibilities and relationship with the CPA firm. A) True B) False Answer: A Terms: Management's responsibility and relationship with CPA firm Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills 8) The auditors determine which disclosures must be presented in the financial statements. A) True B) False Answer: B Terms: Responsibility for fair presentation of financial statements Diff: Easy Objective: LO 6-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 2) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills

3) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 4) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 5) 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 and illegal act may have occurred Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 6) The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills

7) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 8) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 9) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 10) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills

11) An auditor discovers that the company's bookkeeper unintentionally made an 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 12) The auditor has considerable responsibility for notifying users as to whether or not the statements are properly stated. This imposes upon the auditor 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 13) "The auditor should not assume that management is dishonest, but the possibility of dishonesty must be considered." This is an example of: A) unprofessional behavior. B) an attitude of professional skepticism. C) due diligence. D) a rule in the AICPA's Code of Professional Conduct. Answer: B Terms: Auditor should consider the possibility of dishonesty of management Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 14) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 7

15) 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: Auditor's best defense when existing material misstatements in the financial statements Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 16) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 17) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

18) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 19) 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 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 Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills 20) 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 fraud Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

21) 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 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 22) If several employees collude to falsify documents, 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 23) When planning the audit, if the auditor has no reason to believe that illegal acts exist, the auditor should: A) include audit procedures which have a strong probability of detecting illegal acts. B) still include some audit procedures designed specifically to uncover illegalities. C) ignore the issue. D) make inquiries of management regarding their policies for detecting and preventing illegal acts and regarding their knowledge of violations, and then rely on normal audit procedures to detect errors, irregularities, and illegalities. Answer: D Terms: Planning audit and illegal acts Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

24) 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) begin communication with the FASB in accordance with PCAOB regulations. C) may disclaim an opinion on the basis of scope limitations if he is precluded by management from obtaining sufficient appropriate evidence. D) should withdraw from the engagement. Answer: C Terms: Illegal acts occurred Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 25) When an auditor knows that an illegal act has occurred, 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills Topic: Public 26) 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: B Terms: Professional skepticism Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

27) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 28) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 29) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

30) The essence of the attest function is to: A) assure the consistent application of correct accounting procedures. B) determine whether the client's financial statements are fairly stated in accordance with an applicable financial reporting framework. C) examine individual transactions so that the auditor may certify as to their validity. D) detect collusion and fraud. Answer: B Terms: Essence of attest function Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 31) The auditor's evaluation of the likelihood of material employee fraud is normally done initially as a part of: A) tests of controls. B) tests of transactions. C) understanding the entity's internal control. D) the assessment of whether to accept the audit engagement. Answer: C Terms: Evaluation of likelihood of material employee fraud Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills 32) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 33) Most illegal acts 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 Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills

34) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 35) An auditor should recognize that the application of auditing procedures may produce evidence indicating the possibility of errors or fraud and therefore should: A) plan and perform the engagement with an attitude of professional skepticism. B) not rely on 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: Audit procedures that product evidence of errors or fraud Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills 36) 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 Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills

37) 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. Consider the effects of the illegal act on the financial statements, including the adequacy of disclosures. If the auditor concludes that disclosures are inadequate, the auditor should express a qualified or adverse opinion on the financial statements. If the auditor is precluded by management or those charged with governance from obtaining sufficient appropriate evidence to evaluate whether noncompliance that may be material to the financial statements has occurred or is likely to have occurred, the auditor should express a qualified opinion or disclaim an opinion on the financial statements on the basis of the scope limitation. 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. Evaluate the effects of the noncompliance on other aspects of the audit, including the auditor's risk assessment and the reliability of other representations from management. Terms: Actions auditor should take when auditor discovers illegal act Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 38) 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

39) 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 Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills 40) The concept of professional skepticism has been a foundational element of auditing standards for year and continues to be difficult to implement in practice. 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 Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

41) Errors are usually more difficult for an auditor to detect than frauds. A) True B) False Answer: B Terms: Auditor detection of errors and frauds Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 42) 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. A) True B) False Answer: A Terms: Auditor responsibility for searching for illegal acts that do not have a direct effect on the financial statements Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 43) 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. A) True B) False Answer: A Terms: Auditor believes illegal act may have occurred Diff: Easy Objective: LO 6-3 AACSB: Reflective thinking skills 44) Audits are expected to provide a higher degree of assurance for the detection of material frauds than is provided for an equally material error. A) True B) False Answer: B Terms: Degree of assurance for detection of material frauds and errors Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

45) 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. A) True B) False Answer: A Terms: Auditor degree of responsibility for detecting illegal acts Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 46) 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. A) True B) False Answer: B Terms: Illegal act uncovered Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 47) An audit generally provides no assurance that illegal acts that do not have a direct effect on the financial statements will be detected. A) True B) False Answer: A Terms: Indirect-effect illegal acts; No assurance Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 48) Auditing standards indicate that reasonable assurance is a moderate, but not absolute, level of assurance that the financial statements are free of material misstatement. A) True B) False Answer: B Terms: Moderate or high risk of management fraud Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills

49) Asking the right questions and probing further until the auditor is satisfied with the responses can help the auditor to detect a material misstatement in the financial statements. A) True B) False Answer: A Terms: Professional skepticism Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills 50) 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. A) True B) False Answer: B Terms: Objective of audit of financial statements Diff: Challenging Objective: LO 6-3 AACSB: Reflective thinking skills 51) 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. A) True B) False Answer: A Terms: Auditor responsibility for searching for illegal acts that do not have a direct effect on the financial statements Diff: Moderate Objective: LO 6-3 AACSB: Reflective thinking skills Learning Objective 6-4 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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 6-4 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 6-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 7) 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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills

8) 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. ________ 2. ________ 3. ________ 4. ________

Sales returns and allowances Capital stock Buildings Notes payable

5. ________ 6. ________ 7. ________ 8. ________

Salaries and commissions Cost of goods sold Trade accounts receivable 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 Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 9) 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. A) True B) False Answer: B Terms: Cycle approach to segmenting an audit Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 10) Under the cycle approach, the only accounts that have two or more cycles associated with them are cash and accounts receivable. A) True B) False Answer: B Terms: Cycle approach to segmenting an audit Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills 11) Although auditors need to consider the interrelationships between cycles, they typically treat cycles independently to the extent practical to manage complex audits effectively. A) True B) False Answer: A Terms: Cycle approach to segmenting an audit Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills

12) 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. A) True B) False Answer: A Terms: Cycle approach to segmenting an audit Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills Learning Objective 6-5 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 Diff: Moderate Objective: LO 6-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-5 AACSB: Reflective thinking skills 3) When an auditor is determining what information to include in the notes to the financial statements relating to bonds payable, he is concerned with the transaction-related audit objectives. A) True B) False Answer: B Terms: Setting audit objectives Diff: Moderate Objective: LO 6-4 AACSB: Reflective thinking skills

Learning Objective 6-6 1) Which of the following is not one of the three 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 Diff: Easy Objective: LO 6-6 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-6 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 6-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 5) Management makes the following assertions about account balances: A) existence, completeness, classification and cutoff. B) existence, accuracy, classification and rights and obligations. C) existence, completeness, valuation and allocation, and rights and obligations. D) existence, completeness, rights and obligations, and cutoff. Answer: C Terms: Management assertions Diff: Challenging Objective: LO 6-6 AACSB: Reflective thinking skills 6) Which of the following statements is true about the completeness and occurrence assertions? A) Both assertions are relevant to classes of transactions and events and account balances. B) If management asserts that recorded sales transactions represent exchanges of goods or services that actually took place, they are asserting to completeness. C) Violations of the occurrence assertion relate to account overstatements. D) The failure to record a sale that did occur is a violation of the occurrence assertion. Answer: C Terms: Completeness transaction-related audit objective Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 25

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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 9) 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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 10) 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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills

11) 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 Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 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. A) True B) False Answer: A Terms: Management assertions Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills 13) The auditor's audit objectives follow and are closely related to management assertions. A) True B) False Answer: A Terms: Management assertions Diff: Moderate Objective: LO 6-6 AACSB: Reflective thinking skills

Learning Objective 6-7 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 Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 2) The auditor is determining that the the correct selling price was used for billing and that the quantity of goods shipped was the same as the quantity billed. She is gathering evidence about which transaction related audit objective? A) Existence B) Completeness C) Accuracy D) Cut-off Answer: C Terms: Evidence for transaction related audit objective if recorded sales are for amount shipped and correctly billed and recorded Diff: Moderate Objective: LO 6-7 AACSB: Analytic skills 3) The posting and summarization audit objective is the auditor's counterpart to management's assertion of: A) occurrence. B) completeness. C) accuracy. D) classification. Answer: C Terms: Transaction-related audit objectives Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills

4) After the general transaction related-audit objectives are understood, specific transactionrelated audit objectives for each material class of transactions can be developed. Which of the following statements is true? A) There should be at least one specific objective for each relevant general objective. B) There will be only one specific objective for each relevant general objective. C) There will be many specific objectives developed for each relevant general objective. D) There must be one specific objective for each general objective. Answer: A Terms: General and specific audit objectives Diff: Challenging Objective: LO 6-7 AACSB: Reflective thinking skills 5) 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 Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills

6) 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 Diff: Challenging Objective: LO 6-6 and LO 6-7 AACSB: Analytic skills

7) 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 Diff: Challenging Objective: LO 6-6 and LO 6-7 AACSB: Analytic skills

8) General transaction-related audit objectives vary from audit to audit, depending on the nature and characteristics of the client's business and industry. A) True B) False Answer: B Terms: General transaction-related audit objectives Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 9) The audit objective of posting and summarization is associated with the management assertion of accuracy. A) True B) False Answer: A Terms: Audit objective of posting and summarization; Accuracy management assertion Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 10) The transaction-related audit objective of timing is related to the assertion of cutoff. A) True B) False Answer: A Terms: Transaction-related audit objective of timing; Cutoff assertion Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 11) If a sale was for a valid shipment, but the amount of the sales invoice was calculated incorrectly, the accuracy objective was violated. A) True B) False Answer: A Terms: General transaction-related audit objectives Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 12) The effect of a violation of the completeness transaction-related audit objective for cash disbursements transactions would be an overstatement of cash disbursements. A) True B) False Answer: B Terms: Completeness transaction-related audit objective Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills 32

13) The transaction-related audit objective that deals with whether recorded transactions have actually occurred is the completeness objective. A) True B) False Answer: B Terms: Transaction-related audit objective; Completeness objective Diff: Moderate Objective: LO 6-7 AACSB: Reflective thinking skills Learning Objective 6-8 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 Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills

4) The classification balance-related audit objective: A) involves determining if items included on a client's listing are included in the correct general leger 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 Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills 5) Which of the following best describes tests of details of balances? A) Audit procedures designed to test for monetary misstatements in the accounts summarized in the financial statements B) Audit procedures designed to test for the monetary amounts of transactions C) Audit procedures designed to test for reasonableness of account balances D) Audit procedures designed to test for effectiveness in recording accounting information Answer: A Terms: Details of balances Diff: Challenging Objective: LO 6-8 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-7 and LO 6-8 AACSB: Reflective thinking skills

7) 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: Purpose–to make sure that assets are included on the balance sheet at the amounts estimated to be realized. Concept–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. Example–allowance for uncollectible accounts, write-downs of inventory. Terms: Balance related objective of realizable value Diff: Challenging Objective: LO 6-8 AACSB: Reflective thinking skills

8) 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 Diff: Challenging Objective: LO 6-6 and LO 6-8 AACSB: Analytic skills 36

9) Auditors have found that the most efficient way to conduct audits is to focus primarily on testing classes of transactions and performing tests of ending account balances. A) True B) False Answer: A Terms: Testing classes of transactions and ending account balances Diff: Easy Objective: LO 6-7 and LO 6-8 AACSB: Reflective thinking skills 10) 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. A) True B) False Answer: B Terms: Balance-related audit objectives; Transaction-related audit objectives Diff: Moderate Objective: LO 6-7 and LO 6-8 AACSB: Reflective thinking skills 11) Tests of details of balances typically involve the use of comparisons and relationships to assess the overall reasonableness of account balances. A) True B) False Answer: B Terms: Test of details of balances Diff: Easy Objective: LO 6-8 AACSB: Reflective thinking skills 12) 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. A) True B) False Answer: A Terms: Detail tie-in objective; General balance-related objective Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills

13) The cutoff objective, "transactions near the balance sheet date are recorded in the proper period," is a balance-related audit objective. A) True B) False Answer: A Terms: Cutoff objective; Balance-related audit objective Diff: Moderate Objective: LO 6-8 AACSB: Reflective thinking skills Learning Objective 6-9 1) 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 disclosure D) classification and understandability Answer: C Terms: Presentation and disclosure-related objectives Diff: Easy Objective: LO 6-9 AACSB: Reflective thinking skills 2) The presentation and disclosure-related audit objectives are identical to the management assertions for presentation and disclosure. A) True B) False Answer: A Terms: Presentation and disclosure-related objectives Diff: Easy Objective: LO 6-9 AACSB: Reflective thinking skills Learning Objective 6-10 1) Tests of details of balances are specific audit procedures that are intended to: A) test for monetary misstatements in the financial statements. B) prove that the accounts with material balances are classified correctly. C) prove that the trial balance is in balance. D) identify the details of the internal control system. Answer: A Terms: Tests of details balances; Specific audit procedures Diff: Easy Objective: LO 6-10 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 6) 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 analytical procedures and tests of details of balances 4. Complete the audit and issue an audit report Terms: Phases of financial statement audit Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 7) 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 Diff: Challenging Objective: LO 6-10 AACSB: Reflective thinking skills

8) 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 Diff: Moderate Objective: LO 6-3, LO 6-6, LO 6-7, LO 6-8, and LO 6-10 AACSB: Reflective thinking skills 41

9) 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. A) True B) False Answer: A Terms: Tests of controls; Assessed control risk Diff: Easy Objective: LO 6-10 AACSB: Reflective thinking skills 10) 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. A) True B) False Answer: B Terms: Tests of controls Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 11) Rights and obligations is the only balance-related assertion without a similar transaction related assertion. A) True B) False Answer: A Terms: Audit process Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 12) The audit objectives are the well-defined methodology for organizing an audit to ensure that the evidence gathered is sufficient and appropriate. A) True B) False Answer: B Terms: Audit process Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills

13) Obtaining an understanding of the entity and its environment is part of the analytical procedures phase of the audit. A) True B) False Answer: B Terms: Audit process Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills 14) 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. A) True B) False Answer: A Terms: Audit process Diff: Moderate Objective: LO 6-10 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 7 Audit Evidence Learning Objective 7-1 1) All evidence must have the same level of persuasiveness. A) True B) False Answer: B Terms: Audit evidence Diff: Easy Objective: LO 7-1 AACSB: Reflective thinking skills 2) Auditors use evidence to help them draw conclusions. A) True B) False Answer: A Terms: Audit evidence Diff: Easy Objective: LO 7-1 AACSB: Reflective thinking skills

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: Decision to be made by auditors related to evidence Diff: Easy Objective: LO 7-2 AACSB: Reflective thinking skills

2) Audit procedures are concerned with the nature, extent, and timing in gathering audit evidence. Which, of the following, is true as to the timing of audit procedures? A) Prior to the fiscal year-end Subsequent to the fiscal yearof the client end of the client Yes Yes B) Prior to the fiscal year-end Subsequent to the fiscal yearof the client end of the client No No C) Prior to the fiscal year-end Subsequent to the fiscal yearof the client end of the client Yes No D) Prior to the fiscal year-end Subsequent to the fiscal yearof the client end of the client No Yes Answer: A Terms: Timing of audit procedures Diff: Easy Objective: LO 7-2 AACSB: Reflective thinking skills 3) A(n) ________ is the detailed instruction that explains the audit evidence to be obtained during the audit. A) audit objectives B) audit procedure C) audit assertion D) audit program Answer: B Terms: Audit evidence and audit procedures Diff: Easy Objective: LO 7-2 AACSB: Analytic skills

4) Which of the following is not one of the four decisions about what evidence to gather and how much of it to accumulate? A) Which audit procedures to use B) Which accounts must agree to the general ledger C) When to perform the procedures D) What sample size to select for a given procedure Answer: B Terms: Audit evidence and audit procedures Diff: Easy Objective: LO 7-2 AACSB: Analytic skills 5) An audit program is the list of audit procedures for an audit area or an entire audit. A) True B) False Answer: A Terms: Audit program Diff: Easy Objective: LO 7-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 7-3 AACSB: Analytic skills 2) Which of the following is not a characteristic of the reliability of evidence? A) Effectiveness of client internal controls B) Education of auditor C) Independence of information provider D) Timeliness Answer: B Terms: Characteristic of reliability of evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 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 evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 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 internal controls. Answer: A Terms: Relevance of evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 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 evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 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) The decision of how many items to test should not be influenced by the increased costs of performing the additional tests. 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: Testing of items; Sample size Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 6

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 internal control system, 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 Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 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: Purposes of audit documentation Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 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 evidence Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 15) Determine which of the following is most correct 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 internal controls are effective, evidence obtained is more reliable than when the controls are not effective. Answer: D Terms: Reliability of audit evidence Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 17) Given the economic and time constraints in which auditors can collect evidence about 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: Auditor normally gathers evidence that is Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 7-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 7-3 AACSB: Reflective thinking skills 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 evidence Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 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 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 Diff: Challenging Objective: LO 7-3 AACSB: Reflective thinking skills

22) Discuss three of the following influences on the persuasiveness of evidence. 1. Relevance 2. Independence of provider 3. Effectiveness of client's internal controls 4. Auditor's direct knowledge 5. Degree of objectivity 6. Timeliness Answer: 1. Relevance — Evidence must pertain to the audit objective if it is to be persuasive. Relevance must be considered in terms of specific audit objectives as evidence may be relevant to one objective and not another. 2. Independence of provider — Evidence obtained from a source outside the entity is more reliable and persuasive than that obtained from within. 3. Effectiveness of client's internal controls — When a client's internal controls are effective, evidence obtained is more reliable than when they are weak. 4. Auditor's direct knowledge — Evidence obtained directly by the auditor through physical examination, observation, computation and inspection is more competent than information obtained indirectly. 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: Influences persuasiveness of evidence Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 23) 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 Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills

24) 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 internal control. When a client's internal controls are effective, evidence obtained from the client is more reliable than when controls are weak. • 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 Diff: Challenging Objective: LO 7-3 AACSB: Reflective thinking skills 25) Audit evidence to support an opinion about the fairness of a client's financial statements consists entirely of written information. A) True B) False Answer: B Terms: Audit evidence to support an opinion Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 26) The relevance of audit evidence depends on the audit objective being tested. A) True B) False Answer: A Terms: Relevance of audit evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills

27) Inquiries of the client are usually sufficient to provide appropriate evidence to satisfy an audit objective. A) True B) False Answer: B Terms: Inquiries of client; Appropriate evidence Diff: Easy Objective: LO 7-3 AACSB: Reflective thinking skills 28) Objective evidence is more reliable, and hence more persuasive, than subjective evidence. A) True B) False Answer: A Terms: Objective evidence more reliable Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills 29) 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. A) True B) False Answer: B Terms: Sufficiency of evidence and sample size Diff: Moderate Objective: LO 7-3 AACSB: Reflective thinking skills Learning Objective 7-4 1) Calculating the gross margin for the current year under audit 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: Calculate and compare gross margin Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills

2) When the auditor develops 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 Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 3) An example of an external document that provides reliable information for the auditor is: A) employees' time reports. B) bank statements. C) purchase order for company purchases. D) carbon copies of checks. Answer: B Terms: External document Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 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) confirmation. B) sales invoice. C) vendor invoice. D) bank reconciliation. Answer: C Terms: Example of document auditor receives from client but prepared by outside source Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 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: Use of comparisons and relationships to assess whether account balances Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills

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 not expected but do exist No

Significant differences are expected but do not exist No

C) Significant differences are not expected but do exist Yes

Significant differences are expected but do not exist No

D) Significant differences are not expected but do exist No

Significant differences are expected but do not exist Yes

Answer: A Terms: Audit procedures result in significant differences Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 7) When the auditor uses tracing as an audit procedure for tests of transactions she is primarily concerned with which audit objective? A) Occurrence B) Completeness C) Cutoff D) Classification Answer: B Terms: Tracing as an audit procedure concerned with audit objective Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

8) When the auditor uses the audit procedure vouching 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 concerned with audit objective Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 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: Directional testing Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 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

Answer: B Terms: Analytical procedures use during phases of the audit Diff: Moderate Objective: LO 7-4 AACSB: Analytic skills 16

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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 12) When making decisions about evidence for a given audit, the auditor's goal is to obtain a sufficient amount of timely, reliable evidence that is relevant to the information being verified. In addition, the goal of audit efficiency is to gather and evaluate the information: A) no matter the cost involved in obtaining such evidence. B) even if cost is irrelevant to the auditor, because they bill the client for costs incurred. C) at the lowest possible total cost. D) at the cost suggested in the engagement letter. Answer: C Terms: Goal of audit efficiency Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 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: Physical examination Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

14) Which of the following statements is most correct regarding the primary purpose of audit procedures? A) To detect all errors or fraudulent activities as well as illegal activities B) To comply with auditing standards promulgated by the PCAOB for publicly held clients C) To gather corroborative audit evidence about management's assertions regarding the client's financial statements D) To 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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 15) Which of the following generally provides the most reliable evidence? A) Confirmations B) Recalculation C) Reperformance D) Observations Answer: A Terms: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 16) When practical and reasonable, U.S. auditing standards require the confirmation of: A) individual transactions between organizations, such as sales transactions. B) accounts receivable. C) fixed asset additions. D) payroll expenses. Answer: B Terms: Confirmations Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 19) The Auditing Standards Board has concluded that analytical procedures are so important that they are required during: 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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 20) 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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 19

21) 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: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 22) 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 — documentation D) Read — documentation Answer: C Terms: Combination of terms and related audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 23) 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: Confirmations Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 24) An important benefit of industry comparisons is as: A) an aid to understanding the client's business. B) an indicator of errors. C) an indicator of fraud. D) a least-cost indicator for audit procedures. Answer: A Terms: Benefit of industry comparisons Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

25) 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 Diff: Challenging Objective: LO 7-4 AACSB: Analytic skills 26) ________ is the auditor's examination of the client's documents and records to substantiate that the information is included in the financial statements. A) Inspection B) Recalculation C) Observation D) Verification Answer: A Terms: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Analytic skills 27) Which of the following statements regarding the appropriateness of evidence is correct? A) The effectiveness of a client's internal control has no influence on the reliability of most types of evidence. B) Analytical procedures will be reliable evidence even if the client's internal controls are weak. C) One type of evidence is generally sufficient by itself to provide appropriate evidence. D) The objectivity of evidence obtained through inspection is high. Answer: D Terms: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

28) 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) Confirmation 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 Diff: Challenging Objective: LO 7-4 AACSB: Analytic skills 29) 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 Diff: Challenging Objective: LO 7-4 AACSB: Analytic skills

30) 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 in obtaining evidence Diff: Challenging Objective: LO 7-4 AACSB: Reflective thinking skills 31) When using analytical procedures: A) unusual fluctuations occur when significant unexpected differences between the current year's data and other data used in comparisons are found. B) and no unusual fluctuations are noted, the possibility of material misstatement is increased. C) "attention directing" indicates an area where fraud has occurred. D) and no unusual fluctuations are noted, tests of details of balances can be eliminated, Answer: A Terms: Analytical procedures Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

32) 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. The analytical procedures could also indicate the presence of possible misstatements in the financial statements if significant unexpected fluctuations occur. These items may warrant increased audit procedures, whereas when the analytical procedures reveal no unusual fluctuations, the possibility of material misstatement is minimized and it is possible to perform fewer detailed tests on related accounts or to eliminate certain audit procedures, reduce sample sizes, or to move the procedures farther away from the balance sheet date. Terms: Analytical procedures Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 33) There are four important purposes of analytical procedures. Identify three of these four purposes and, for each purpose, give a specific example of an analytical procedure that an auditor might perform. Answer: Four important purposes of analytical procedures are: • To help the auditor understand the client's industry and business, the auditor might analyze recent trends in the client's gross margin percentages to assess the effects of competition in the industry. • To aid in the assessment of the client's ability to continue as a going concern, the auditor might analyze several of the client's key ratios including the ratio of long-term debt to net worth, the ratio of profits to total assets, and the current ratio. • To indicate the presence of possible misstatements in the financial statements, the auditor might compare the current year's unaudited account balances with the previous year's audited balances. • To reduce the extent of detailed tests, the auditor might perform a simple analytical procedure such as multiplying the client's monthly rent times 12 as a test of the client's rent expense account. If the product agrees with the balance in rent expense, no additional testing of the account may be necessary. Terms: Purposes of analytical procedures Diff: Challenging Objective: LO 7-4 AACSB: Reflective thinking skills 24

34) 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 specific document or record to determine specific facts about it. It is the inspection or count by the auditor of a tangible asset. 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 is associated with evidence defined as physical examination. 7. Vouch — The use of documents to verify recorded transactions or amounts. Terms: Audit evidence and audit procedures Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

35) 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 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 related evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 26

36) Match nine of the terms (a-k) with the definitions provided below (1-9): a. b. c. d. e. f. g. h. i. j. k.

Foot Compute Scan Inquire Count Trace Reperform Read Examine Observe 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; Foot; Compute; Scan; Inquire; Count; Trace; Read; Observe; Compare Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 27

37) 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: Analytical procedures; Audit procedures; Reliability of evidence; Sufficiency of evidence Diff: Moderate Objective: LO 7-2, LO 7-3, and LO 7-4 AACSB: Reflective thinking skills

38) 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 Diff: Moderate Objective: LO 7-4 AACSB: Analytic skills 39) 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 Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

40) Confirmations are among the most expensive type of evidence to obtain. A) True B) False Answer: A Terms: Confirmations; Cost of evidence Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 41) Whenever practical and reasonable, the confirmation of accounts receivable is required of CPAs. A) True B) False Answer: A Terms: Confirmations of accounts receivable required of CPAs Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 42) Inquiries of clients and recalculations normally have a low cost associated with them. A) True B) False Answer: A Terms: Inquiries of clients and reperformance have low cost Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 43) 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. A) True B) False Answer: B Terms: Analytical procedures reveal unusual fluctuations Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 44) The type of audit evidence known as inquiry requires the auditor to obtain oral or written information from the client in response to questions. A) True B) False Answer: A Terms: Audit evidence; Inquiry Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills 30

45) Auditor judgment is the primary determinant in determining the amount of evidence gathered. A) True B) False Answer: A Terms: Auditor judgment; Evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 46) Analytical procedures must be used in the planning and completion phases of the audit. A) True B) False Answer: A Terms: Analytical procedures used in planning and completion phases of audit Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 47) Confirmations are ordinarily used to verify account balances, but may be used to verify transactions. A) True B) False Answer: A Terms: Confirmations to verify balances and transactions Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 48) Accounts receivable confirmations must be controlled by the client from the time they are prepared until the time they are returned to the auditor. A) True B) False Answer: B Terms: Confirmations control Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills

49) Cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size. A) True B) False Answer: A Terms: Cost of audit procedures; Sample size Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 50) When the auditor foots the journals and the subsidiary ledgers, it is considered reperformance. A) True B) False Answer: B Terms: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 51) Inspection consists of looking at a process or procedure being performed by others. A) True B) False Answer: B Terms: Audit evidence Diff: Moderate Objective: LO 7-4 AACSB: Reflective thinking skills 52) 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. A) True B) False Answer: B Terms: Internal document Diff: Easy Objective: LO 7-4 AACSB: Reflective thinking skills

Learning Objective 7-5 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 Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills 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 for audit Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills 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 for audit Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills

4) Due professional care, the third general standard, is concerned with what is done by the independent auditor and how well it is done. For example, due care in the matter of audit documentation requires that audit documentation of the evidence gathered by the auditor meets 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 Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills 5) Audit documentation is the joint property of the auditor and the audit client. A) True B) False Answer: B Terms: Audit documentation Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills 6) Auditing standards require that records for audits of private companies be retained for a minimum of seven years. A) True B) False Answer: B Terms: Audit documentation provided with permission of client Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills 7) The SEC requires the auditors of public companies to retain e-mail correspondence related to the audit. A) True B) False Answer: A Terms: Adjusting entries and reclassification entries Diff: Moderate Objective: LO 7-5 AACSB: Reflective thinking skills

Learning Objective 7-6 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 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 Diff: Challenging Objective: LO 7-6 AACSB: Reflective thinking skills 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

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 Diff: Challenging Objective: LO 7-6 AACSB: Reflective thinking skills

3) The permanent audit file would usually include the following: 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 auditors test of controls for the current years audit Answer: C Terms: Permanent file Diff: Challenging Objective: LO 7-6 AACSB: Reflective thinking skills 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 internal control. D) results of analytical procedures from prior years. Answer: A Terms: Permanent files as audit documentation Diff: Moderate Objective: LO 7-6 AACSB: Reflective thinking skills 5) 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. The major types of supporting schedules include analysis schedules and tests of reasonableness. 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. For example, marketable securities, property, plant and equipment, long-term debt, equity accounts. Auditors are focusing on the significance of the activity in the account during the year. Tests of Reasonableness: Contains information that enables the auditor to evaluate whether the client's balance appears to contain a misstatement. Example, depreciation expense, allowance for uncollectibles, income tax provision. Tests are primarily analytical procedure tests in which the auditor forms an expectation of the balance that appears in the working trial balance. Terms: Major types of supporting schedules; Analysis and tests of reasonableness Diff: Moderate Objective: LO 7-6 AACSB: Reflective thinking skills

6) 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: Audit documentation in current file; Working trial balance; Lead schedules and support schedules Diff: Moderate Objective: LO 7-6 AACSB: Reflective thinking skills 7) Reclassification entries are made in the statements to present accounting information properly, even when the general ledger balances are correct. A) True B) False Answer: A Terms: Adjusting entries and reclassification entries Diff: Moderate Objective: LO 7-6 AACSB: Reflective thinking skills 8) An example of a supporting schedule is a reconciliation of amounts, which consists of the details that make up a year-end balance. A) True B) False Answer: B Terms: Audit files Diff: Moderate Objective: LO 7-6 AACSB: Reflective thinking skills Learning Objective 7-7 1) Audit evidence is often available only in electronic form, and auditors must evaluate how this affects their ability to gather sufficient, appropriate evidence. A) True B) False Answer: A Terms: Technology and audit evidence Diff: Moderate Objective: LO 7-7 AACSB: Reflective thinking skills 37

2) An auditor can use engagement management software to facilitate tracking audit progress. A) True B) False Answer: A Terms: Technology and audit evidence Diff: Moderate Objective: LO 7-7 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 8 Audit Planning and Analytical Procedures 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: Measure of how willing auditor is to accept that the financial statements may be materially misstated after audit is completed Diff: Easy Objective: LO 8-1 AACSB: Reflective thinking skills 2) A measure of the auditor's assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of the client's internal control is called: A) control risk. B) acceptable audit risk. C) statistical risk. D) inherent risk. Answer: D Terms: A measure of auditor's assessment of likelihood that there are material misstatements in an account before considering internal control Diff: Easy Objective: LO 8-1 AACSB: Reflective thinking skills

3) When inherent risk is high, there will need to be: A) A lower assessment of audit risk More evidence accumulated by the auditor Yes Yes B) A lower assessment of audit risk No

More evidence accumulated by the auditor No

A lower assessment of audit risk Yes

More evidence accumulated by the auditor No

A lower assessment of audit risk No

More evidence accumulated by the auditor Yes

Answer: D Terms: Inherent risk is high Diff: Moderate Objective: LO 8-1 AACSB: Reflective thinking skills 4) In what order should the following steps occur? A. Assess client business risk B. Understand the client's business and industry C. Perform preliminary analytical procedures D. Assess acceptable audit risk A) D, B, C, A B) B, A, C, D C) B, D, A, C D) D, C, B, A Answer: B Terms: Steps in planning an audit Diff: Moderate Objective: LO 8-1 AACSB: Reflective thinking skills

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: First standard of fieldwork; Proper planning Diff: Challenging Objective: LO 8-1 AACSB: Analytic skills 6) 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 profession reputation. • 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 Diff: Moderate Objective: LO 8-1 AACSB: Reflective thinking skills 7) When an auditor decides there is higher inherent risk for an account, one potential effect is that more audit evidence will be required for that account. A) True B) False Answer: A Terms: Inherent risk Diff: Easy Objective: LO 8-1 AACSB: Reflective thinking skills 8) As acceptable audit risk is decreased, the likely cost of conducting an audit increases. A) True B) False Answer: A Terms: Acceptable audit risk Diff: Easy Objective: LO 8-1 AACSB: Reflective thinking skills

9) Obtaining sufficient appropriate evidence is essential if the CPA firm is to minimize legal liability. A) True B) False Answer: A Terms: Acceptable audit risk Diff: Moderate Objective: LO 8-1 AACSB: Reflective thinking skills 10) A 100 % audit risk is complete certainty. A) True B) False Answer: B Terms: Acceptable audit risk Diff: Moderate Objective: LO 8-1 AACSB: Reflective thinking skills

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) Facilitating high-quality work at a Good client relations reasonable cost Yes Yes B) Good client relations No

Facilitating high-quality work at a reasonable cost No

Good client relations Yes

Facilitating high-quality work at a reasonable cost No

Good client relations No

Facilitating high-quality work at a reasonable cost Yes

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

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: Auditors accumulate more evidence when audit is for company Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills

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 Rodgers 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 clients refusal to allow communication between predecessor and successor auditors Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 5) A successor auditor may perform which of the following for a new audit client? A) Speak to local attorneys, banks and other businesses regarding the company's Speak to the predecessor auditors about reputation disagreements they had with management Yes Yes B) Speak to local attorneys, banks and other businesses regarding the company's Speak to the predecessor auditors about reputation disagreements they had with management No No C) Speak to local attorneys, banks and other businesses regarding the company's Speak to the predecessor auditors about reputation disagreements they had with management Yes No D) Speak to local attorneys, banks and other businesses regarding the company's Speak to the predecessor auditors about reputation disagreements they had with management No Yes Answer: A Terms: Successor auditor may perform communication for new audit client Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

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 audit fee. Answer: D Terms: Lower acceptable audit risk Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 7) A written understanding detailing what the auditors will do in determining if the financial statements are fair representations of the company's financial statements and 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 8) If an auditor is requested to perform nonaudit services for a public company audit client, who is responsible for agreeing to those services with the audit firm? A) The client's management B) The client's chief executive officer C) The client's chief financial officer D) The client's audit committee Answer: D Terms: Responsibility for agreeing nonaudit services for a public company audit client Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills Topic: SOX

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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 11) Written communication that the auditor will provide reasonable assurance for the detection of fraud is found in: A) engagement letter. B) representation letter. C) responsibility letter. D) client letter. Answer: A Terms: Written communication that auditor will provide reasonable assurance Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 9

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 the intended uses of the statements. D) the audit firm and the intended uses of the statements Answer: C Terms: Audit risk Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 14) An engagement letter sent to a publicly held audit client usually would not include a: 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 Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 8-2 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills

20) An auditor who accepts an audit engagement and does not possess the industry expertise of the business entity should: A) engage financial experts familiar with the nature of the business entity. B) obtain a knowledge of matters that relate to the nature of the entity's business. C) refer a substantial portion of the audit to another CPA who will act as the principal auditor. D) first inform management that an unqualified opinion cannot be issued. Answer: B Terms: Auditor accepts audit engagement and does not possess industry expertise Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills 21) 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

22) Which is usually included in an engagement letter? A) A reference to standards acceptable in the United States of America A reference to GAAS Yes Yes B) A reference to standards acceptable in the United States of America No

A reference to GAAS No

A reference to standards acceptable in the United States of America Yes

A reference to GAAS No

A reference to standards acceptable in the United States of America No

A reference to GAAS Yes

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

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

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

Ratios to be used by the auditor in the planning phase No

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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

24) When may the auditor refer to a specialist in the audit report? A) Only if the specialist's report Only if the specialist assisted in the results in a modification of the audit audit of an account material to the opinion financial statements Yes Yes B) Only if the specialist's report Only if the specialist assisted in the results in a modification of the audit audit of an account material to the opinion financial statements No No C) Only if the specialist's report Only if the specialist assisted in the results in a modification of the audit audit of an account material to the opinion financial statements Yes No D) Only if the specialist's report Only if the specialist assisted in the results in a modification of the audit audit of an account material to the opinion financial statements No Yes Answer: C Terms: Auditors refer to specialist in audit report Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

25) Which is usually included in the engagement letter? A) Name(s) of the client personnel The projected type of opinion on the responsible for supplying the auditor with financials statement to be audited information Yes Yes B) The projected type of opinion on the financials statement to be audited No

Name(s) of the client personnel responsible for supplying the auditor with information No

The projected type of opinion on the financials statement to be audited Yes

Name(s) of the client personnel responsible for supplying the auditor with information No

The projected type of opinion on the financials statement to be audited No

Name(s) of the client personnel responsible for supplying the auditor with information Yes

Answer: B Terms: Engagement letter Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

26) 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 27) 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 Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 28) 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 is required for both public and private company audits. Terms: Engagement letter Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills

29) 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 with. 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 30) 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 31) 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 accounting issues, scope of the audit, type of opinion, or fees. 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 18

32) 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 Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 33) 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. A) True B) False Answer: B Terms: Acceptance of new client Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 34) For prospective clients that have previously been audited by another CPA firm, the predecessor auditor is required to communicate with the successor auditor. A) True B) False Answer: B Terms: Communications between predecessor and successor auditors Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills

35) 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. A) True B) False Answer: B Terms: Communications between predecessor and successor auditors Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 36) 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. A) True B) False Answer: B Terms: Communications between predecessor and successor auditors Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 37) An auditor must evaluate a specialist's professional qualifications and understand the objectives of the specialist's work. A) True B) False Answer: A Terms: Auditor evaluate specialist's work Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 38) Because of audit risk, some CPA firms now refuse any new clients in certain high-risk industries. A) True B) False Answer: A Terms: Audit risk Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

39) An engagement letter establishes a clear understanding of the terms of the engagement between the client and the auditor, but it is optional for private companies. A) True B) False Answer: A Terms: Engagement letter Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 40) Because of the requirements of Rule 201 of the AICPA's Code of Professional Conduct which state that auditors should "undertake only those professional services that the member or the member's firm can reasonably expect to be completed with professional competence," auditors are not normally permitted to consult with, or rely on the work of, outside specialists during an audit engagement. A) True B) False Answer: B Terms: Use of outside specialists during audit engagement Diff: Easy Objective: LO 8-2 AACSB: Reflective thinking skills 41) 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. A) True B) False Answer: B Terms: Communications between predecessor and successor auditors Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 42) A major consideration in audit staffing is the need for continuity from year to year. A) True B) False Answer: A Terms: Consideration in assigning staff to audit engagement Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills

43) 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. A) True B) False Answer: A Terms: Communications between predecessor and successor auditors Diff: Moderate Objective: LO 8-2 AACSB: Reflective thinking skills 44) An engagement letter can affect the CPA firm's legal responsibilities to the client, but does not affect responsibility to external users of audited financial statements. A) True B) False Answer: A Terms: Engagement letter Diff: Challenging Objective: LO 8-2 AACSB: Reflective thinking skills Learning Objective 8-3 1) In making client acceptance decisions, 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) CPA Firm's potential ongoing revenue from the audit client. Answer: C Terms: Client acceptance decisions Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills 2) Most auditors assess inherent risk as high for related parties and related-party 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: Inherent risk assessed high for relate parties and transactions Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills

3) The audit team gathers information about a new client's business and industry in order to obtain: A) an understanding of the clients internal control system for financial reporting. B) an understanding of how economic events and transactions have an effect on the company's financial statements. C) information about control risk. D) information regarding whether the company is engaging in financial statement fraud. Answer: B Terms: Information about new client's business and industry Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 4) The auditor determines that Mathews 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) landlord has weak 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: Auditor determines client occupies office for which it pays no rent Diff: Moderate Objective: LO 8-3 AACSB: Analytic skills 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 Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills 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 company at market rates. D) has had a distributor relationship with the company for 10 years. Answer: A Terms: Related party transactions Diff: Moderate Objective: LO 8-3 AACSB: Analytic skills 23

7) Which of the following is not a primary reason for obtaining a good understanding of the client's industry and external environment? A) Risk associated with a specific industry may affect the auditor's assessment of client business risk. B) Risk associated with a specific industry may affect the auditor's assessment of acceptable audit risk. C) Risk associated with a specific industry may affect the auditor's assessment of acceptable control risk. D) Many control risks are common to all clients in certain industries. Answer: C Terms: Inherent risk factor Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 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 transaction Diff: Challenging Objective: LO 8-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills 24

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 arms-length transactions. D) disclosures are required only for public companies. Answer: B Terms: Related party transactions Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 12) 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. 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 party Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills 13) 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 organizational structure, code of ethics, and the minutes of meetings of the board of directors and shareholders. The organizational structure details the authority and duties among members of an organization. It indicates if the company is centralized or decentralized. 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 Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills

14) 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: • Advances in information technology have increased connectivity among companies, customers, and vendors. Auditors must understand the risks associated with this increased connectivity. • 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. • Companies have expanded operations globally, often through joint ventures and strategic alliances. • Information technology affects internal control 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 systems approach to understand the client's business. The auditor can obtain a sound understanding of the client's business and industry through several means, including discussions with previous auditors and by reviewing the permanent files for the client; conferences with the client's personnel; studying AICPA industry audit guides, textbooks, technical magazines, and specialized journals; and by participating in industry associations and training programs. Terms: Factors that increase the importance of obtaining an understanding of a client's business and industry Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 15) 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. • Certain inherent risks are typically common to all clients in certain industries. Familiarity with those risks aids the auditor in assessing their relevance to the client. • 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 Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills

16) 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. A) True B) False Answer: A Terms: Code of ethics and board of directors' meeting minutes; Understanding of company management and governance structure Diff: Easy Objective: LO 8-3 AACSB: Reflective thinking skills 17) Many inherent risks are common to all clients in certain industries. A) True B) False Answer: A Terms: Inherent risk Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 18) Transactions with related parties must be disclosed in the financial statements if they are deemed to be material. A) True B) False Answer: A Terms: Related parties Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 19) All know related parties must be identified and included in the auditor's permanent files related to the client. A) True B) False Answer: A Terms: Related parties Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills

20) Because of the lack of independence between related parties, the Sarbanes-Oxley Act prohibits all related party transactions. A) True B) False Answer: B Terms: Related parties Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 21) Management's philosophy and operating style influence the risk of material misstatements in the financial statements. A) True B) False Answer: A Terms: Management integrity Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 22) Ordinarily, the auditor should review corporate minutes during the later stages of an audit. A) True B) False Answer: B Terms: Corporate minutes Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 23) Material transactions between the client and the client's related parties must be disclosed in the auditor's report. A) True B) False Answer: B Terms: Material related party transactions Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: A Terms: Business risk and factors that impact auditor's assessment Diff: Moderate Objective: LO 8-3 AACSB: Reflective thinking skills 28

Learning Objective 8-4 1) An auditor has accessed client business risk and the risk of material misstatements to the clients financial statements. These are done in order to: A) apply the audit risk model to determine the appropriate extent of audit evidence. B) determine the reliance on the company's internal control systems for financial reporting. C) determine the test of balances to be performed by the audit team. D) assure the CPA firm that they can perform the audit effectively and efficiently. Answer: A Terms: Business risk and risk of material misstatements Diff: Moderate Objective: LO 8-4 AACSB: Reflective thinking skills 2) Business risk: A) is the risk after considering the effectiveness of top management controls. B) is the risk that the client's internal controls will fail. C) can include a new technology which threatens to erode a company's competitive advantage. D) cannot be mitigated by management. Answer: C Terms: Business risk Diff: Moderate Objective: LO 8-4 AACSB: Reflective thinking skills 3) Define business risk. List several factors that may impact the auditor's assessment of business risk. Answer: Business risk is the risk that a company will fail to achieve its objectives. Factors that may impact business risk include: • General economic conditions, • Significant declines in the economy that threaten the client's cash flows, • New technology eroding a company's competitive advantage • Company failing to execute its strategies as well as its competitors • Extent of competition within an industry, • Changing regulatory requirements, • Competence of management, • Ability to maintain sufficient cash flows and secure financing, and • Successful implementation of business strategies. Terms: Business risk and factors that impact auditor's assessment Diff: Challenging Objective: LO 8-4 AACSB: Reflective thinking skills

4) Management is the primary source for identifying client business risks. A) True B) False Answer: A Terms: Business risk Diff: Easy Objective: LO 8-4 AACSB: Reflective thinking skills 5) Sarbanes-Oxley encourages management to certify that it has informed the auditor and audit committee of any significant deficiencies in internal control. A) True B) False Answer: B Terms: Internal control Diff: Easy Objective: LO 8-4 AACSB: Reflective thinking skills Learning Objective 8-5 1) Auditors perform preliminary analytical procedures to better understand the client's business and to assess client business risk. A) True B) False Answer: A Terms: Analytical procedures Diff: Easy Objective: LO 8-5 AACSB: Reflective thinking skills 2) In order to be meaningful, a company's ratios should be compared to their prior year's ratios, not industry benchmarks. A) True B) False Answer: B Terms: Analytical procedures Diff: Easy Objective: LO 8-5 AACSB: Reflective thinking skills

Learning Objective 8-6 1) During audit planning, the auditor uses analytical procedures primarily to: A) identify weaknesses in internal control. B) determine if the company's financial statements appear reasonable and are free of material misstatement. C) determine the correspondence of the company's financial statements to the valuation and accuracy audit objectives. D) determine the nature, extent, and timing of audit procedures. Answer: D Terms: Audit planning phase and primary purpose of analytical procedures Diff: Moderate Objective: LO 8-6 AACSB: Reflective thinking skills 2) Which of the following is most correct with respect to the use of analytical procedures? A) Analytical procedures may be used in evaluating balances in the testing phase as long as the auditor also uses them in assessing the going concern assumption. B) Analytical procedures must be used throughout the audit. C) Analytical procedures used in the testing phase of the audit are primarily used to direct an auditor's attention so that the auditor's understanding of the business is improved. D) Analytical procedures are performed by studying plausible relationships between financial and nonfinancial data. Answer: D Terms: Use of analytical procedures Diff: Challenging Objective: LO 8-6 AACSB: Reflective thinking skills 3) Analytical procedures: A) are not a type of audit evidence. B) are not required during the completion phase of the audit. C) performed during the planning phase of the audit are used as a substantive test in support of account balances. D) performed in the completion phase serve as a final review for material misstatements or financial problems. Answer: D Terms: Analytical procedures Diff: Challenging Objective: LO 8-6 AACSB: Reflective thinking skills

4) Discuss the four primary purposes of analytical procedures performed during the planning phase of an audit. Answer: The four primary purposes of preliminary analytical procedures are: • to help the auditor understand the client's industry and business, • to help the auditor assess the going concern assumption, • to indicate areas of possible misstatements, and • to reduce the extent of detailed tests. Terms: Primary purposes of analytical procedures Diff: Moderate Objective: LO 8-6 AACSB: Reflective thinking skills 5) Auditors routinely conduct analytical procedures in the planning, testing, and completion phases of the audit. Identify the primary and secondary purposes of performing analytical procedures in each phase of the audit. Answer: • Planning — primary purposes are to understand the client's business and industry and indicate possible misstatements. Secondary purposes are to assess going concern and reduce detailed tests. • Testing — primary purpose is to reduce detailed tests and secondary purpose is to indicate possible misstatements • Completion — primary purpose is to indicate possible misstatements and secondary purpose is to assess going concern Terms: Primary and secondary purposes of analytical procedures in planning, testing, and completion phases of audit Diff: Challenging Objective: LO 8-6 AACSB: Reflective thinking skills 6) One purpose of performing preliminary analytical procedures in the planning phase of an audit is to help the auditor make a preliminary assessment of control risk. A) True B) False Answer: B Terms: Preliminary analytical procedures Diff: Moderate Objective: LO 8-6 AACSB: Reflective thinking skills

Learning Objective 8-7 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) Auditors should investigate the most significant differences between budgeted and actual results. 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: Risk of material misstatement with accounting estimates Diff: Easy Objective: LO 8-7 AACSB: Reflective thinking skills 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) Variance analysis of actual versus budgeted amounts for production C) Reperforming the client's depreciation expense using the client's accounting policies for capital expenditures made during the year D) Reconciling fixed asset dispositions with the fixed asset ledger Answer: D Terms: Analytical procedures Diff: Moderate Objective: LO 8-7 AACSB: Reflective thinking skills 3) Which of the following statements is not correct with respect to analytical procedures? A) Auditing standards emphasize the need for auditors to develop and use expectations. B) Analytical procedures must be performed throughout the audit. C) Analytical procedures may be performed at any time during the audit. D) Analytical procedures use comparisons and relationships to assess whether account balances appear reasonable. Answer: B Terms: Analytical procedures Diff: Moderate Objective: LO 8-7 AACSB: Reflective thinking skills

4) 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 Diff: Challenging Objective: LO 8-7 AACSB: Reflective thinking skills 5) When are auditors likely to encounter judgment problems in the use of analytical procedures? A) Whenever the auditor places reliance on management's explanations for unusual fluctuations in account balances without first developing independent expectations B) Whenever the auditor allows unaudited balances to unduly influence his/her expectations of current balances C) Whenever the auditor fails to consider the pattern reflected by several unusual fluctuations when trying to explain what caused them D) The auditor is likely to encounter judgment problems in each of the above instances. Answer: D Terms: Judgment problems in use of analytical procedures Diff: Challenging Objective: LO 8-7 AACSB: Reflective thinking skills 6) The major concern when using nonfinancial data in analytical procedures is the: A) accuracy of the nonfinancial data. B) source of the nonfinancial data. C) type of nonfinancial data. D) presence of multiple sources of nonfinancial data. Answer: A Terms: Concern when using nonfinancial data in analytical procedures Diff: Challenging Objective: LO 8-7 AACSB: Reflective thinking skills

7) Whenever an auditor compares client data to client-prepared budgets, there are two special concerns. Indicate if the two items below are concerns. A) Assessing whether the budgets were Client data may have been altered to realistic plans conform to the budget A concern A concern B) Assessing whether the budgets were Client data may have been altered to realistic plans conform to the budget Not a concern Not a concern C) Assessing whether the budgets were Client data may have been altered to realistic plans conform to the budget A concern Not a concern D) Assessing whether the budgets were Client data may have been altered to realistic plans conform to the budget Not a concern A concern Answer: A Terms: Comparison of client data to client-prepared budgets Diff: Challenging Objective: LO 8-7 AACSB: Reflective thinking skills Learning Objective 8-8 1) 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 Diff: Moderate Objective: LO 8-8 AACSB: Reflective thinking skills

2) 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. A) True B) False Answer: A Terms: Common financial ratios Diff: Easy Objective: LO 8-8 AACSB: Reflective thinking skills 3) The most widely used profitability ratio is return on assets. A) True B) False Answer: B Terms: Common financial ratios Diff: Easy Objective: LO 8-8 AACSB: Reflective thinking skills 4) The quick ratio has the same denominator as the current ratio. A) True B) False Answer: A Terms: Common financial ratios Diff: Easy Objective: LO 8-8 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 9 Materiality and Risk Learning Objective 9-1 1) If it is probable that the judgment of a reasonable person will be changed or influenced by the omission or misstatement of information, then that information is, by definition of FASB Statement No. 2: A) material. B) insignificant. C) significant. D) relevant. Answer: A Terms: FASB Statement No. 2; Probable judgment of a reasonable person Diff: Easy Objective: LO 9-1 AACSB: Reflective thinking skills 2) The scope paragraph of the standard unqualified auditor's 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 Diff: Easy Objective: LO 9-1 AACSB: Reflective thinking skills 3) Auditors are responsible for determining whether financial statements are materially misstated, so upon discovering a material misstatement they must bring it to the attention of: A) regulators. B) the audit firm's managing partner. C) the client shareholders. D) the client. Answer: D Terms: Discovery of a material misstatement must bring it to the attention Diff: Easy Objective: LO 9-1 AACSB: Reflective thinking skills

4) Determining materiality requires professional judgment. A) True B) False Answer: A Terms: Materiality Diff: Easy Objective: LO 9-1 AACSB: Reflective thinking skills Learning Objective 9-2 1) Audit standards require the auditor to consider materiality early in the audit. Which statement(s) regarding preliminary materiality 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 are true Answer: C Terms: Preliminary materiality assessment Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 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 that 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 Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 2

4) The preliminary judgment about materiality and the amount of audit evidence accumulated are ________ related. A) directly B) indirectly C) not D) inversely Answer: D Terms: Preliminary judgment about materiality and amount of evidence accumulated Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 5) Which of the following is the primary basis used to decide materiality for a for-profit 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 Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills

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) I and II D) neither I nor II Answer: C Terms: Qualitative factors can affect auditor's assessment of materiality Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 9) 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 Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills 10) 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 Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills

11) 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

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

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 Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills 12) 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 it and the dollar amount of evidence needed. Answer: A Terms: Setting preliminary judgment about materiality Diff: Challenging Objective: LO 9-2 AACSB: Reflective thinking skills

13) 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 Diff: Challenging Objective: LO 9-2 AACSB: Reflective thinking skills 14) 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 Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills

15) 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 account 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 3 percent annually for the past five years but income for the current year has declined 1 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 Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills 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. A) True B) False Answer: A Terms: Preliminary judgments about materiality Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 17) Preliminary judgments about materiality are often changed during the course of the engagement. A) True B) False Answer: A Terms: Preliminary judgments about materiality Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills

18) Net assets are the most often used base for deciding materiality. A) True B) False Answer: B Terms: Base for deciding materiality Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 19) The lower the dollar amount of the preliminary judgment the more audit evidence is required. A) True B) False Answer: A Terms: Amount of preliminary judgment and audit evidence required Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 20) Amounts involving fraud are not usually considered qualitative factors affecting the preliminary materiality judgment. A) True B) False Answer: B Terms: Qualitative factors affecting preliminary materiality judgment; Fraud Diff: Easy Objective: LO 9-2 AACSB: Reflective thinking skills 21) CPA firms can establish policy guidelines to help their auditors determine materiality. A) True B) False Answer: A Terms: Difficulty in applying concept of materiality Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills

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. A) True B) False Answer: B Terms: Statements on Auditing Standards; Objective guidance on establishing preliminary materiality level Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills 23) If the preliminary judgment of materiality increases, the amount of audit evidence required will decrease. A) True B) False Answer: A Terms: Preliminary judgment of materiality and audit evidence Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills 24) Net income before tax is the normal base used to determine materiality in a not-for-profit company. A) True B) False Answer: B Terms: Base used to determine materiality Diff: Moderate Objective: LO 9-2 AACSB: Reflective thinking skills Learning Objective 9-3 1) When auditors allocate the preliminary judgment about materiality to account balances, the materiality allocated to any given account balance 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 Diff: Easy Objective: LO 9-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 9-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 6) Which of the following are major difficulties auditors face when allocating materiality to balance sheet accounts? A) Certain accounts contain more misstatements Only overstatements Audit costs can than others need be considered affect allocation Yes No Yes B) Certain accounts contain more misstatements than others Yes

Only overstatements need be considered Yes

Audit costs can affect allocation No

C) Certain accounts contain more misstatements than others Yes

Only overstatements need be considered Yes

Audit costs can affect allocation Yes

D) Certain accounts contain more misstatements than others No

Only overstatements need be considered Yes

Audit costs can affect allocation No

Answer: A Terms: Major difficulties auditors face when allocating materiality to balance sheet accounts Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills

7) When allocating performance materiality: A) it is easy to predict in advance which accounts are mot 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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 9-3 AACSB: Reflective thinking skills 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: Tolerable misstatements Diff: Challenging Objective: LO 9-3 AACSB: Reflective thinking skills

10) 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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 11) Auditor's 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 auditor's 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 Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 12) Most practitioners allocate the preliminary judgment about materiality to both the balance sheet and income statement accounts. A) True B) False Answer: B Terms: Allocate preliminary judgment about materiality to balance sheet accounts Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills

13) 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. A) True B) False Answer: A Terms: Primary purpose of allocating the preliminary judgment about materiality Diff: Easy Objective: LO 9-3 AACSB: Reflective thinking skills 14) Both overstatements and understatements must be considered when allocating materiality to balance sheet accounts. A) True B) False Answer: A Terms: Allocating materiality; Consideration of overstatements and understatements Diff: Easy Objective: LO 9-3 AACSB: Reflective thinking skills 15) 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. A) True B) False Answer: A Terms: Tolerable misstatements and audit evidence Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills 16) 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. A) True B) False Answer: A Terms: Maximize audit efficiency, allocate less tolerable misstatements Diff: Moderate Objective: LO 9-3 AACSB: Reflective thinking skills

Learning Objective 9-4 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: Known and likely misstatements in the financial statements Diff: Easy Objective: LO 9-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills

3) Likely misstatements can result from: A) Differences between management's and an auditor's judgment about account balances Yes

Projections of misstatements based on an auditor's tests of a sample from a population Yes

Differences between management's and an auditor's judgment about account balances Yes

Projections of misstatements based on an auditor's tests of a sample from a population No

Computation of the sampling error for the cash account No

Differences between management's and an auditor's judgment about account balances No

Projections of misstatements based on an auditor's tests of a sample from a population Yes

Computation of the sampling error for the cash account Yes

Differences between management's and an auditor's judgment about account balances No

Projections of misstatements based on an auditor's tests of a sample from a population No

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

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

Answer: A Terms: Likely misstatements result from Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 9-4 AACSB: Reflective thinking skills 5) Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur. Answer: Step 1. Set preliminary judgment about materiality. This is the combined amount of misstatements in the financial statements that would be considered material. This decision is made in the planning stage of the audit. Step 2. Allocate preliminary judgment about materiality to segments. In this step, the auditor normally allocates the preliminary judgment about materiality to the balance sheet accounts. The amount of materiality allocated to an account is referred to as that account's performance materiality. This allocation is performed in the audit planning stage. Step 3. Estimate total misstatement in segment. In this step, the auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This would be performed after the substantive tests for each account are completed. Step 4. Estimate the combined misstatement. In this step, the projected errors for each account are added, along with total sampling error, to calculate the combined misstatement. This would be performed after all substantive tests have been completed. Step 5. Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, then the auditor concludes the financial statements are fairly presented. This would be performed after all substantive tests have been completed, in the final review stage of the audit. Terms: Five steps in applying materiality in audit Diff: Challenging Objective: LO 9-2, LO 9-3, and LO 9-4 AACSB: Reflective thinking skills 6) The preliminary judgment on materiality is compared to the total estimated misstatement amount to determine if an account balance is materially misstated. A) True B) False Answer: A Terms: Preliminary judgment on materiality; Estimated total misstatements Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills

7) Total estimated misstatements include known misstatements and projected misstatements plus a sampling error. A) True B) False Answer: A Terms: Total estimated misstatements and sampling error Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills 8) If the total misstatement of an account is known, a sampling error still needs to be determined. A) True B) False Answer: B Terms: Total estimated misstatements and sampling error Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills 9) Sampling error represents the minimum misstatement amount that exists in all accounts subjected to sampling. A) True B) False Answer: B Terms: Total estimated misstatements and sampling error Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills 10) If the auditor approaches the audit of the accounts in s sequential manner, the findings of the audit of accounts audited earlier can be used to revise the performance materiality established for accounts audited later. A) True B) False Answer: A Terms: Total estimated misstatements and sampling error Diff: Moderate Objective: LO 9-4 AACSB: Reflective thinking skills

Learning Objective 9-5 1) Which of the following audit risk components may be assessed in non-quantitative terms? A) Control Risk Inherent Risk Detection Risk Yes Yes Yes B) Control Risk Yes

Inherent Risk Yes

Detection Risk No

Control Risk No

Inherent Risk No

Detection Risk Yes

Control Risk No

Inherent Risk No

Detection Risk No

Answer: A Terms: Audit risk components assessed in non-quantitative terms Diff: Easy Objective: LO 9-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 9-5 AACSB: Reflective thinking skills

3) When dealing with audit risk: A) auditors accept some 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) most audit firms prefer to use a quantitative assessment for risk. Answer: A Terms: Audit risk Diff: Moderate Objective: LO 9-2 and LO 9-5 AACSB: Reflective thinking skills 4) 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 Diff: Easy Objective: LO 9-5 AACSB: Reflective thinking skills 5) The most important element of the audit risk model is control risk. A) True B) False Answer: B Terms: Audit risk model and control risk Diff: Easy Objective: LO 9-5 AACSB: Reflective thinking skills 6) The audit risk model that must be used for planning audit procedures and evaluating audit results is: = AAR. A) True B) False Answer: B Terms: Audit risk model Diff: Moderate Objective: LO 9-5 AACSB: Reflective thinking skills

Learning Objective 9-6 1) The measurement of the auditor's assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal controls is defined as: A) audit risk. B) inherent risk. C) sampling risk. D) detection risk. Answer: B Terms: Assessment of likelihood of material misstatements due to error or fraud Diff: Easy Objective: LO 9-6 AACSB: Reflective thinking skills 2) The risk that audit evidence for a segment 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 3) As the risk of material misstatement increases, detection risk should: A) medium increase. B) decrease. C) stay the same. D) Is indeterminate. Answer: B Terms: Risk of material misstatement increases, detection risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills

4) Inherent risk is ________ related to 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 5) Auditors frequently refer to the terms audit assurance, overall assurance, and level of assurance to refer to ________. 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 6) 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 7) 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) I and II D) None of the above Answer: A Terms: Planned detection risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 22

8) 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 9) 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 Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 10) To what extent do auditors typically rely on internal controls of their public company clients? A) Extensively B) Only very little C) Infrequently D) Never Answer: A Terms: Extent auditor rely on internal controls of public company client Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills Topic: Public 11) Auditors typically rely on 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 auditor rely on internal controls of private company client Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills

12) 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 Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills 13) 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 Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills 14) 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 Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills

15) Auditors may assess inherent risk and control risk: A) Jointly to determine the risk of Separately and combine their effects material misstatement in the audit risk model Yes Yes B) Jointly to determine the risk of material misstatement No

Separately and combine their effects in the audit risk model No

Jointly to determine the risk of material misstatement Yes

Separately and combine their effects in the audit risk model No

Jointly to determine the risk of material misstatement No

Separately and combine their effects in the audit risk model Yes

Answer: A Terms: Auditor may assess inherent risk and control risk Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills 16) In a financial statement audit, inherent risk is evaluated to help an auditor asses 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 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 Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills

17) 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 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 Diff: Challenging Objective: LO 9-6 AACSB: Reflective thinking skills 18) 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) increase the performance materiality level for the area. D) expand planning procedures. Answer: C Terms: Low inherent risk Diff: Easy Objective: LO 9-5 AACSB: Reflective thinking skills

19) 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 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 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; Diff: Moderate Objective: LO 9-1, LO 9-2, LO 9-3, and LO 9-6 AACSB: Reflective thinking skills 27

20) 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 Diff: Moderate Objective: LO 9-3, LO 9-4 and LO 9-6 AACSB: Analytic skills 21) If acceptable audit risk is low, and inherent risk and control risk are both low, then planned detection risk should be high. A) True B) False Answer: A Terms: Relationship of acceptable audit risk, inherent risk, control risk, and planned detection risk. Diff: Easy Objective: LO 9-5 and LO 9-6 AACSB: Reflective thinking skills 22) If the audit assurance rate is 95%, then the level of acceptable audit risk is 5%. A) True B) False Answer: A Terms: Audit risk Diff: Moderate Objective: LO 9-3 and LO 9-6 AACSB: Reflective thinking skills

23) A high detection risk equates to a low amount of audit evidence needed. A) True B) False Answer: B Terms: Detection risk and amount of evidence needed Diff: Easy Objective: LO 9-6 AACSB: Reflective thinking skills 24) For a private company client, auditors are required to test any internal controls they believe have not been operating effectively during the period under audit. A) True B) False Answer: B Terms: Auditors required to test internal controls for private companies Diff: Easy Objective: LO 9-6 AACSB: Reflective thinking skills 25) There is a direct relationship between acceptable audit risk and planned detection risk. A) True B) False Answer: A Terms: Inherent risk and control risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 26) Acceptable audit risk and the amount of substantive evidence required are inversely related. A) True B) False Answer: A Terms: Acceptable audit risk and substantive evidence Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 27) As control risk increases, the amount of substantive evidence the auditor plans to accumulate should increase. A) True B) False Answer: A Terms: Control risk and substantive evidence Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills

28) Inherent risk and control risk are directly related. A) True B) False Answer: B Terms: Inherent risk and control risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 29) 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. A) True B) False Answer: A Terms: Acceptable audit risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills 30) Audit assurance is the complement of planned detection risk, that is, one minus planned detection risk. A) True B) False Answer: B Terms: Audit assurance and planned detection risk Diff: Moderate Objective: LO 9-6 AACSB: Reflective thinking skills Learning Objective 9-7 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 Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills 4) There are several factors that affect an audit firm's business risk and, therefore, acceptable audit risk. Discuss three of these factors. Answer: Business risk and acceptable audit risk are 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 Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills

5) 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 AAR IR CR

= = = =

planned detection risk acceptable audit risk inherent risk 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 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 internal controls. Terms: Audit risk model Diff: Moderate Objective: LO 9-5, LO 9-6, and LO 9-7 AACSB: Reflective thinking skills 6) 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. A) True B) False Answer: A Terms: Auditor believes client will have financial difficulties after audit report is issued; External users rely heavily on financial statements Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills

7) Engagement risk is effectively the audit firm's business risk. A) True B) False Answer: A Terms: Engagement risk and business risk Diff: Moderate Objective: LO 9-7 AACSB: Reflective thinking skills Learning Objective 9-8 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 Diff: Easy Objective: LO 9-8 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 9-8 AACSB: Reflective thinking skills 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) Degree of separation of duties D) Susceptibility to misappropriation of assets Answer: C Terms: Assessing inherent risk Diff: Challenging Objective: LO 9-8 AACSB: Reflective thinking skills 33

4) Harker, CPA is in the audit planning phase of Dracule Industries. An understanding needs to be established regarding the responsibilities of Harker and Dracule's Management. For each of the task items listed below indicate the responsible party from the list of choices given. Each choice may be used once, more than once or not at all. Task to be performed: Responsible Party: 1. Obtain an understanding of internal a. Auditor is responsible controls b. Management is responsible 2. Preparation of the financial statements c. Both are responsible 3. Assess inherent risk d. Neither are responsible 4. Following GAAP or IFRS 5. Detect Material Error 6. Comply with laws and regulations 7. Assess the risk of the allowance for doubtful accounts estimate 8. Determine the known and likely errors or misstatements Answer: 1. a 2. b 3. a 4. c 5. a 6. b 7. c 8. a Terms: Responsible parties Diff: Moderate Objective: LO 9-1, LO 9-2, LO 9-3, LO 9-4, LO 9-5, LO 9-6, LO 9-7, and LO 9-8 AACSB: Reflective thinking skills

5) The risk of material misstatement is a combination of two client controlled factors: inherent risk and control risk. What is inherent risk, why is it important and 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 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 Diff: Easy Objective: LO 9-8 AACSB: Reflective thinking skills 6) The risk of fraud should be assessed for the entire audit as well as by cycle, account, and objective. A) True B) False Answer: A Terms: Fraud Diff: Moderate Objective: LO 9-8 AACSB: Reflective thinking skills 7) The auditing profession has established guidelines for setting inherent risk. A) True B) False Answer: B Terms: Inherent risk Diff: Moderate Objective: LO 9-8 AACSB: Reflective thinking skills

8) Auditors begin their assessment of inherent risk during the planning phase and update the assessments throughout the audit. A) True B) False Answer: A Terms: Inherent risk Diff: Moderate Objective: LO 9-8 AACSB: Reflective thinking skills Learning Objective 9-9 1) As the acceptable level of detection risk increases, an auditor may change the: A) timing of substantive tests by performing them at an interim date rather than year end. B) timing of the tests on controls by performing them throughout the year rather than at one time. C) assess the level of inherent risk to a lower amount. D) increase the sample size to achieve a more effective test. Answer: A Terms: Detection risk Diff: Moderate Objective: LO 9-9 AACSB: Reflective thinking skills 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) I and II D) neither I nor i Answer: C Terms: Risk assessment procedures Diff: Moderate Objective: LO 9-9 AACSB: Reflective thinking skills

3) 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 Diff: Moderate Objective: LO 9-9 AACSB: Analytic skills

4) 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 response for the list of responses. Each response can be used once, more than once or not at all. Client changes: Possible effect on the audit: 1. An internal audit department has been a. Increase the acceptable level of detection established. 2. A new inventory control system has been risk. b. Decrease the acceptable level of detection installed that reduces the access of risk. unauthorized parties. 3. Inexperienced accounting personnel were c. Change has no effect on the acceptable level of detection risk. hired in the accounting department. 4. Excess cash was used to purchase complex derivatives. 5. Controls over the sales credit approval process have laxed. 6. New government regulations now apply to Dracule Industries. 7. Management has become overly aggressive in reaching target goals. 8. An expert was hired to help determine the value of the ore content in ending materials inventory. Answer: 1. a 2. a 3. b 4. b 5. b 6. b 7. b 8. a Terms: Audit risk Diff: Moderate Objective: LO 9-6, LO 9-7, LO 9-8, and LO 9-9 AACSB: Analytic skills

5) In applying the audit risk model, auditors are concerned about overstatements, not understatements. A) True B) False Answer: B Terms: Audit risk model Diff: Easy Objective: LO 9-9 AACSB: Reflective thinking skills 6) One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model. A) True B) False Answer: A Terms: Audit risk Diff: Easy Objective: LO 9-9 AACSB: Reflective thinking skills Learning Objective 9-10 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 Diff: Moderate Objective: LO 9-10 AACSB: Reflective thinking skills 2) Which of the following is a correct statement? A) The audit risk model helps in evaluating results. B) Special care must be exercised when the auditor decides on the basis of accumulated evidence that the original assessment of control risk was understated. C) The auditor violates due care if he knows that the original assessment of audit risk is inappropriate and he fails to change it. D) Performance materiality is part of the audit risk model. Answer: C Terms: Risk assessment procedures Diff: Moderate Objective: LO 9-10 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 10 Internal Control, Control Risk, and Section 404 Audits Learning Objective 10-1 1) Which of the following is not one of the three primary objectives of effective 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 Diff: Easy Objective: LO 10-1 AACSB: Analytic skills 2) Which of management's assertions with respect to implementing 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 Diff: Easy Objective: LO 10-1 AACSB: Reflective thinking skills 3) 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 control Diff: Moderate Objective: LO 10-1 AACSB: Analytic skills

4) 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 Diff: Moderate Objective: LO 10-1 AACSB: Analytic skills 5) 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 according 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 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 internal control Diff: Easy Objective: LO 10-1 AACSB: Reflective thinking skills 6) Section 404 of the Sarbanes-Oxley Act requires that public companies issue an internal control report. A) True B) False Answer: A Terms: Sarbanes-Oxley Act Diff: Easy Objective: LO 10-1 AACSB: Reflective thinking skills Topic: SOX

7) 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. A) True B) False Answer: A Terms: Internal control Diff: Moderate Objective: LO 10-1 AACSB: Reflective thinking skills Learning Objective 10-2 1) Which of the following is responsible for establishing a private company's internal control? A) Senior Management B) Internal Auditors C) FASB D) Audit committee Answer: A Terms: Internal control Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills 2) Two key concepts that underlie management's design and implementation 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 Diff: Easy Objective: LO 10-2 AACSB: Analytic skills 3) The PCAOB places responsibility for the reliability 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; internal control responsibility Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills Topic: Public 3

4) Which of the following parties provides an assessment of the effectiveness 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 Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills 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: Employees steal assets Diff: Easy Objective: LO 10-2 AACSB: Ethical understanding and reasoning abilities

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 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 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 internal control structure and procedures for financial reporting D) A statement that the external auditors are solely responsible Answer: A Terms: Sarbanes-Oxley; Internal control report Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills Topic: SOX 7) When management is evaluating the design 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

Answer: C Terms: Internal control design Diff: Easy Objective: LO 10-2 AACSB: Analytic skills Topic: SOX 5

8) When one material weakness is present at the end of the year, management of a public company must conclude that internal control over financial reporting is: A) insufficient. B) inadequate. C) ineffective. D) inefficient. Answer: C Terms: Internal control weakness; Public company Diff: Easy Objective: LO 10-2 AACSB: Analytic skills Topic: Public 9) The auditors 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 internal controls over all relevant assertions in the financial statements. C) to report to management that the 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 Diff: Moderate Objective: LO 10-2 AACSB: Analytic skills Topic: Public 10) Management must disclose material weaknesses in internal control in its audit report: A) whenever the weakness is deemed significant to a single class of transactions. B) whenever the weakness is significant to overall financial reporting objectives. C) if the weakness exists at the end of the year. D) only if the auditor identifies the weakness as significant. Answer: C Terms: Material weaknesses in internal control Diff: Moderate Objective: LO 10-2 AACSB: Reflective thinking skills Topic: Public

11) In performing the audit of internal control over financial reporting the auditor emphasizes internal control over class 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 Diff: Moderate Objective: LO 10-2 AACSB: Reflective thinking skills Topic: Public 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 Diff: Moderate Objective: LO 10-2 AACSB: Ethical understanding and reasoning abilities 13) When considering internal controls, an important point to consider is that: A) auditors can ignore controls affecting internal management information. B) auditors are concerned with the client's internal controls over the safeguarding of assets if they affect the financial statements. C) management is responsible for understanding and testing internal control over financial reporting. D) companies must use the COSO framework to establish internal controls. Answer: B Terms: Effectively designed internal controls; testing of controls Diff: Moderate Objective: LO 10-2 AACSB: Analytic skills

14) Of the following statements about 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 Diff: Moderate Objective: LO 10-2 AACSB: Reflective thinking skills 15) The Sarbanes-Oxley Act requires: A) all public companies to issue reports on internal controls. B) all public companies to define adequate internal controls. C) the auditor of public companies to design effective internal controls. D) the auditor of public companies to withdraw from an engagement if internal controls are weak. Answer: A Terms: Sarbanes-Oxley Act Diff: Challenging Objective: LO 10-2 AACSB: Reflective thinking skills Topic: SOX 16) The financial statements may not correctly reflect accounting frameworks such as GAAP or IFRS if the: A) controls affecting the reliability of financial reporting are inadequate. B) company's controls do not promote efficiency. C) company's controls do not promote effectiveness. D) company's controls do not promote compliance with applicable rules and regulations. Answer: A Terms: Financial statements reflect accounting frameworks Diff: Challenging Objective: LO 10-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 10-2 AACSB: Reflective thinking skills 8

18) An auditor should consider two key issues when obtaining an understanding of a client's 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 internal controls Diff: Challenging Objective: LO 10-2 AACSB: Reflective thinking skills 19) When a company designs and implements internal controls, cost of the controls is not a valid consideration. A) True B) False Answer: B Terms: Design and implement internal control; cost Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills 20) Reasonable assurance allows for: A) low likelihood that material misstatements will not be prevented or detected by internal controls. B) no likelihood that material misstatements will not be prevented or detected by internal control. C) moderate likelihood that material misstatements will not be prevented or detected by internal control. D) high likelihood that material misstatements will not be prevented or detected by internal control. Answer: A Terms: Reasonable assurance Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills Topic: Public

21) Which of the following is most correct regarding the requirements under Section 404 of the Sarbanes Oxley Act? A) The audits of internal control and the financial statements provide reasonable assurance as to misstatements. B) The audit of internal control provides absolute assurance of misstatement. C) The audit of financial statements provides absolute assurance of misstatement. D) The audits of internal control and the financial statements provide absolute assurance as to misstatements. Answer: A Terms: Sarbanes Oxley Act Section 404 Diff: Easy Objective: LO 10-2 AACSB: Reflective thinking skills 22) To issue a report on internal control over financial reporting for a public company, an auditor must: A) evaluate management's assessment process. B) independently assess the design and operating effectiveness of internal control. C) evaluate management's assessment process and independently assess the design and operating effectiveness of internal control. D) test controls over significant account balances. Answer: C Terms: Internal control over financial reporting for public company Diff: Moderate Objective: LO 10-2 AACSB: Reflective thinking skills Topic: Public Learning Objective 10-3 1) Which of the following activities would be least likely to strengthen a company's 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 internal control Diff: Easy Objective: LO 10-3 AACSB: Analytic skills

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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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: Increase risks to an organization Diff: Moderate Objective: LO 10-3 AACSB: Analytic skills

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 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 IT duties Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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 purposes 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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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 internal control by management Answer: C Terms: Control activities Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 12

8) Which of the following deal with ongoing or periodic assessment of the quality of internal control by management? A) Quality monitoring activities B) Monitoring activities C) Oversight activities D) Management activities Answer: B Terms: Quality of internal control Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 9) Which of the following best describes an entity's accounting information and communication system? A) Record and Monitor process transactions transactions Initiate transactions Yes Yes Yes B) Monitor transactions No

Record and process transactions No

Initiate transactions No

Monitor transactions Yes

Record and process transactions No

Initiate transactions No

Monitor transactions No

Record and process transactions Yes

Initiate transactions Yes

Answer: D Terms: Accounting information and communication system Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills

10) An audit procedure that would most likely be used by an auditor in performing tests of control procedures in which the segregation of functions and that leaves no "audit" trail is: A) inspection. B) observation. C) reperformance. D) reconciliation. Answer: B Terms: Tests of control procedures; segregation of functions Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 11) Internal controls normally include procedures designed to provide reasonable assurance that: A) employees act with integrity when performing their assigned tasks. B) transactions are executed in accordance with management's authorization. C) decision processes leading to management's authorization of transactions are sound. D) collusive activities would be detected by segregation of employee duties. Answer: B Terms: Internal controls; reasonable assurance Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 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 internal control. C) comparison of recorded accountability with assets. D) timing of the tests to be performed. Answer: B Terms: Competence of client personnel Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 15) Without an effective ________, the other components of the COSO framework are unlikely to result in effective 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 control Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 16) Which of the following groups establishes and maintains the company's internal controls? A) Internal auditors B) Board of Directors C) Management D) Audit committee Answer: C Terms: Establishes and maintains company's internal control Diff: Challenging Objective: LO 10-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 10-3 AACSB: Analytic skills

18) To promote operational efficiency, the internal audit department would ideally report to: A) line management. B) PCAOB. C) Chief Accounting Officer. D) audit committee. Answer: D Terms: Operational efficiency Diff: Challenging Objective: LO 10-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 10-3 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 10-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 10-3 AACSB: Analytic skills 22) 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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills Topic: Public

23) 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. For example, a properly designed and used shipping document can be the basis for releasing goods from storage to the shipping department, informing billing of the quantity of goods to bill to the customer and the appropriate billing date, and updating the perpetual inventory records. • 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. For example, computer screen prompts may force online data entry of critical information before the record is electronically routed for authorizations and approvals. Similarly, screen controls can validate the information entered, such as when an invalid general ledger account number is automatically rejected when the account number does not match the chart of accounts master file. Terms: Principles for design and use of documents and records Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 24) Management's identification and analysis of risk is an ongoing process and is a critical component of effective 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 and, • economic downturns Terms: Factors which may lead to increased risk Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills

25) 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 Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 26) In developing an understanding of the client's accounting information system the auditor follows a sequential process. Describe the process below: Answer: 1. Major classes of transactions of the entity 2. How these transactions are initiated and recorded 3. What accounting records exist and their nature 4. How the system captures other events that are significant to the financial statements 5. The nature and details of the financial reporting process followed Terms: Sequential process Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 27) 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 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 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 internal control performance to determine whether controls are operating as intended and are modified when needed. Terms: Internal control framework; COSO Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills

28) 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 • management's philosophy and operating style • organizational structure • human resource policies and practices. Terms: Control environment Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 29) List the three steps in management's assessment of risk and then list two of the categories of management assertions that must be satisfied during the risk assessment process. Answer: The steps taken by management in the risk assessment process are: • identify the factors affecting risk • assess the significance of risks and likelihood of occurrence • determine actions necessary to manage the risks. The categories of management assertions that must be satisfied are: • assertions about classes of transactions and other events • assertions about account balances • assertions about presentation and disclosure. Terms: COSO components of internal control and risk assessment Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 30) Control activities are a subcomponent of the information and communication component of internal control. A) True B) False Answer: B Terms: Internal control components Diff: Easy Objective: LO 10-3 AACSB: Analytic skills

31) Adequate documents and records is a subcomponent of the control environment. A) True B) False Answer: B Terms: Control environment Diff: Easy Objective: LO 10-3 AACSB: Reflective thinking skills 32) The chart of accounts is helpful in preventing classification errors if it accurately describes which type of transaction should be in each account. A) True B) False Answer: A Terms: Internal control components Diff: Easy Objective: LO 10-3 AACSB: Reflective thinking skills 33) Auditing standards prohibit reliance on the work of internal auditors due to the lack of independence of the internal auditors. A) True B) False Answer: B Terms: Auditing standards; internal auditors Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills 34) 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. A) True B) False Answer: A Terms: Internal auditors Diff: Moderate Objective: LO 10-3 AACSB: Reflective thinking skills

Learning Objective 10-4 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 walk-through. D) testing controls. Answer: C Terms: Tracing transactions through accounting system Diff: Easy Objective: LO 10-4 AACSB: Analytic skills 2) The purpose of phase 3 in the "process for understanding internal control and assessing control risk" is to: A) design, perform and evaluate tests of controls. B) obtain and document an understanding of internal control design an operation. C) assess control risk. D) decide planned detection risk and substantive tests. Answer: A Terms: Process for understanding internal control and assessing risk Diff: Moderate Objective: LO 10-4 AACSB: Reflective thinking skills 3) Narratives, flowcharts, and internal control questionnaires are three common methods of: A) testing the internal controls. B) documenting the auditor's understanding 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 internal control questionnaires Diff: Easy Objective: LO 10-4 AACSB: Reflective thinking skills 4) When dealing with the documentation 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 control Diff: Moderate Objective: LO 10-4 AACSB: Reflective thinking skills 22

5) Audit evidence regarding the separation of duties is normally best obtained by: A) preparing flowcharts of operational processes. B) preparing narratives of operational processes. C) observation of employees applying control activities. D) inquiries of employees applying control activities. Answer: C Terms: Audit evidence of separation of duties Diff: Moderate Objective: LO 10-4 AACSB: Reflective thinking skills 6) Walkthroughs combine observation, inspection, and inquiry to assure that the controls designed by management have been implemented. A) True B) False Answer: A Terms: Walkthroughs; understanding internal control Diff: Easy Objective: LO 10-4 AACSB: Reflective thinking skills Topic: Public 7) A narrative should describe the disposition of every document and record in the system. A) True B) False Answer: A Terms: Understanding internal controls Diff: Easy Objective: LO 10-4 AACSB: Reflective thinking skills 8) For most uses, flowcharts are superior to narratives as a method of communicating the characteristics of internal control. A) True B) False Answer: A Terms: Flowcharts Diff: Moderate Objective: LO 10-4 AACSB: Reflective thinking skills

9) When documenting their understanding of a client's internal controls, auditors are required to use narratives. A) True B) False Answer: B Terms: Understanding internal controls; narratives Diff: Moderate Objective: LO 10-4 AACSB: Reflective thinking skills Learning Objective 10-5 1) The person responsible for reconciling sales invoices to customer orders does not access to the company's master price list in order to correctly compute sales. This is an example of a(n): A) operating deficiency. B) design deficiency. C) training deficiency. D) management deficiency. Answer: B Terms: Reconciling sales invoices to correctly compute sales Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills 2) You are performing the audit of internal control for Clifton Company. Which of the following would represent a material weakness in internal control? A) The company's audit committee has experienced 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 internal control Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills Topic: Public 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 constitute: A) a deficiency in operation of internal controls. B) a deficiency in design of internal controls. C) a deficiency of management. D) not constitute a deficiency. Answer: A Terms: Lack of knowledge Diff: Moderate Objective: LO 10-5 AACSB: Ethical understanding and reasoning abilities 24

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 Diff: Moderate Objective: LO 10-5 AACSB: Ethical understanding and reasoning abilities 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 internal control. D) prepare audit documentation in order to opine on the company's internal control system. Answer: A Terms: Entry level controls Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills

7) Which of the following deficiency exists if a necessary control is missing or not properly formulated? A) Control B) Significant C) Design D) Operating Answer: C Terms: Control deficiency Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills 8) To determine if significant 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 Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills

9) The auditor must communicate: A) only material weaknesses in internal control to those charged with governance. B) both significant deficiencies and material weaknesses in internal control to those charged with governance. C) any significant deficiencies in internal control to those charged with governance using a management letter. D) issues regarding internal control to those charged with governance in writing within 90 days following the audit report release. Answer: B Terms: Significant deficiencies Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills 10) Before making the final assessment of internal control at the end of an integrated audit, the auditor must: A) Test controls Perform substantive tests of details Yes Yes B) Test controls No

Perform substantive tests of details No

Test controls Yes

Perform substantive tests of details No

Test controls No

Perform substantive tests of details Yes

Answer: A Terms: Final assessment of internal control for integrated audit Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills Topic: Public

11) Significant deficiencies and material weaknesses in internal control of a public company must be reported in writing to which of the following? A) Public Company Accounting Oversight Board B) Members of management who are responsible for the related area of the company C) Audit committee of the company's board of directors and to management D) AICPA Answer: C Terms: Internal controls; significant deficiencies; material weaknesses Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills Topic: Public 12) Significant deficiencies are matters that come to an auditor's attention and should be communicated to an entity's audit committee because they represent: A) material frauds perpetrated by high-level management. B) internal control deficiencies that could adversely affect a company's ability to initiate, record, process, or report external financial statements reliably. C) flagrant violations of the entity's documented conflict-of-interest policies. D) intentional attempts by client personnel to limit the scope of the auditor's field work. Answer: B Terms: Significant deficiencies; audit committee Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills 13) 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; governance Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 10-5 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 10-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 10-5 AACSB: Analytic skills

17) 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 assigned functions. A design deficiency exists if a necessary control is missing or not properly designed. An operating 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 Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills 18) Define the following terms: control deficiency, significant deficiency, and material weakness. 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 significant deficiency exists if one or more control deficiencies exist that is less severe than a material weakness but important enough to merit attention by those responsible for oversight of the company's financial statements. • A material weakness exists if a significant deficiency, by itself, or in combination with other significant deficiencies, results in a reasonable possibility that internal control will not prevent or detect material financial statement misstatements on a timely basis. Terms: Control deficiency; Significant deficiency; Material weakness Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills

19) Describe the auditor's responsibilities related to required communications between the auditor and those charged with governance (remove auditor committee) regarding internal control. Answer: The auditor must communicate significant deficiencies and material weaknesses in writing to those charged with governance as soon as they become aware of their existence. The communication is usually addressed to the audit committee and to management. Timely communications may provide management an opportunity to address control deficiencies before management's report on internal control must be issued. In some instances, deficiencies can be corrected sufficiently early such that both management and the auditor can conclude that controls are operating effectively as of the balance sheet date. These communications must be made no later than 60 days following the audit report release. Terms: Control activities Diff: Challenging Objective: LO 10-5 AACSB: Reflective thinking skills 20) 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. Internal control questionnaires, flowcharts, and walkthroughs are useful tools to identify where controls are lacking and the likelihood of misstatement is therefore increased. 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: Required communications between auditor and those charged with governance Diff: Challenging Objective: LO 10-5 AACSB: Reflective thinking skills; Analytic skills

21) The assessment of control risk is the measure of the auditor's expectation that internal controls will prevent material misstatements from occurring or detect and correct them if they have occurred. A) True B) False Answer: A Terms: Internal control risk assessment Diff: Moderate Objective: LO 10-5 AACSB: Reflective thinking skills Learning Objective 10-6 1) If the results of tests of controls support the design and operations of controls as expected, the auditor uses ________ 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 Diff: Moderate Objective: LO 10-6 AACSB: Analytic skills 2) An auditor is likely to use four types of procedures to support the operating effectiveness 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 internal controls Diff: Moderate Objective: LO 10-6 AACSB: Reflective thinking skills

3) Which of the following represents a correct statement regarding internal control testing? A) When auditors plan to use evidence about the operating effectiveness 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 internal controls can only be performed by the auditor at the end of the fiscal year. Answer: C Terms: Internal control risk assessment Diff: Challenging Objective: LO 10-6 AACSB: Analytic skills 4) In evaluating the operational effectiveness 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; internal controls; audit procedures Diff: Moderate Objective: LO 10-6 AACSB: Reflective thinking skills 5) The procedures to obtain an understanding of internal control are only applied when the assessed control risk is high. A) True B) False Answer: B Terms: Internal control Diff: Easy Objective: LO 10-6 AACSB: Analytic skills 6) Controls that are applied throughout the accounting period must be tested both at an interim date and then again on the balance sheet date. A) True B) False Answer: B Terms: Internal controls Diff: Moderate Objective: LO 10-6 AACSB: Analytic skills

Learning Objective 10-7 1) When determining what type of report to issue on internal control under Section 404: A) an adverse opinion on internal control must be given if any weaknesses in a key internal control is discovered. B) a scope limitation requires the auditor to disclaim an opinion on internal controls. C) if the auditor gives a qualified opinion on the financial statements, they must give a qualified opinion on internal controls. D) a scope limitation requires the auditor to express a qualified opinion or a disclaimer of opinion on internal controls. Answer: D Terms: Internal control audit requirements of auditor Diff: Easy Objective: LO 10-7 AACSB: Reflective thinking skills Topic: SOX 2) The scope of the auditor's report on internal control is limited to obtaining reasonable assurance that significant weaknesses in internal control are identified. A) True B) False Answer: B Terms: Section 404 of the Sarbanes-Oxley Act Diff: Moderate Objective: LO 10-7 AACSB: Reflective thinking skills Topic: SOX 3) To issue an unqualified opinion on internal control over financial reporting, there must be no identified material weaknesses and no restrictions on the scope of the audit. A) True B) False Answer: A Terms: Unqualified opinion on internal control Diff: Moderate Objective: LO 10-7 AACSB: Reflective thinking skills Topic: Public

Learning Objective 10-8 1) A control available in a small company, which may be necessitated because of lack of competent personnel, is: A) a wider segregation of duties. B) a voucher system. C) fewer transactions to process. D) the owner-manager's direct involvement in the control process. Answer: D Terms: Control; smaller company; competent personnel Diff: Easy Objective: LO 10-8 AACSB: Ethical understanding and reasoning abilities 2) When auditing a private company, the auditor should obtain an understanding of internal control sufficient to: A) provide reasonable protection against client fraud and defalcations by client employees. B) assess control risk. C) provide a basis for suggestions to the client for improving the accounting system. D) provide a method for safeguarding assets, checking the accuracy and reliability of accounting data, promoting operational efficiency, and encouraging adherence to prescribed managerial policies. Answer: B Terms: Internal control understanding; Private company Diff: Easy Objective: LO 10-8 AACSB: Reflective thinking skills

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

Moderate No

High Yes

Low Yes

Moderate Yes

High No

Low No

Moderate Yes

High No

Answer: C Terms: Control risk Diff: Moderate Objective: LO 10-8 AACSB: Analytic skills 4) The auditor's consideration of a private company's internal control is: A) required by GAAP. B) required by GAAS. C) required by the IRS. D) recommended by the SEC. Answer: B Terms: Private company's internal control Diff: Moderate Objective: LO 10-8 AACSB: Reflective thinking skills

5) Which of the following may represent the biggest challenge smaller public companies face in implementing effective internal control? A) A lack of expertise B) Reduced importance C) Limited resources D) Limited available guidance Answer: C Terms: Internal control biggest challenge Diff: Challenging Objective: LO 10-8 AACSB: Reflective thinking skills Topic: Public 6) Which of the following is most correct for audits of non-public companies? A) An audit of internal control is required. B) An audit of internal control is not required. C) An audit of the design of internal controls is required. D) An audit of the operational effectiveness of internal controls is required. Answer: B Terms: Audits of non-public companies Diff: Moderate Objective: LO 10-8 AACSB: Reflective thinking skills

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

Control environment Control activities Independent checks on performance Internal control Monitoring Separation of duties General authorization Specific authorization Risk assessment

________ 1. Management's ongoing and periodic assessment of the quality of internal control performance to determine that controls are operating as intended and are modified when needed. ________ 2. Company-wide policies for the approval of all transactions within stated limits. ________ 3. The actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about internal control and its importance to the entity. ________ 4. Segregation of the following activities in an organization: custody of assets, accounting, authorization, and operational responsibility. ________ 5. Management's identification and analysis of risks relevant to the preparation of financial statements in accordance with an applicable accounting framework. ________ 6. Policies and procedures that help ensure that necessary actions are taken to address risks in the achievement of the entity's objectives. ________ 7. A process designed to provide reasonable assurance regarding the achievement of management's objectives in the following categories: (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with applicable laws and regulations. Answer: 1. E 2. G 3. A 4. F 5. I 6. B 7. D Terms: Control environment; Control activities; Internal control; Monitoring; Separation of duties; General authorization; Risk assessment Diff: Moderate Objective: LO 10-1 through LO 10-8 AACSB: Reflective thinking skills 38

8) 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. A) True B) False Answer: A Terms: Control activities; control risk Diff: Easy Objective: LO 10-8 AACSB: Analytic skills 9) If, when obtaining an understanding of control activities of a relatively small client, the auditor identified no control activities, the auditor would probably reassess whether the client is auditable. A) True B) False Answer: A Terms: Control activities Diff: Easy Objective: LO 10-8 AACSB: Analytic skills 10) Auditors of private companies may rely on prior periods' tests of controls. A) True B) False Answer: A Terms: Private companies; test of controls Diff: Easy Objective: LO 10-8 AACSB: Reflective thinking skills 11) In an audit of a non-public company, the less control risk there is, the smaller the amount of planned substantive evidence that is required. A) True B) False Answer: A Terms: Non-public company; control risk; substantive evidence Diff: Easy Objective: LO 10-8 AACSB: Analytic skills

12) The auditor of a private company is not required by auditing standards to issue a written report on significant deficiencies in internal control. A) True B) False Answer: B Terms: Internal controls for smaller companies Diff: Easy Objective: LO 10-8 AACSB: Reflective thinking skills 13) A company's size should have no impact on the nature of internal control and the controls that are implemented. A) True B) False Answer: B Terms: Internal controls for smaller companies Diff: Moderate Objective: LO 10-8 AACSB: Reflective thinking skills 14) Control risk is generally set at minimum for most private companies. A) True B) False Answer: B Terms: Internal controls for smaller companies Diff: Moderate Objective: LO 10-8 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 11 Fraud Auditing Learning Objective 11-1 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 Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 4) Most cases of fraudulent reporting involve: A) inadequate disclosures. B) an overstatement of income. C) an overstatement of liabilities. D) an overstatement of expenses. Answer: B Terms: Financial statements subject to manipulation Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills

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 where revenues and expenses are shifted between periods Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 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 perpetrated by Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 8) 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 statement. Misappropriation of assets involve theft of an entity's assets. Terms: Fraud and main categories Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 9) Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to deceive users. A) True B) False Answer: A Terms: Fraud in financial statement auditing Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills

10) The two main categories of fraud are fraudulent financial reporting and misappropriation of assets. A) True B) False Answer: A Terms: Categories of fraud; Fraudulent financial reporting and misappropriation of assets Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 11) "Cookie jar reserves" are often created by companies whenever their earnings are high to create reserves for future periods when earnings need to be "boosted" upward. A) True B) False Answer: A Terms: Cookie jar reserves Diff: Easy Objective: LO 11-1 AACSB: Reflective thinking skills 12) Misappropriation of assets is normally perpetrated at the lowest levels of the organization hierarchy. A) True B) False Answer: A Terms: Misappropriation of assets Diff: Moderate Objective: LO 11-1 AACSB: Reflective thinking skills 13) Fraudulent financial reporting usually involves manipulation of amounts rather than disclosures. A) True B) False Answer: A Terms: Fraudulent financial reporting Diff: Moderate Objective: LO 11-1 AACSB: Reflective thinking skills

Learning Objective 11-2 1) Which of the following are elements of the fraud triangle? A) Attitudes/rationalization Risk Factors Yes No

Opportunities 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 Diff: Easy Objective: LO 11-2 AACSB: Reflective thinking skills 2) Financial statement manipulation risk is arguably present for all companies' financial statements. However, the risk is elevated 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 Diff: Easy Objective: LO 11-2 AACSB: Reflective thinking skills

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 practice of making overly aggressive forecasts D) High turnover of accounting, internal audit, and information technology staff Answer: C Terms: Factor relates to opportunities to commit fraudulent financial reporting Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 6) Which of the following is a factor that relates to attitudes or rationalization 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 to third parties D) High turnover of accounting, internal audit and information technology staff Answer: C Terms: Factor that relates to attitudes or rationalization to commit fraudulent financial reporting Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 6

7) Which of the following is not a factor that relates to opportunities to misappropriate assets? A) Inadequate 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 Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 8) Which of the following is a factor that relates to incentives to misappropriate assets? A) Significant accounting estimates involving subjective judgments B) Significant personal financial obligations 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 to misappropriate assets Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 9) Which of the following does not represent an increased opportunity to commit fraud? A) Related party transactions B) The company founder is the CEO and Chairman of the Board. C) The financial statements involve accounting estimates. D) The company is a new audit client for the CPA firm. Answer: D Terms: Increased opportunity to commit fraud Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 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. D) share most of the same conditions. Answer: C Terms: Fraud triangle Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 11-2 AACSB: Reflective thinking skills 12) Who is most likely to perpetrate fraudulent financial reporting? A) Members of the board of directors B) Production employees C) Management of the company D) The internal auditors Answer: C Terms: Fraudulent financial reporting Diff: Easy Objective: LO 11-1 and 11-2 AACSB: Reflective thinking skills 13) Determine from the following the factor that would most likely elevate the auditor's concern about the risk of financial statement fraud. A) Company cannot borrow debt capital without restrictive covenants. B) Company finds it difficult to sell equity capital for expansion. C) Company has a significant portion of liquid assets on its balance sheet. D) Company reports substantial net income but ever decreasing cash flow from operations. Answer: D Terms: Most likely elevate auditor's concern about risk of financial statement fraud Diff: Moderate Objective: LO 11-2 AACSB: Analytic skills

14) 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 Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 15) 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. Weak internal controls. 5. Significant related party transactions. Attitudes/Rationalization: 1. Inappropriate or ineffective support of the entity's ethics and values. 2. Known history of violations of 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 Diff: Challenging Objective: LO 11-2 AACSB: Reflective thinking skills 16) Incentives and opportunities are two conditions that are generally present when financial statement fraud occurs. A) True B) False Answer: A Terms: Conditions present when material misstatements due to fraud occur Diff: Easy Objective: LO 11-2 AACSB: Reflective thinking skills

17) Fraud is more prevalent in large businesses than small businesses and not-for-profit organizations. A) True B) False Answer: B Terms: Fraud prevalence in organizations Diff: Easy Objective: LO 11-2 AACSB: Reflective thinking skills 18) The same three fraud triangle risk conditions apply to fraudulent financial reporting and misappropriation of assets. A) True B) False Answer: A Terms: Fraud triangle risk conditions Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 19) "An attitude, character, or set of ethical values exist that allow management or employees to commit a dishonest act …." describes the opportunities condition included in the fraud triangle. A) True B) False Answer: B Terms: Opportunities conditions included in fraud triangle Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 20) An ineffective board of director oversight over financial reporting is an example of an incentives/pressures risk factor. A) True B) False Answer: B Terms: Fraud risk factor describing incentives/pressures Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills

21) A common incentive for companies to manipulate financial statements is a decline in the company's financial prospects. A) True B) False Answer: A Terms: Fraud risk factor describing incentives/pressures Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills 22) The pressure to do "whatever it takes" to meet goals is one of the main reasons why financial statement fraud occurs. A) True B) False Answer: A Terms: Risk factors related to incentives, opportunities, and attitudes Diff: Moderate Objective: LO 11-2 AACSB: Reflective thinking skills Learning Objective 11-3 1) Auditor's need to exhibit professional skepticism when auditing a client. This auditing standard is best expressed by which of the following? A) The auditor neither assumes dishonesty or honesty of management. B) The auditor assumes dishonesty of management. C) The auditor assumes honesty of management. D) The auditor assumes management lacks integrity. Answer: A Terms: Professional skepticism when auditing a client Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills

2) Which of the following matters related to the auditor's consideration of material misstatements due to fraud are required to be documented? A) Reasons supporting a conclusion that there is not a significant risk of material improper expense recognition B) Procedures performed to obtain information necessary to identify and assess the risks of material fraud C) Results of the internal auditor's procedures performed to address the risk of management override of controls D) Discussions with management regarding the hiring of a new plant manager Answer: B Terms: Auditing standards requiring auditors to document matters related to auditor consideration of material misstatements due to fraud Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 3) As part of the brainstorming sessions, auditors are directed to emphasize: A) How management could perpetrate and conceal fraudulent financial The audit team's response to reporting potential fraud risks Yes Yes B) How management could perpetrate and conceal fraudulent financial reporting No

The audit team's response to potential fraud risks No

C) How management could perpetrate and conceal fraudulent financial reporting Yes

The audit team's response to potential fraud risks No

D) How management could perpetrate and conceal fraudulent financial reporting No

The audit team's response to potential fraud risks Yes

Answer: A Terms: Auditors directed to emphasize in brainstorming sessions Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 12

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 are the nature of the fraud risks identified by management? C) Is management using all assets effectively? D) What internal controls have been implemented to address the fraud risks? Answer: C Terms: Source of information to assess fraud risks Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-3 AACSB: Reflective thinking skills 7) Explain professional skepticism and the need for maintaining professional skepticism during an audit. Answer: Auditing standards state that, in exercising professional skepticism, an auditor "neither assumes that management is dishonest nor assumes unquestioned honesty." Auditors need to maintain their skepticism and a questioning mind throughout the audit so that they can identify fraud risk and critically evaluate audit evidence. Terms: Professional skepticism Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills

8) 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 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 Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 9) Describe the sources of information gathered to assess fraud risks. Answer: When the auditor is assessing fraud risks the following information sources should be considered: • Information obtained from communications among audit team members about their knowledge of the company and its industry; including how and where the company's financial statements might be susceptible to material misstatements due to fraud. • Responses to auditor inquiries of management about their views of the risks of fraud and about existing programs and controls to address specific identified fraud risks. • Specific risk factors in fraudulent financial reporting or misappropriation of assets. • The results of analytical procedures obtained during planning that indicate possible implausible or unexpected analytical relationships. • Knowledge obtained through other procedures such as client acceptance and retention decisions, interim review of financial statements, and consideration of inherent and control risks. Terms: Sources of information to assess fraud risks Diff: Challenging Objective: LO 11-3 AACSB: Reflective thinking skills 10) Financial statements of all companies are potentially subject to manipulation. A) True B) False Answer: A Terms: Financial statements subject to manipulation Diff: Easy Objective: LO 11-3 AACSB: Reflective thinking skills

11) Information and idea exchange sessions by the audit team are required by current auditing standards. A) True B) False Answer: A Terms: Information and idea exchange by audit team sessions required by current audit standards Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 12) Upon discovering information that indicates a material misstatement due to fraud, the auditor must assume that the misstatement is an isolated incident. A) True B) False Answer: B Terms: Assessment of fraud risk Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 13) The presence of fraud risk factors increases the likelihood of fraud and may suggest that fraud is being perpetrated. A) True B) False Answer: A Terms: Presence of fraud risk factors Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills 14) When the auditor receives inconsistent responses from management and others within the organization, the auditor should obtain additional audit evidence to resolve the inconsistency. A) True B) False Answer: A Terms: Presence of fraud risk factors Diff: Moderate Objective: LO 11-3 AACSB: Reflective thinking skills

Learning Objective 11-4 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 Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 2) Which of the following parties is responsible for implementing 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 internal controls to minimize likelihood of fraud Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 16

5) Which party has the primary responsibility to oversee an organization's financial reporting and 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 internal control processes Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 6) Management is responsible for: A) Identifying and measuring fraud risks Yes

Taking steps to mitigate identified risks Yes

B) Identifying and measuring fraud risks No

Taking steps to mitigate identified risks No

Identifying and measuring fraud risks Yes

Taking steps to mitigate identified risks No

D) Identifying and measuring fraud risks No

Taking steps to mitigate identified risks Yes

Answer: A Terms: Management is responsibilities with fraud risks Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills

7) 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) Employee conduct–Employees should conduct themselves in a professional manner and prohibit unprofessional behavior 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 for Code of Conduct Diff: Challenging Objective: LO 11-4 AACSB: Reflective thinking skills Topic: Public 8) Senior management is responsible for promoting a culture of honesty and ethics. Describe what that implies for the organization. Answer: 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. 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 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 Diff: Challenging Objective: LO 11-4 AACSB: Reflective thinking skills 9) Management and the board of directors are responsible for setting the "tone at the top." A) True B) False Answer: A Terms: Responsibility for setting tone at the top Diff: Easy Objective: LO 11-4 AACSB: Reflective thinking skills 18

10) If employees have positive feelings about their employers, they are less likely to commit fraud. A) True B) False Answer: A Terms: Responsibility for determining organization financial reporting and internal control Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 11) Management must recognize that almost any employee is capable of committing a dishonest act under the right circumstances. A) True B) False Answer: A Terms: Primary responsibility to assess fraud risks and establish corporate governance programs Diff: Moderate Objective: LO 11-4 AACSB: Reflective thinking skills 12) Audit committee oversight also serves as a deterrent to fraud by senior management. A) True B) False Answer: A Terms: Strongest internal corporate governance mechanisms Diff: Challenging Objective: LO 11-4 AACSB: Reflective thinking skills

Learning Objective 11-5 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 evidence of possible misstatements due to Review accounting estimates for fraud biases 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 Diff: Moderate Objective: LO 11-5 AACSB: Reflective thinking skills 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 to 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 Diff: Moderate Objective: LO 11-5 AACSB: Reflective thinking skills 20

3) Auditors are required to perform certain procedures in every audit to address the risk of management override 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 internal controls Diff: Moderate Objective: LO 11-5 AACSB: Reflective thinking skills 4) Because fraud perpetrators are often knowledgeable about audit procedures, auditors should incorporate unpredictability into the audit plan. A) True B) False Answer: A Terms: Auditors to incorporate unpredictability into audit plan Diff: Moderate Objective: LO 11-5 AACSB: Reflective thinking skills 5) The auditors should pay careful attention to accounting principles that involve subjective measurements or complex transactions. A) True B) False Answer: A Terms: Responding to the risk of fraud Diff: Moderate Objective: LO 11-5 AACSB: Reflective thinking skills Learning Objective 11-6 1) Auditing standards specifically require auditors to identify ________ as a fraud risk in most audits. A) overstated assets B) understated liabilities C) improper revenue recognition D) overstated expenses Answer: C Terms: Specific fraud risk areas Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 21

2) Company management is often under pressure to increase revenue and/or net income. One approach is to use a "bill and hold" arrangement. This 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 Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 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 billing 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 Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 23

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 areas Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 10) 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 Terms: Types of revenue manipulation Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills 11) 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 Diff: Challenging Objective: LO 11-6 AACSB: Reflective thinking skills

12) When the allowance for doubtful accounts is understated, bad debt expense is understated and net income is also understated. A) True B) False Answer: B Terms: Fraud risk areas Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills Topic: Public 13) Fictitious revenue transactions have the same level of documentary evidence as legitimate transactions. A) True B) False Answer: B Terms: Revenue recognition and fraud Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills Topic: Public 14) Auditors should rely on original, rather than duplicate, copies of documents. A) True B) False Answer: A Terms: Fraud risk areas Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills Topic: Public 15) The two most common areas of fraud in payroll are the creation of fictitious employees and the overstatement of individual payroll hours. A) True B) False Answer: A Terms: Fraud risk areas Diff: Moderate Objective: LO 11-6 AACSB: Reflective thinking skills Topic: Public

Learning Objective 11-7 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 CL or IDEA to search for fictitious revenue transactions. D) use EXCEL to perform analytical procedures at the disaggregated level. Answer: B Terms: Fraud risk areas Diff: Moderate Objective: LO 11-7 AACSB: Reflective thinking skills 2) Which of the following is least likely to uncover fraud? A) External auditors B) Internal auditors C) Internal controls D) Management Answer: A Terms: Lease likely to uncover of fraud risks Diff: Moderate Objective: LO 11-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-7 AACSB: Analytic skills 26

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 Diff: Challenging Objective: LO 11-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 11-7 AACSB: Reflective thinking skills 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 communicate with whom when senior management fraud may be present Diff: Challenging Objective: LO 11-7 AACSB: Reflective thinking skills 8) 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 information inquiry, assessment inquiry, and interrogative inquiry. Information 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. Terms: Inquiry techniques Diff: Challenging Objective: LO 11-7 AACSB: Reflective thinking skills

9) PCAOB Standard 5 states that fraud of any magnitude by senior management is at least a significant deficiency in internal controls. A) True B) False Answer: A Terms: Senior management fraud Diff: Moderate Objective: LO 11-7 AACSB: Reflective thinking skills Topic: Public 10) Most frauds are discovered via a tip. A) True B) False Answer: A Terms: Fraud Diff: Easy Objective: LO 11-7 AACSB: Reflective thinking skills Topic: Public 11) Interrogative inquiry is often confrontational. A) True B) False Answer: A Terms: Inquiry techniques Diff: Moderate Objective: LO 11-7 AACSB: Reflective thinking skills Topic: Public 12) Auditors may expand other substantive procedures to address the heightened risks of fraud. A) True B) False Answer: A Terms: Fraud risk areas Diff: Moderate Objective: LO 11-7 AACSB: Reflective thinking skills Topic: Public

Auditing and Assurance Services, 15e (Arens) Chapter 14 Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 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 Diff: Easy Objective: LO 14-1 AACSB: Reflective thinking skills 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 "bricks and mortar" business are: A) unchanged. B) expanded. C) mitigated. D) decreased. Answer: A Terms: Auditor objectives for sales and cash collections Diff: Moderate Objective: LO 14-1 AACSB: Analytic skills 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. A) True B) False Answer: A Terms: Objective in audit of sales and collection cycle; Account balances fairly presented Diff: Easy Objective: LO 14-1 AACSB: Reflective thinking skills

4) The sales and collection cycle applies to businesses that transfer goods to customers or provides services to businesses. A) True B) False Answer: A Terms: Sales and collection cycle Diff: Moderate Objective: LO 14-1 AACSB: Reflective thinking skills 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: Class of transactions; Sales and collection cycle Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Answer: D Terms: Initiates transaction in sales and collection cycle Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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: Document indicates request for merchandise Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills

4) A ________ is a document that is matched with the customer order to assure that the correct quantity and type of goods are shipped. A) sales order B) customer order C) vendor invoice D) sales invoice Answer: A Terms: Document matched with customer order Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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: Event must take place in order to assure payment Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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; Properly authorized person Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 7) A document prepared to initiate shipment of the goods sold by an independent shipper is the: A) sales order. B) bill of lading. C) sales invoice. D) customer order. Answer: B Terms: Document prepared to initiate shipment of goods Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 9) Generally, when is the earliest point in the sales and collection cycle in which revenue can be recognized? A) When the sale is approved B) When the credit approval process is finalized C) When the cash is collected D) When the goods have been shipped Answer: D Terms: Sales and collection cycle; revenue recognized Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills

12) The total of the individual account balances in the accounts receivable subsidiary ledger 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 subsidiary ledger Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 13) In the accounts receivable subsidiary ledger 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 subsidiary ledger Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 5

16) The document that requires adjustments to the customers subsidiary ledger account is the: A) bill of lading. B) sales invoice. C) credit memo. D) monthly statement. Answer: C Terms: Document that requires adjustment to the customer's account Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 17) A document that initiates shipment of goods and indicates the description of the merchandise, the quantity shipped, and customer name and address is the: A) bill of lading. B) sales invoice. C) picking ticket. D) vendor invoice. Answer: A Terms: Document that initiates shipment of goods Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 18) The ________ is a contract between a carrier (e.g., a trucking company) and the seller of goods that dictates the details surrounding the shipment of goods. A) bill of lading B) sales invoice C) picking ticket D) remittance advice Answer: A Terms: Contract that dictates details for shipment of goods Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 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 internal controls in sales and collection cycle; Credit approval Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 22) When posting items from the sales journal, details of the journal and journal totals are posted to which items? 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 Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 7

23) Credit memos are normally issued to: A) adjust the customers balance to the amount owed to the company because of returned goods or an allowance. B) assist in the aging of accounts receivable. C) reduce customer frustration and sales losses. D) inform the customer of the balance due. Answer: A Terms: Credit memos Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 25) When processing and recording cash receipts, an important fact to consider is: A) the most important concern is depositing cash at least twice daily. B) the most important concern is the possibility of theft. C) theft can occur only after the receipts are entered in the records. D) it the customer fails to include a remittance advice, the check should be returned to the customer. Answer: B Terms: Processing and recording cash receipts Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 26) Sales should be recorded, at the earliest, when: A) the order is received. B) the order is received and credit is approved. C) credit is approved and it is verified that there is enough inventory to fill the order. D) the shipment takes place. Answer: D Terms: Sales recorded Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 8

27) 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 charge off of uncollectible accounts class of transactions. Terms: Documents and class of transactions Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 28) 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 that comprise the sales and collection cycle Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills

29) 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), and • That each shipment is billed for the proper amount (accuracy). Terms: Aspects of billing and related objectives Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 30) 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 related 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 Diff: Challenging Objective: LO 14-2 AACSB: Analytic skills

31) Match seven of the terms for documents and records (a-k) with the descriptions provided below (1-7): a. b. c. d. e. f. g. h. i. j. k.

Customer order form Sales order Bill of lading Sales invoice Summary sales report Accounts receivable master file Monthly statement Remittance advice Prelisting of cash receipts Credit memo 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 Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 32) A sales invoice is a document that usually indicates credit approval. A) True B) False Answer: B Terms: Sales invoice; Credit approval Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 33) Credit should be approved before a customer's order is received. A) True B) False Answer: B Terms: Credit approved Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 34) Credit should be approved before goods are shipped to a customer. A) True B) False Answer: A Terms: Credit approved Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills

35) The receipt of a customer order from a customer is the starting point for the entire sales and collection cycle. A) True B) False Answer: A Terms: Customer order; Starting point for sales and collection cycle Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 36) The preparation of a sales invoice is the final step in the sales and collection cycle. A) True B) False Answer: B Terms: Sales invoice; Final step in sales and collection cycle Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 37) A bill of lading is a special type of sales invoice used when goods are shipped interstate. A) True B) False Answer: B Terms: Bill of lading; Sales invoice Diff: Easy Objective: LO 14-2 AACSB: Reflective thinking skills 38) The shipping point is critical because it is the first point at which company assets are released to another party. A) True B) False Answer: A Terms: Shipping point critical; Assets released Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 39) A bill of lading is a written contract between the seller and the buyer. A) True B) False Answer: B Terms: Bill of lading; Written contract Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills

40) 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. A) True B) False Answer: A Terms: Lockbox system Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 41) 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. A) True B) False Answer: A Terms: Sales and collection cycle Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 42) The prelisting of cash receipts should be prepared by the individual who has primary responsibility for the recording of cash receipts. A) True B) False Answer: B Terms: Prelisting of cash receipts Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills 43) A credit memo is a document used internally that indicates authority to write-off an account receivable as uncollectible. A) True B) False Answer: B Terms: Credit memos Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills

44) If a company uses a periodic inventory system, the shipping records are used to update the inventory quantities. A) True B) False Answer: B Terms: Shipping records and inventory records Diff: Moderate Objective: LO 14-2 AACSB: Analytic skills 45) The sales journal is generated from the sales transaction file. A) True B) False Answer: A Terms: Sales transaction file and sales journal Diff: Moderate Objective: LO 14-2 AACSB: Reflective thinking skills Learning Objective 14-3 1) When designing audit procedures, tracing of source documents to the customers 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; Assertion Diff: Easy Objective: LO 14-3 AACSB: Reflective thinking skills 2) When assessing risk control, 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 internal controls and deficiencies. D) associate the key controls and deficiencies with the objectives. Answer: B Terms: Assess control risk Diff: Easy Objective: LO 14-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 6) When assessing planned control risk for sales: A) the key 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills

7) The document that the accounting staff will use as the primary basis for recording sales transactions and updating the customers accounts receivable subsidiary ledger is the: A) sales order. B) bill of lading. C) sales journal. D) sales invoice. Answer: D Terms: Document used as primary basis for recording sales transactions Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 8) In determining the level of audit efficiency, once the auditor has identified the key internal controls and identified any deficiencies in order to determine the level of control risk appropriate for a private company client, it is appropriate to decide whether: A) substantive tests can be reduced sufficiently to justify costs of performing tests of controls. B) substantive tests can be increased sufficiently to justify costs of performing tests of controls. C) tests of controls can be increased sufficiently to justify costs of performing substantive tests. D) tests of controls can be reduced sufficiently to justify costs of performing substantive tests. Answer: A Terms: Audit efficiency and internal controls Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 17

11) An effective procedure to test for unbilled 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills

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; Unit prices compared with Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 18) Which one of the following best describes the auditors responsibilities regarding appropriate authorizations in the sales/collections cycle? A) B, C, and D should all be of concern to the auditor. B) Credit must be authorized before the sale. C) Goods must be shipped after the authorization. D) Prices must be authorized. Answer: A Terms: Authorizations in sales/collection cycle Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills 19) Which one of the following is of the least concern to the auditor when designing substantive tests of transactions for the sales/collection cycle? A) Sales being included in the journal for which no shipment was made B) Sales to related parties, such as officers and subsidiaries C) Sales recorded more than once D) Shipments being made to nonexistent customers and recorded as sales Answer: B Terms: Substantive tests of transactions for sales/collection cycle Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills 20

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 Diff: Challenging Objective: LO 14-3 AACSB: Analytic skills 21) Which one of the following would the auditor consider to be an incompatible operation if the cashier receives remittances from the mailroom? 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; Separation of duties Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills 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

Answer: A Terms: Point authorization deemed critical Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 21

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 Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 24) 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 at least 2 potential errors (unintentional) and at least 1 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 were recorded as sales. Terms: Substantive audit procedures for tests of transactions for sales; Misstatements; Fraud Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills 25) 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. • 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 Diff: Challenging Objective: LO 14-3 AACSB: Reflective thinking skills

26) When assessing planned control risk for sales, the auditor is concerned about proper authorization at three key points. Discuss each of these three points. Answer: Credit must be properly authorized before a sale takes place; goods should be shipped only after proper authorization; and prices including base terms, freight, and discounts must be properly authorized. Terms: Assessing planned control risk; Proper authorization Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 27) Separation of duties in the sales/collection cycle should mandate that the credit-granting function be separate from the sales function. A) True B) False Answer: A Terms: Separation of duties in the sales/collection cycle; credit-granting function Diff: Easy Objective: LO 14-3 AACSB: Reflective thinking skills 28) Tracing from source documents to the journal is useful for testing the existence objective. A) True B) False Answer: B Terms: Tracing; Existence objective Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 29) In converting from a design format audit program to a performance format audit program, procedures are combined. A) True B) False Answer: B Terms: Design and performance format audit procedures Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 30) Management's assertions for sales and collection activities remain the same whether sales are generated through traditional or e-commerce activities. A) True B) False Answer: A Terms: Management's assertions for sales and collection activities Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 23

31) Misstatements involving the completeness objective for sales lead to overstatements of assets and income. A) True B) False Answer: B Terms: Misstatements involving the completeness objective for sales Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 32) Violations of the existence objective for sales are of greater concern to the auditor than violations of the completeness objective. A) True B) False Answer: A Terms: Violations of the existence objective for sales; violations of the completeness objective Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 33) An effective procedure to test the existence objective for sales is to vouch sales journal entries to copies of sales orders, shipping documents, and sales invoices. A) True B) False Answer: A Terms: Procedure to test the existence objective for sales Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 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. A) True B) False Answer: A Terms: Significant internal control deficiency; Tests of controls Diff: Challenging Objective: LO 14-3 AACSB: Analytic skills

35) The appropriate test of controls for separation of duties are ordinarily restricted to the auditor's observations of activities and discussions with personnel. A) True B) False Answer: A Terms: Test of controls for separation of duties Diff: Moderate Objective: LO 14-3 AACSB: Reflective thinking skills 36) Sales should be billed and recorded as soon as possible after the shipment takes place. A) True B) False Answer: A Terms: Internal control Diff: Moderate Objective: LO 14.2, 14.3, and 14.5 AACSB: Reflective thinking skills Learning Objective 14-4 1) Transaction-related audit objectives are essentially the same for processing credit memos as for sales with certain differences. Which of the following are 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; Credit memos Diff: Challenging Objective: LO 14-4 AACSB: Reflective thinking skills 2) Smith Manufacturing Company's accounts receivable clerk has a friend who is also a Smith's customer. 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 Diff: Moderate Objective: LO 14-4 AACSB: Analytic skills

3) 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 fictitious sales returns and allowances. Terms: Transaction-related audit objectives for credit memos and sales Diff: Challenging Objective: LO 14-4 AACSB: Reflective thinking skills 4) When auditors evaluate sales returns and allowances, a primary emphasis is on the objective of occurrence. A) True B) False Answer: A Terms: Sales returns and allowances; Objective of occurrence Diff: Easy Objective: LO 14-4 AACSB: Reflective thinking skills 5) Sales returns and allowances are often ignored by auditors because they are often immaterial. A) True B) False Answer: A Terms: Sales returns and allowances; Immaterial Diff: Moderate Objective: LO 14-4 AACSB: Reflective thinking skills 6) When auditing sales returns and allowances, the emphasis is normally on testing the completeness objective. A) True B) False Answer: B Terms: Auditing sales returns and allowances; Completeness objective Diff: Moderate Objective: LO 14-4 AACSB: Reflective thinking skills

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: Employee authorized to make customer entries Diff: Moderate Objective: LO 14-5 AACSB: Analytic skills 2) An audit procedure that compares the name, amount, and dates shown on remittance advices, either paper of electronic via direct deposit, with cash receipts journal entries and with related duplicate deposit slips would be effective in detecting: A) kiting. B) lapping. C) illicit write-offs of customers as uncollectible accounts. D) sales without proper credit authorization. Answer: B Terms: Audit procedure compares names with cash receipts journal entries Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills

3) To prevent fraud, management should deny cash access to anyone responsible for: A) Opening mail from Entering sales Entering cash receipts customers transactions transactions Yes Yes Yes B) Opening mail from customers No

Entering sales transactions No

Entering cash receipts transactions Yes

Opening mail from customers No

Entering sales transactions Yes

Entering cash receipts transactions Yes

Opening mail from customers Yes

Entering sales transactions No

Entering cash receipts transactions No

Answer: C Terms: Fraud; Cash access Diff: Moderate Objective: LO 14.2, 14.3, and 14.5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 14-5 AACSB: Analytic skills

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 Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills 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 is 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 Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 14-5 AACSB: Reflective thinking skills

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) Segregate duties so that the bookkeeper in charge of the general ledger has no access to incoming mail. B) Segregate duties so that no employee has access to both checks from customers and currency from daily cash receipts. C) Have customers send payments directly to the company's depository bank. D) Request that customer's payment checks be made payable to the company and addressed to the treasurer. Answer: C Terms: Prevent lapping problem Diff: Challenging Objective: LO 14-5 AACSB: Reflective thinking skills 9) Preparation of a proof of cash would not be useful in discovering differences between the actual and reported cash balances if the differences were due to: A) deposits in transit. B) collections on the company's behalf by the bank which are deposited directly to the company's account. C) cash receipts that were not recorded in the relevant accounting records. D) service charges. Answer: C Terms: Proof of cash Diff: Challenging Objective: LO 14-5 AACSB: Analytic skills 10) The completeness transaction-related audit objective must be considered when determining key controls for for sales. List three 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 or other applicable reports, and (4) are statements sent to customers each month. Terms: Completeness assertion for cash receipts and existing controls Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills

11) 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 from 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 segregation of duties and a mandatory vacation policy for employees who hand 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 time-consuming, it is ordinarily performed only when specific concerns with embezzlement exist because of a deficiency in internal control. Terms: Lapping; Internal control deficiency Diff: Challenging Objective: LO 14-5 AACSB: Reflective thinking skills 12) You are part of the audit team that is auditing Hillsburg Hardware Co. and you have been assigned to the sales and collection business process. You are testing whether the cash received has been recorded in the cash receipts journal. (completeness objective /assertion). List two tests of controls and at least one test of transactions that you would do to satisfy yourself regarding the completeness assertion. Answer: Control Tests: 1. Observe prelisting of cash receipts. 2. Observe endorsement of incoming checks. 3. Examine file of batch totals to initials of data control clerk. 4. Observe whether monthly statements are sent. Transaction Tests: 1. Trace amounts of prelisted cash receipts to the cash receipts journal, testing for names, amounts, dates. 2. Compare the prelisting with the duplicate deposit slip. Terms: Sales and collection business process; Tests of controls and test of transactions for completeness objective/assertion Diff: Challenging Objective: LO 14-5 AACSB: Reflective thinking skills

13) In planning the audit, an auditor takes 3 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 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 Diff: Challenging Objective: LO 14-5 AACSB: Reflective thinking skills 14) 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. A) True B) False Answer: A Terms: Cash embezzlement Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills 15) An essential part of the auditors responsibility in auditing cash receipts is to identify deficiencies in internal control that increase the likelihood of fraud. A) True B) False Answer: A Terms: Cash receipts from sales on account; Misappropriated; Fraud Diff: Moderate Objective: LO 14-5 AACSB: Reflective thinking skills 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 offs 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 Diff: Challenging Objective: LO 14-6 AACSB: Reflective thinking skills 32

2) The estimation of bad debts expense relates to the write-off of uncollectible accounts. A) True B) False Answer: A Terms: Audit test for write-off of uncollectible accounts Diff: Easy Objective: LO 14-6 AACSB: Reflective thinking skills 3) There should generally be correspondence in the client's file establishing the uncollectibility of their account. A) True B) False Answer: A Terms: Audit test for write-off of uncollectible accounts Diff: Easy Objective: LO 14-6 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 15 Audit Sampling for Tests of Controls and Substantive Tests of Transactions 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills

4) One of the causes of nonsampling risk is: A) improper supervision and instruction of the client's employees. B) ineffective audit procedures. C) inadequate sample size. D) exceptions being found in the sample. Answer: B Terms: Nonsampling risk Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 5) 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) The use of random sampling Answer: B Terms: Correct regarding sampling risk Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 6) 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

Designing the sampling process Yes

Designing the sample selection No

Designing the sampling process No

Designing the sample selection Yes

Answer: A Terms: Increase likelihood that sample is representative Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills

7) 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 8) 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills

9) Sampling risk may be controlled by: A) Adjusting the sample size Yes

Using an appropriate method of selecting sample items Yes

Adjusting the sample size No

Using an appropriate method of selecting sample items No

Adjusting the sample size Yes

Using an appropriate method of selecting sample items No

Adjusting the sample size No

Using an appropriate method of selecting sample items Yes

Answer: A Terms: Sampling risk controlled by Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 10) 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills

11) Briefly explain why auditors utilize audit sampling. Answer: Auditors use sampling techniques primarily because it is generally impractical to audit all transactions or balances. Consequently, auditors must design strategies to select items from the population that are likely to be representative of the remaining unaudited population items. In addition, auditors often use sampling techniques because of economic realities. That is, clients generally do not want to incur the substantial fees associated with auditing every transaction or balance. Terms: Audit sampling Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 12) 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. Terms: Sampling and nonsampling risks Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 13) 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 Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 14) 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. The auditor can control nonsampling risk through careful design of audit procedures and through proper instruction, supervision, and review. Terms: Nonsampling risk Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills

15) Sampling risk results from the auditor's failure to recognize exceptions in transaction data. A) True B) False Answer: B Terms: Sampling risk Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 16) If an auditor does a test in the wrong direction, sampling risk will increase. A) True B) False Answer: B Terms: Nonsampling risk Diff: Easy Objective: LO 15-1 AACSB: Reflective thinking skills 17) 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. A) True B) False Answer: A Terms: Sample considered to be representative Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 18) In practice, auditors do not know whether a sample is representative, even after all testing is complete. A) True B) False Answer: A Terms: Representative sample Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 19) One way to control sampling risk is to increase sample size. A) True B) False Answer: A Terms: Control sampling risk is with sample size Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 6

20) A sample of all items in a population will have a zero sampling risk. A) True B) False Answer: A Terms: Sample of all items in a population will have zero sampling risk Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 21) It is virtually impossible to reduce sampling risk to zero. A) True B) False Answer: A Terms: Sampling risk Diff: Moderate Objective: LO 15-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-2 AACSB: Reflective thinking skills 2) 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 Diff: Easy Objective: LO 15-2 AACSB: Reflective thinking skills

3) Which of the following statements is most correct with 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. Answer: C Terms: Quantification of sampling risk Diff: Easy Objective: LO 15-2 AACSB: Reflective thinking skills 4) 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 non-probabilistic sample results Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 5) Which of the following statements is a valid criticism of nonstatistical sampling? A) Many audit tests, such as footing of journals, must be performed outside a statistical sampling context. B) The cost of performing random selection or testing often exceeds the benefits. C) Nonstatistical sampling does not differ substantially from statistical sampling methods. D) Conclusions may be drawn in more precise ways when using statistical sampling methods. Answer: D Terms: Criticism of non-statistical sampling Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills

6) 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 methods are acceptable and commonly used. Answer: B Terms: Probabilistic and non-probabilistic sample selection Diff: Challenging Objective: LO 15-2 AACSB: Reflective thinking skills 7) Nonprobabilistic selection methods are not based on mathematical probabilities; therefore: A) the extent to which a sample is representative of the population may be difficult to determine. B) they are discouraged by the AICPA. C) they are not allowed by the Statements on Auditing Standards. D) they are not as effective as statistical sampling. Answer: A Terms: Non-probabilistic selection methods Diff: Challenging Objective: LO 15-2 AACSB: Reflective thinking skills 8) An advantage of using statistical sampling techniques is that such techniques: A) mathematically measure 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 Diff: Challenging Objective: LO 15-2 AACSB: Reflective thinking skills 9) 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 Diff: Challenging Objective: LO 15-2 AACSB: Reflective thinking skills

10) Which of the following statements best expresses the impact that the performance of audit procedures has on statistical vs. nonstatistical sampling? A) Audit procedures on the sample item will vary as a result of using either statistical or nonstatistical sampling. B) The audit procedures will be the same for either statistical or nonstatistical sampling but they must be performed differently for each. C) Statistical sampling requires quantitative audit procedures, whereas nonstatistical sampling requires judgmental audit procedures. D) Audit procedures on the sample item will not vary as a result of using either statistical or nonstatistical sampling. Answer: D Terms: Statistical and nonstatistical sampling Diff: Challenging Objective: LO 15-2 AACSB: Reflective thinking skills 11) 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 non-probabilistic sampling can be used for the former but not the latter. 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 Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 12) You are designing the audit plan for Mathews & Company. You are a strong proponent for statistical sampling over nonstatistical sampling. Make your case. Answer: • More efficient samples • Quantifies sampling risk • Improved correlation between the sample and the population Terms: Statistical sampling vs. nonstatistical sampling Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 13) It is equally acceptable under professional auditing standards for auditors to use either statistical or nonstatistical sampling methods. A) True B) False Answer: A Terms: Equally acceptable to use statistical or nonstatistical sampling methods Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 10

14) When using nonstatistical sampling, the sample must be a probabilistic one. A) True B) False Answer: B Terms: Nonstatistical sampling; sample must be probabilistic Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 15) The use of haphazard sample selection is encouraged under professional auditing standards. A) True B) False Answer: B Terms: Haphazard sample selection Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 16) Directed sample selection, block sample selection, and haphazard sample selection are three types of probabilistic sample selection methods. A) True B) False Answer: B Terms: Probabilistic sample selections; Directed sample selection, block sample selection and haphazard selections Diff: Moderate Objective: LO 15-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-3 AACSB: Reflective thinking skills

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 selection of items generators Generalized audit 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

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 Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills

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: Random number tables Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-3 AACSB: Reflective thinking skills 13) 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. Generally, systematic samples are easily drawn from the population and supporting documentation is easily developed. The key disadvantage is the potential for bias. Once the first item in the sample is selected, all other items are chosen automatically. Auditors should be careful to consider any potential pattern in the data prior to selecting their sample to ensure that their selection considers the possible bias. Terms: Systematic sample selection Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 15

14) 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 constituting 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 Diff: Challenging Objective: LO 15-3 AACSB: Reflective thinking skills 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. A) True B) False Answer: A Terms: Selecting same with random numbers Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 16) Although systematic sample selection is easy to use, its primary disadvantage is that it is not a probabilistic sampling method. A) True B) False Answer: B Terms: Systematic sample selection; probabilistic sampling method Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills

17) Nonprobabilistic sampling methods are not based on mathematical probabilities and therefore the representativeness of the sample may be difficult to determine. A) True B) False Answer: A Terms: Nonprobabilistic selection methods Diff: Moderate Objective: LO 15-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 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) CUER cannot be considered in the context of specific audit objectives. Answer: A Terms: Sample exception rate Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 17

4) Which of the following is most correct when using audit sampling for exception rates? A) Auditor is concerned with the lowest rate. B) Auditor is concerned with the highest rate. C) Auditor is concerned with the average on previous audits. D) This doesn't impact the auditor's decision. Answer: B Terms: Auditing sampling for exception rates Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 5) The highest estimated exception rate in the population at a particular acceptable risk of assessing control risk too low is: A) the upper exception rate. B) estimated population exception rate. C) the computed upper exception rate. D) the tolerable exception rate. Answer: C Terms: Highest estimated exception rate in population; Acceptable risk of assessing control risk too low Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 6) You are determining the significance of the following: you set a 5% risk of assessing control risk to low and your computation of the upper deviation risk is 7%. What could you conclude? A) There is a 95% chance the deviation rate is 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 Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 7) 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 Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 18

8) If the auditor concludes that the CUER is 5% at a 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%. A) True B) False Answer: A Terms: Estimated population exception rate Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills 9) The upper limit of the interval estimate is also known as the confidence interval. A) True B) False Answer: B Terms: Computed upper exception rate (CUER) Diff: Moderate Objective: LO 15-4 AACSB: Reflective thinking skills Learning Objective 15-5 1) The risk which the auditor is willing to take in accepting a control as being effective when the true population exception rate is greater than a tolerable 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 Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills 2) The exception rate the auditor will permit in the population and still be willing to reduce the assessed level of control risk is called 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 Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 15-5 AACSB: Analytic skills 4) When the computed upper exception rate is greater than the tolerable exception rate, 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. D) Write a letter to management which outlines the control deficiencies. Answer: A Terms: Computed upper exception rate is greater than tolerable exception rate Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills 6) Which of the following represents the best description of the tolerable exception? 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 EPER Answer: A Terms: Tolerable exception rate Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 20

7) When analyzing exceptions, the auditor should keep in mind that: A) all exceptions must be reported to management. B) they should determine the breakdown in the 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 Diff: Moderate Objective: LO 15-5 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 9) Auditors often use the ________ to determine the estimated population exception rate. A) current year's audit results B) tolerable exception rate C) preceeding year's audit results D) estimated computed by management Answer: A Terms: Estimate of population exception rate Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 12) In testing controls, an overreliance on internal controls that reduces substantive tests and increases the likelihood of not detecting a material misstatement occurs because: A) true deviation in the population was less than the sample. B) true deviation in the population was greater than the sample. C) auditor judgment was flawed. D) it is inherent in the audit risk model. Answer: B Terms: Testing controls; Overreliance on internal controls Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills

21) A danger in setting the acceptable risk of overreliance too low is: A) The risk that the auditor is willing to The risk that the auditor is willing 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 to The risk that the auditor is willing 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 to The risk that the auditor is willing 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 to The risk that the auditor is willing 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills

23) Whenever auditors use sampling, they risk making incorrect conclusions about the population. The risk that the auditor concludes that controls are nore 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 Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills 25) The difference between the tolerable exception rate and the estimated population exception rate is called: A) accuracy of the initial sample estimate. B) inflation factor of the initial sample estimate. C) precision of the initial sample estimate. D) reliability of the initial sample estimate. Answer: C Terms: Difference between tolerable exception and estimated population exception rate Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-1 and LO 15-5 AACSB: Reflective thinking skills

29) An auditor plans to examine a sample of 40 canceled checks for a countersignature which is prescribed in the client's control procedures manual. Two of the checks in sample cannot be located by the company or the auditor. The auditor would most likely: A) treat the missing checks as a deviation when evaluating the results of the sample. B) draw a conclusion on a sample size of 38. C) substitute two more checks to get to a sample size of 40. D) recalculate the sample excluding the original 40 checks. Answer: A Terms: Missing canceled checks in population Diff: Challenging Objective: LO 15-4 and LO 15-5 AACSB: Analytic skills Topic: Public 30) 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 Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills 31) 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 Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 32) The auditor must use the same TER and ARO levels for all attributes of an audit test. A) True B) False Answer: B Terms: Acceptable risk of overreliance Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 28

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. A) True B) False Answer: A Terms: Tolerable exception rate Diff: Easy Objective: LO 15-5 AACSB: Reflective thinking skills 34) The only way to know with certainty whether a sample is representative is to subsequently audit the entire population. A) True B) False Answer: A Terms: Know with certainty whether sample is representative is to audit entire population Diff: Moderate Objective: LO 15-1 and LO 15-5 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Acceptable risk of overreliance Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 36) Acceptable risk of overreliance is normally lower for a public company audit than a private company audit. A) True B) False Answer: A Terms: Acceptable risk of overreliance Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills Topic: Public

37) The conjoined sample exception rate is the auditor's "best estimate" of the actual exception rate in the entire population. A) True B) False Answer: B Terms: Sample exception rate Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 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. A) True B) False Answer: A Terms: Sample exception rate and tolerable exception rate Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 39) Tolerable exception rate (TER) is inversely related to sample size. A) True B) False Answer: A Terms: Tolerable exception rate and sample size relationship Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills 40) When the SER exceeds the TER, the auditor should decide whether to increase sample size or to revise assessed control risk on the basis of cost versus benefit. A) True B) False Answer: B Terms: Control risk assessment Diff: Moderate Objective: LO 15-5 AACSB: Reflective thinking skills

41) In nonstatistical sampling, the calculated sampling error is the difference between the tolerable exception rate and the sample exception rate. A) True B) False Answer: A Terms: Nonstatistical sampling; Calculated sampling error; Difference between tolerable exception rate and sample exception rate Diff: Challenging Objective: LO 15-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 15-6 AACSB: Analytic skills 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 Diff: Easy Objective: LO 15-6 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 15-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 and LO 15-7 AACSB: Reflective thinking skills

5) Match eight of the terms (a-k) with the definitions provided below (1-8): a. Haphazard selection b. Attributes sampling c. Block sample selection d. Judgmental sampling e. Non-probabilistic sample selection f. Probabilistic sample selection g. Random sample h. Representative sample i. Statistical sampling j. Systematic sample selection k. Sampling distribution ________ 1. The use of mathematical measurement techniques to calculate formal statistical results and quantify sampling risk. ________ 2. A non-probabilistic method of sample selection in which items are selected in measured sequences. ________ 3. A sample whose characteristics are the same as those of the population. ________ 4. A statistical, probabilistic method of sample evaluation that results in an estimate of the proportion of items in a population containing a characteristic of interest. ________ 5. A non-probabilistic method of sample selection in which items are chosen without regard to their size, source, or other distinguishing characteristics. ________ 6. An auditor selects items such that each population item has a known probability of being included in the sample. ________ 7. A frequency distribution of the results of all possible samples of a specified size that could be obtained from a population containing some specific parameters. ________ 8. A sample in which every possible combination of elements in the population has an equal chance of constituting the sample.

Answer: 1. i 2. c 3. h 4. b 5. a 6. f 7. k 8. g Terms: Haphazard selection; Attributes sampling; Block sample selection; Probabilistic sample selection; Random sample; Representative sample; Statistical sampling; Sampling distribution Diff: Moderate Objective: LO 15-1, LO 15-2, LO 15-3, LO 15-5, and LO 15-6 AACSB: Reflective thinking skills Learning Objective 15-7 1) A principal advantage of statistical methods of attributes sampling over nonstatistical methods is that they provide a scientific 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 Diff: Moderate Objective: LO 15-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-7 AACSB: Reflective thinking skills

3) When audit procedures have been completed for an attributes sampling application, the auditor must generalize from the sample to the population. Which of the following statements would be incorrect regarding this process? A) The auditor would use an attributes sampling table to determine the computed upper exception rate. B) If the sample size is not equal to those provided for in the attributes sampling evaluation tables, the auditor cannot use attribute sampling. C) It would be wrong for the auditor to conclude that the population exception rate is exactly the same as the sample exception rate. D) In selecting the table corresponding to the ARO, it should be the same as the ARO used for determining the initial sample size. Answer: B Terms: Attributes sampling application Diff: Challenging Objective: LO 15-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 15-7 AACSB: Reflective thinking skills 5) In the evaluation of the results of an attributes sample, the fact that the exception rate in the sample was 2% rather than the estimated population exception rate of 4% would cause the computed upper exception rate to: A) be less than the tolerable exception rate. B) equal the tolerable exception rate. C) exceed the tolerable exception rate. D) cannot be determined from the information given. Answer: A Terms: Attributes sample; Exception rate in sample, estimated population exception rate, and computed upper exception rate Diff: Challenging Objective: LO 15-7 AACSB: Reflective thinking skills

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 will have the least effect on sample size. Answer: A Terms: Attributes sampling Diff: Moderate Objective: LO 15-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 15-5 and LO 15-7 AACSB: Reflective thinking skills 8) 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 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. 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 Diff: Challenging Objective: LO 15-7 AACSB: Reflective thinking skills

9) 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. In the planning section there are 9 steps, beginning with "state the audit objective" and ending with "determine the initial sample size." Name and discuss at least 3 steps between the ones listed above. Answer: The steps that comprise the "plan the sample" section in attributes sampling are: 1. State the objectives of the audit test. Typically, in attributes sampling, the overall objective is to test the application of controls and determine whether transactions contain monetary misstatements. 2. Decide whether audit sampling applies. Audit procedures involving documentation normally can be performed using sampling, whereas procedures involving observation, inquiry of the client, and analytical procedures are not suited to audit sampling. 3. Define attributes and exception conditions. In this step, the auditor carefully defines the attributes of interest and the conditions that constitute exceptions or errors. 4. Define the population. The population is the body of data about which the auditor wished to generalize, from which the sample must be drawn. 5. Define the sampling unit. In attributes sampling, the sampling unit is normally a document, identified by document numbers, or a transaction recorded in a journal. 6. Specify tolerable exception rate. This is the exception rate that the auditor will permit in the population and still be willing to rely on internal controls. 7. Specify acceptable risk of overreliance. This 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 tolerable exception rate. 8. Estimate the population exception rate. This is the exception rate the auditor expects to find in the population before testing begins. 9. Determine the initial sample size. The initial sample size is determined from tables, based on values for the tolerable exception rate, acceptable risk of assessing control risk too low, and the estimated exception rate. Terms: Steps in Plan the sample in attributes sampling Diff: Challenging Objective: LO 15-7 AACSB: Reflective thinking skills 10) Statistical sampling eliminates any professional judgment for the auditor. A) True B) False Answer: B Terms: Statistical sampling and professional judgment Diff: Moderate Objective: LO 15-7 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 16 Completing the Tests in the Sales and Collection Cycle: Accounts Receivable 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 Diff: Easy Objective: LO 16-1 AACSB: Reflective thinking skills 2) The appropriate and sufficient evidence to be obtained from tests of details must be decided on an: A) efficiency basis. B) effectiveness basis. C) audit objectives basis. D) none of the above. Answer: C Terms: Tests of details Diff: Easy Objective: LO 16-1 AACSB: Reflective thinking skills 3) Auditors are especially concerned with three aspects 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 Diff: Easy Objective: LO 16-1 AACSB: Reflective thinking skills

4) For sales, the occurrence transaction-related audit objective affects which of the following balance-related audit objective? A) Existence B) Completeness C) Rights D) Detail tie-in Answer: A Terms: Sales transaction-related audit objective Diff: Moderate Objective: LO 16-1 AACSB: Reflective thinking skills 5) For cash receipts, the occurrence transaction-related audit objective affects which of the following balance-related audit objective? A) Existence B) Completeness C) Rights D) Detail tie-in Answer: B Terms: Cash receipts transaction-related objective Diff: Moderate Objective: LO 16-1 AACSB: Reflective thinking skills 6) For sales, the completeness transaction-related audit objective affects the existence balancerelated audit objective. A) True B) False Answer: B Terms: Completeness transaction-related audit objective; Existence balance-related audit objective Diff: Moderate Objective: LO 16-1 AACSB: Reflective thinking skills 7) Recording a sale that did not occur violates the occurrence transaction-related audit objective and the existence balance-related audit objective. A) True B) False Answer: A Terms: Cash receipts; Occurrence transaction-related audit objective; existence balance-related audit objective Diff: Moderate Objective: LO 16-1 AACSB: Reflective thinking skills

8) The accounts receivable balance-related audit objective net realizable value is not affected by assessed control risk for sales or cash receipts. A) True B) False Answer: A Terms: Accounts receivable balance-related audit objective net realizable value; Assessed control risk Diff: Moderate Objective: LO 16-1 AACSB: Reflective thinking skills 9) The results of the tests of controls determine whether assessed control risk for sales and cash receipts needs to be revised. A) True B) False Answer: A Terms: Tests of controls and control risk Diff: Easy Objective: LO 16-1 AACSB: Reflective thinking skills 10) 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. A) True B) False Answer: B Terms: Tests of controls and substantive tests of transactions Diff: Easy Objective: LO 16-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 16-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-2 AACSB: Analytic skills

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 Diff: Challenging Objective: LO 16-2 AACSB: Analytic skills 6) 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 sales from previous years c. compare sales returns and allowances as a percentage of gross sales with previous years Terms: Analytical procedures; Sales and collection cycle Diff: Moderate Objective: LO 16-2 AACSB: Analytic skills 7) Favorable results from analytical procedures may reduce the extent to which the auditor needs to test details of balances. A) True B) False Answer: A Terms: Analytical procedures; Test details of balances Diff: Easy Objective: LO 16-2 AACSB: Reflective thinking skills

8) When analytical procedures in the sales and collection cycle uncover unusual fluctuations, the auditor should make additional inquiries of management. A) True B) False Answer: A Terms: Analytical procedures; Sales and collection cycle Diff: Easy Objective: LO 16-2 AACSB: Reflective thinking skills 9) A high inherent risk increases planned detection risk and decreases planned substantive tests. A) True B) False Answer: B Terms: Analytical procedures Diff: Moderate Objective: LO 16-2 AACSB: Reflective thinking skills Learning Objective 16-3 1) The understatement of sales and accounts receivable is best uncovered by: A) testing 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 Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills

3) A listing of the balances in the accounts receivable master file at the balance sheet date, by total balance outstanding and by the amount of time the component parts have been outstanding, 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 master file Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills

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 objective? A) Realizable value B) Accuracy C) Cutoff D) Existence Answer: C Terms: Audit procedures to uncover credit sales Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills

6) Cutoff misstatements occur when: A) The auditor fails to obtain the end-of-year bank statement directly from the Subsequent period bank, obtaining instead the transactions are statement which includes recorded in the the two succeeding weeks current period Yes Yes

Current period transactions are recorded in the subsequent period No

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

Subsequent period transactions are recorded in the current period No

Current period transactions are recorded in the subsequent period 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

Subsequent period transactions are recorded in the current period Yes

Current period transactions are recorded in the subsequent period Yes

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

Subsequent period transactions are recorded in the current period Yes

Current period transactions are recorded in the subsequent period No

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

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 Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 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 master file amounts, and the total is correctly added and agrees with the general ledger. C) Accounts receivable are owned. D) Existing accounts receivable are included. Answer: B Terms: Tests of details for accounts receivable Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 9) An auditor is performing a credit analysis of customers with balances over 60 days due. She 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 10

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 master file B) Customer file C) Aged trial balance D) Sales register Answer: C Terms: Central role in auditing accounts receivable Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 13) Most tests of accounts receivable are based on what schedule, file, or listing? A) Sales master file B) Aged accounts receivable trial balance C) Accounts receivable master file D) Accounts receivable general ledger account Answer: B Terms: Tests of accounts receivable Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 14) If the client's 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 11

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 Diff: Moderate Objective: LO 16-3 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 12

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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 20) Which of the following audit procedure 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 13

21) Generally accepted accounting principles require that revenue be reported net of sales returns and allowances: 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Analytic skills

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

Inquiries of the client No

Review minutes from board of directors meetings Yes

Inquiries of the client No

Review minutes from board of directors meetings No

Inquiries of the client Yes

Answer: A Terms: Limited rights to accounts receivable Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 16-3 AACSB: Analytic skills

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 bank deposits on the bank statement of a different period. Answer: D Terms: Test for cash receipts cutoff Diff: Challenging Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-3 AACSB: Analytic skills 28) For effective 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 Diff: Challenging Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills

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 or II Answer: C Terms: Accounts receivable; Realizable value Diff: Moderate Objective: LO 16-3 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 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: Revenue recognition Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 17

34) 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 Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 35) 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 Diff: Moderate Objective: LO 16-3 AACSB: Analytic skills 36) 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 are footed, and the total is compared to the general ledger. In addition, a sample of individual balances on the aged trial balance should be traced to supporting documents 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 master file. Terms: Audit objectives for accounts receivable Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills

37) Assuming the client's internal controls are adequate, describe how the auditor can verify proper cutoff of sales transactions. Answer: Assuming the client's internal controls are adequate, 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 internal controls; Cutoff of sales transactions Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 38) Tests of detail tie-in are normally conducted last in the audit of the sales and collections cycle. A) True B) False Answer: B Terms: Tests of detail tie-in; Sales and collections cycle Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 39) The criterion used by most merchandising and manufacturing clients for determining when revenue recognition takes place is whether title to the goods has passed. A) True B) False Answer: B Terms: Revenue recognition Diff: Easy Objective: LO 16-3 AACSB: Reflective thinking skills 40) The balance-related audit objectives of realizable value and rights are not affected by assessed control risk. A) True B) False Answer: A Terms: Balance-related audit objectives; Realizable value and rights; Assessed control risk Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills

41) Tests of the presentation and disclosure-related objectives are generally done as part of the completion phase of the audit. A) True B) False Answer: A Terms: Tests of presentation and disclosure-related objectives; Completion phase of audit Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 42) Confirmation is the most common test of details of balances for the accuracy of accounts receivable. A) True B) False Answer: A Terms: Confirmation; Test of details of balances Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 43) Tests of the realizable value balance-related audit objective are for the purpose of evaluating the allowance for doubtful accounts. A) True B) False Answer: A Terms: Tests of realizable value balance-related audit objective Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills 44) 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. A) True B) False Answer: A Terms: Cash receipts cutoff; Sales or sales returns and allowances cutoff Diff: Moderate Objective: LO 16-3 AACSB: Reflective thinking skills

Learning Objective 16-4 1) Which of the following is the principle "weakness" of using negative confirmations for your tests of details of balances for accounts receivable? A) They can only be used for large balance accounts. B) They cannot not 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 Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 21

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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 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 customer's purchase order and the duplicate sales invoice to determine that the merchandise was ordered. Answer: A Terms: Positive confirmations follow-up procedures Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 22

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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 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) collectability of the receivables is in doubt. D) pledging of the receivables is probable. Answer: A Terms: Auditor perform alternative procedures to substantiate existence of accounts receivable Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 12) If the auditor decides not to confirm accounts receivable, 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 23

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 Diff: Challenging Objective: LO 16-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 16-4 AACSB: Reflective thinking skills 15) Confirmation of accounts receivable provide evidence related to the existence, accuracy and cutoff objectives. A) True B) False Answer: A Terms: Confirmation of accounts receivable; Existence, accuracy, and cutoff objectives Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 16) Auditing standards require the confirmation of accounts receivable in normal circumstances. What are the two exceptions to this requirement? Answer: The two exceptions are: 1. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. 2. 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 Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 24

17) Describe the differences between positive and negative confirmations. Which type is generally viewed as more reliable? Answer: A positive confirmation requests the recipient to respond regardless of whether the balance as stated on the confirmation is correct or incorrect. In contrast, a negative confirmation requests the recipient to respond only if the balance as stated on the confirmation is incorrect. 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 Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 18) 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 after the confirmation date includes examining remittance advices and entries in the cash receipts records. • Duplicate sales invoices-useful to verify the actual issuance of a sales invoice and the actual date of the billing • Shipping documents-used to establish whether the shipment was made and as a test of cutoff • Correspondence with the client-used to disclose disputed and questionable receivables not uncovered by other means Terms: Alternative procedures; Existence objective for accounts receivable; Confirmation requests Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 19) 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 no responses. 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 Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills

20) 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 confirmation requests Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 21) 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. • Blank confirmation is a type of positive confirmation that does not state the amount, but requests the recipient to fill in the balance or furnish other information. • 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 responses only if the information is incorrect. Terms: Positive confirmation; Blank confirmation; Invoice confirmation; Negative confirmation Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills

22) 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 Diff: Challenging Objective: LO 16-4 AACSB: Reflective thinking skills 23) 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 internal controls • substantive tests of transactions • analytical procedures as evidence of the fairness of accounts receivable, and • assumes that the large majority of recipients will provide a conscientious reading and response to the confirmation request Terms: Negative confirmations Diff: Challenging Objective: LO 16-4 AACSB: Reflective thinking skills 24) A confirmation is a type of audit evidence. A) True B) False Answer: A Terms: Confirmation of accounts receivable balances Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 25) Tests of details of balances focus on testing the year-end balances of balance sheet accounts. A) True B) False Answer: A Terms: Tests of details of balances Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills

26) Both U.S. and international auditing standards require the use of confirmations for accounts receivable. A) True B) False Answer: B Terms: Accounts receivable confirmed Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 27) Blank confirmations are considered less reliable than standard positive confirmations. A) True B) False Answer: B Terms: Blank confirmations; Standard positive confirmations Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 28) Negative confirmations are less expensive, and less reliable, than positive confirmations. A) True B) False Answer: A Terms: Negative confirmations; Positive confirmations Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 29) 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. A) True B) False Answer: B Terms: Positive confirmations; Negative confirmations Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 30) If auditors consider confirmations of accounts receivable to be ineffective evidence because response rates will be very low, they need not confirm accounts receivable. A) True B) False Answer: A Terms: Confirmations of accounts receivable Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 28

31) Negative confirmations normally require a larger sample size than positive confirmations. A) True B) False Answer: A Terms: Negative confirmations; Positive confirmations Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 32) When sending confirmations during most audits of accounts receivable, the emphasis is often on confirming larger and older accounts. A) True B) False Answer: A Terms: Confirmations of accounts receivable Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 33) When a customer disagrees with the amount shown on an account receivable confirmation, the auditor should not ask the client to reconcile the difference. A) True B) False Answer: B Terms: Accounts receivable confirmation Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 34) Auditors must maintain control of confirmations until they are returned from the customer. A) True B) False Answer: A Terms: Control of confirmations Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 35) When a customer does not return an accounts receivable confirmation, it is acceptable, without performing alternative procedures, to assume the amount is 100% overstated when generalizing from the sample to the population. A) True B) False Answer: A Terms: Alternative procedures; Accounts receivable confirmation Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills 29

36) Stratification of accounts receivable is desirable when using confirmations. A) True B) False Answer: A Terms: Stratification of accounts receivable Diff: Easy Objective: LO 16-4 AACSB: Reflective thinking skills 37) Each client misstatement in accounts receivable must be analyzed to determine whether it was consistent with the original assessed level of control risk. A) True B) False Answer: A Terms: Alternative procedures; Accounts receivable confirmation Diff: Moderate Objective: LO 16-4 AACSB: Reflective thinking skills

Learning Objective 16-5 1) 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.

Accounts receivable balance-related audit objectives Aged trial balance Alternative procedures Blank confirmation form Cutoff misstatements Evidence planning worksheet Negative confirmation Positive confirmation Realizable value of accounts receivable Timing difference in an account receivable confirmation 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 and is collectible. ________ 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 form used to help the auditor decide whether planned detection risk for tests of details of balances should be low, medium, or high for each balance-related audit objective. ________ 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 master file 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. f 5. g 6. j 7. b Terms: Alternative procedures; Positive and negative confirmations; Aged trial balance; Cutoff misstatements; Evidence planning worksheet; Timing difference; Accounts receivable confirmation Diff: Moderate Objective: LO 16-3, LO 16-4, and LO 16-5 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 17 Audit Sampling for Tests of Details of Balances 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 Diff: Easy Objective: LO 17-1 AACSB: Reflective thinking skills

2) Tests for rates of occurrence are appropriately used in all but which of the following situations? A) Testing of internal Substantive testing of Substantive testing of controls transactions details of balances Yes Yes Yes B) Testing of internal controls No

Substantive testing of transactions Yes

Substantive testing of details of balances Yes

Testing of internal controls Yes

Substantive testing of transactions Yes

Substantive testing of details of balances No

Testing of internal controls No

Substantive testing of transactions No

Substantive testing of details of balances Yes

Answer: C Terms: Tests for rates of occurrence Diff: Easy Objective: LO 17-1 AACSB: Reflective thinking skills 3) 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 effectiveness of internal controls. In substantive tests of transactions, the auditor is concerned about both the effectiveness 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 Diff: Moderate Objective: LO 17-1 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills 2) The auditors 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 Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 5

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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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) Acceptable audit risk Answer: B Terms: Not considered in determining initial sample size of test of details Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 10) If an auditor concludes that 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 internal controls are effective; Reduction of preliminary assessment of control risk; Impact on acceptable risk of incorrect acceptance Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 6

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 Diff: Moderate Objective: LO 17-2 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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: Risk 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 misstatement. percent. Yes Yes B) The dollar difference between the point estimate and tolerable misstatement. No

The extent to which items in the population have been audited 100 percent. No

C) The dollar difference between the point estimate and tolerable misstatement. Yes

The extent to which items in the population have been audited 100 percent. No

D) The dollar difference between the point estimate and tolerable misstatement. No

The extent to which items in the population have been audited 100 percent. Yes

Answer: A Terms: Nonstatistical sampling; Auditor subjectively consider possibility of true population misstatements Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 8

17) The appropriate assumption to make regarding the overall percent of error in those population items containing an error is: A) determined using random number tables. B) set after a quantitative analysis of client's internal control system. C) based on the auditor's personal judgment in the circumstances. D) based on statistical analysis using confidence limits. Answer: C Terms: Assumption made regarding overall percent of error in population Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 18) When errors are found in a sample, auditors in practice generally make the assumption: A) of a 100% assumption for all errors. 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills

19) Which of the following needs to be considered when the auditor generalizes from the sample to the population? A) Acceptable risk of incorrect acceptance Sampling error Yes Yes B) Acceptable risk of incorrect acceptance No

Sampling error No

Acceptable risk of incorrect acceptance Yes

Sampling error No

Acceptable risk of incorrect acceptance No

Sampling error Yes

Answer: A Terms: Factors considered when auditor generalizes from sample to populations Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 20) The client's trial balance has a balance of $410,000 for merchandise inventory. As the auditor you are willing to accept a balance that is within $20,000 of either side of the recorded balance. You compute a 95% confidence interval of $395,000 to $425,000. You could therefore: A) reject the trial balance amount. B) accept the trial balance amount. C) increase the sample size to assure more precision. D) use alternative audit procedures to satisfy yourself as to the correct balance. Answer: B Terms: Confidence interval decisions Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills

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; Sample results support conclusion that recorded account balance was not materially misstated which it was materially misstated Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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; Auditor reaction Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 23) When selecting a stratified sample, the sample size is: A) determined for the unstratified population and then apportioned to each stratum. B) determined for each stratum and selected from that stratum. C) determined for each stratum and selected randomly from the entire unstratified population. D) always larger than if unstratified sampling had been used. Answer: B Terms: Sample size for stratified sample Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 26) Which of the following is a correct statement? A) When 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 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 12

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 Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 30) The AICPA audit sampling formula for computing nonstatistical tests of details of balances sample size is to multiply the population recorded amount by the ________ and then divide by the ________. A) confidence factor, ARIA B) confidence factor, tolerable misstatement C) ARO, tolerable misstatement D) risk of incorrect acceptance, confidence factor Answer: B Terms: Formula for computing nonstatistical tests of details of balances sample size Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills

32) There are 14 steps to audit sampling for 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 projected misstatement (point estimate), combined with the allowance for sampling risk, is less than tolerable misstatement, the auditor will accept the population as fairly stated. Terms: Steps included in the Evaluate the Results section for nonstatistical sampling Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 33) 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

Terms: Steps in sampling for tests of details and tests of controls Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills

34) 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 tests 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. Directly related, but has only a minor effect on sample size. Terms: Factors that influence sample size for nonstatistical tests of details of balances Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 35) There are 14 steps to audit sampling for 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 amount of materiality allocated to the account under audit. 7. Specify the acceptable risk of incorrect acceptance. This is the risk that the auditor is willing to take of accepting a balance as correct when the true misstatement in the balance is greater than tolerable misstatement. 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 Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 15

36) 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. • Sample size. Terms: Factors to consider whether population misstatement exceeds tolerable misstatement Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 37) 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 unqualified 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 Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 38) For stratified sampling, the auditor selects samples independently from each stratum. A) True B) False Answer: A Terms: Stratification of accounts receivable Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills

39) The larger the sample size, the more confident the auditor can be that the point estimate is close to the true population value. A) True B) False Answer: A Terms: Evaluating sample results Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills 40) Acceptable risk of incorrect acceptance is directly affected by acceptable audit risk. A) True B) False Answer: A Terms: Acceptable risk of incorrect acceptance and acceptable audit risk Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills 41) Tolerable misstatement is inversely related to sample size. A) True B) False Answer: A Terms: Tolerable misstatements related to sample size Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 42) Acceptable risk of incorrect acceptance (ARIA) and sample size are inversely related; that is, as ARIA increases, sample size decreases. A) True B) False Answer: A Terms: Relation of acceptable risk of incorrect acceptance and sample size Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 43) Estimated misstatement in the population and sample size are inversely related; that is, as estimated misstatement increases, sample size decreases. A) True B) False Answer: B Terms: Relation of estimated misstatement in the population and sample size Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 17

44) The purpose of stratification is to permit auditors to emphasize certain aspects of a population and deemphasize others. A) True B) False Answer: A Terms: Purpose of stratification Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 45) An auditor using nonstatistical sampling cannot formally measure sampling error. A) True B) False Answer: A Terms: Nonstatistical sampling Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 46) If the misstatement in a population is larger then tolerable misstatement without considering sampling error, the population will be considered unacceptable. A) True B) False Answer: B Terms: Population not considered acceptable Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 47) When using nonstatistical sampling, the larger the sample size, the greater the auditor's confidence that the point estimate is close to the true population value. A) True B) False Answer: A Terms: Nonstatistical sampling Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 48) Required sample size increases as the auditor's tolerable misstatement for an account balance or class of transactions decreases. A) True B) False Answer: A Terms: Required sample size and tolerable misstatement Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 18

49) The primary factor affecting the auditor's decision about acceptable risk of incorrect acceptance (ARIA) is assessed inherent risk. A) True B) False Answer: B Terms: Acceptable risk of incorrect acceptance Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 50) The purpose of stratified sampling is to achieve a greater confidence level (lower risk of incorrect acceptance) for a given sample size. A) True B) False Answer: B Terms: Stratified sampling; Confidence level and sample size Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 51) ARIA measures the auditor's desired assurance for an account balance. A) True B) False Answer: A Terms: Acceptable risk of incorrect acceptance Diff: Easy Objective: LO 17-2 AACSB: Reflective thinking skills 52) Acceptable audit risk and acceptable risk of incorrect acceptance are inversely related; that is, as AAR increases, ARIA decreases. A) True B) False Answer: B Terms: Acceptable audit risk and acceptable risk of incorrect acceptance Diff: Challenging Objective: LO 17-2 AACSB: Reflective thinking skills 53) An increased sample size will always cause the population to be accepted. A) True B) False Answer: B Terms: Sample size and analyzing exceptions Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 19

54) Sampling used for tests of details of balances provides results in terms of exception rates. A) True B) False Answer: B Terms: Sampling used for tests of details of balances Diff: Moderate Objective: LO 17-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 21

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: Monetary unit sampling Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 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, population is Diff: Moderate Objective: LO 17-3 AACSB: Analytic skills 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 of the sample Diff: Moderate Objective: LO 17-3 AACSB: Analytic skills 22

9) The auditor must deal with layers of the computed upper deviation rate from the attributes table because there are different error assumptions for each error. Assume a sample of 100 had found one error, and the computed upper deviation rate is shown in the following table: Number of Errors 0 1

Upper Precision Limit from Table .023 .038

The precision limit for the layer with one error is: A) 2.3%. B) 3.8% C) 6.1%. D) 1.5%. Answer: D Terms: Computed upper deviation from the attributes table; Precision limit with one error Diff: Moderate Objective: LO 17-3 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills

12) Which of the following item(s) are needed to determine the sample size using MUS? A) Recorded population A point estimate for misstatements. value A confidence factor No Yes No B) A point estimate for misstatements. Yes

Recorded population value A confidence factor No Yes

C) A point estimate for misstatements. No

Recorded population value A confidence factor Yes Yes

D) Recorded population A point estimate for misstatements. value A confidence factor Yes No No Answer: C Terms: Determining sample sizes using MUS Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 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 bounds. Answer: D Terms: Maximum misstatements in monetary-unit sampling Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills

18) Which of the following is not a disadvantage of monetary unit sampling? A) It may be difficult to select samples from large population without computer assistance. B) The total misstatement bounds resulting when misstatements are found may be too low to be useful to the auditor. C) The total misstatement bounds resulting when misstatements are found may be too high to be useful to the auditor. D) Each of the above is a disadvantage. Answer: B Terms: Disadvantage of monetary-unit sampling Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 17-3 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills 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; Relationship between tolerable misstatement size and required sample size Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills

23) 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 Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 24) 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 Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 25) 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 appealing to auditors because of its ease of application. • 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 exceptions 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 Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills

26) 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. Terms: Monetary-unit sampling to evaluate population with negative balances Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 27) To determine the sampling interval, the population is divided by the confidence factor. A) True B) False Answer: B Terms: Sample size and monetary unit sampling Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 28) MUS has the statistical simplicity of attributes sampling, yet provides a statistical result expressed as a percentage. A) True B) False Answer: B Terms: Monetary unit sampling Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 29) 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. A) True B) False Answer: B Terms: Monetary unit sampling Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills

30) When auditors apply MUS to a sample, the sample is selected using random sampling techniques. A) True B) False Answer: B Terms: MUS applied to a sample; Random sampling techniques Diff: Easy Objective: LO 17-3 AACSB: Reflective thinking skills 31) The use of monetary unit sampling is most appropriate when the auditor expects to find many errors and when a monetary result is desired. A) True B) False Answer: B Terms: Monetary-unit sampling most appropriate Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 32) When using MUS, the projected misstatement is the percentage misstatement times the sampling interval. A) True B) False Answer: A Terms: Monetary unit sampling; projected misstatement Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 33) Accounts with zero or negative year-end balances have no chance of being included in a standard probability proportional to size (PPS) sample. A) True B) False Answer: A Terms: Standard probability proportionate to size (PPS) sample Diff: Challenging Objective: LO 17-3 AACSB: Reflective thinking skills

34) If the misstatement bound exceeds tolerable misstatement, the population is considered acceptable. A) True B) False Answer: B Terms: Monetary unit sampling Diff: Moderate Objective: LO 17-3 AACSB: Reflective thinking skills 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, when in Diff: Easy Objective: LO 17-4 AACSB: Reflective thinking skills 2) The method used to measure the estimated total error 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 Diff: Moderate Objective: LO 17-4 AACSB: Reflective thinking skills 3) The auditor is concerned with the audited value rather than the error 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 Diff: Moderate Objective: LO 17-4 AACSB: Reflective thinking skills 31

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 Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 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: Auditor desires accurate estimate of dollar value of exceptions and believes more than just a few exceptions will be discovered Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 6) The 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 Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 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) Variable sampling Answer: D Terms: Sampling plan designed to estimate a numerical measurement of population Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 9) When dealing with variables sampling and sampling risk, it is important to understand that: A) for variables sampling, auditors uses 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 Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills 33

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 Diff: Easy Objective: LO 17-3 and LO 17-4 AACSB: Reflective thinking skills 12) The confidence limits in variables sampling are similar to the_________ in monetary-unit sampling. A) point estimate B) misstatement bounds C) standard deviation D) standard error of the mean Answer: B Terms: Confidence limits in variable sampling similar to monetary-unit sampling Diff: Challenging Objective: LO 17-3 and LO 17-4 AACSB: Reflective thinking skills 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: Confidence limits in variable sampling similar to monetary-unit sampling Diff: Challenging Objective: LO 17-4 AACSB: Reflective thinking skills

14) 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 not materially misstated or that it is materially misstated. ARIA is the statistical risk that the auditor has accepted a population that is actually materially misstated. This is a serious concern to auditors because there are potential legal implications in 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. The only time that ARIR affects the auditor's actions is when an auditor concludes 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 Diff: Challenging Objective: LO 17-2 and LO 17-4 AACSB: Reflective thinking skills

15) 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 that use the statistical inference processes. ________ 3. The risk that the auditor is willing to take of concluding a balance is materially misstated when it is, in fact, fairly stated. ________ 4. A statistical sampling method that provides upper and lower 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 is greater than 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 Diff: Moderate Objective: LO 17-2, LO 17-3, LO and 17-4 AACSB: Reflective thinking skills

16) Acceptable risk of incorrect rejection is the statistical risk that the auditor has concluded that a population is materially misstated when it is not. A) True B) False Answer: A Terms: Acceptable risk of incorrect rejection Diff: Easy Objective: LO 17-4 AACSB: Reflective thinking skills 17) Difference estimation frequently results in smaller sample sizes than any other variables sampling method. A) True B) False Answer: A Terms: Difference estimation Diff: Moderate Objective: LO 17-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 17-5 AACSB: Reflective thinking skills 2) 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 Diff: Moderate Objective: LO 17-5 AACSB: Reflective thinking skills

3) When using difference estimation, the precision interval is calculated by a statistical formula. A) True B) False Answer: A Terms: Precision interval Diff: Moderate Objective: LO 17-5 AACSB: Reflective thinking skills 4) The sample size is inversely related to the computed precision interval in difference estimation; that is, as sample size increases, the computed precision interval decreases. A) True B) False Answer: A Terms: Sample size and computed precision interval in difference estimation Diff: Moderate Objective: LO 17-5 AACSB: Reflective thinking skills 5) 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. A) True B) False Answer: A Terms: Difference estimation sampling; Confidence limits Diff: Moderate Objective: LO 17-5 AACSB: Reflective thinking skills 6) The population standard deviation has a significant effect on the computed precision interval. A) True B) False Answer: B Terms: Difference estimation; Population standard deviation; Computed precision interval Diff: Moderate Objective: LO 17-5 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 18 Audit of the Acquisition and Payment Cycle: Tests of Controls, Substantive Tests of Transactions, and Accounts Payable 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 Diff: Easy Objective: LO 18-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 18-1 AACSB: Reflective thinking skills 3) The acquisition and payment cycle consists of one class of transactions. A) True B) False Answer: B Terms: Acquisition and payment cycle and class of transactions Diff: Easy Objective: LO 18-1 AACSB: Reflective thinking skills 4) The cash account is not part of the acquisitions and payment cycle. A) True B) False Answer: B Terms: Cash account and acquisitions and payment cycle Diff: Easy Objective: LO 18-1 AACSB: Reflective thinking skills 1

5) Auditing the acquisition and payment cycle often takes more time than any other cycle. A) True B) False Answer: A Terms: Acquisitions and payment cycle Diff: Easy Objective: LO 18-1 AACSB: Reflective thinking skills 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/services B) Issuance of payment to vendor C) Approval of a new vendor D) Purchase requisition Answer: A Terms: Initiates acquisition and payment cycle Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills 3) Which of the following accounts is not included in the acquisitions class of transactions? A) Inventory B) Prepaid expenses C) Purchase discounts D) Accounts payable Answer: C Terms: Account not included in acquisition class of transactions Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills

4) 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 Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills 5) 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 Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills 6) The computer-generated file which records acquisitions, disbursements and allowances for each vendor is the: A) Accounts payable master file. 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 Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills

7) 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 Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 8) Smaller privately held companies may not maintain an accounts payable master file 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 master file and small companies Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 9) 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 Diff: Easy Objective: LO 18-2 AACSB: Reflective thinking skills 10) 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 Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 4

11) Absent disputed amounts and minor timing differences, the vendor's statements should reconcile to the: A) acquisition journal. B) accounts payable master file. C) cash disbursements amount for purchases. D) vouchers payable amount for vendors. Answer: B Terms: Vendor's statements should reconcile to Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 12) 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: Role in acquisition and payment cycle Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 13) 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. • 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 Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills

14) 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 identify the description, quantity, and other related information for goods or services that the company is purchasing. Unlike requisitions, purchase orders are directed to specific vendors. Terms: Purchase requisitions and purchase orders Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills

15) 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 master file 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 that specifies the details of an acquisition transaction and amount of money owed to the vendor 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 Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 7

16) The acquisition and payment cycle typically begins with the initiation of purchase requisition for goods and services from an authorized individual. A) True B) False Answer: A Terms: Acquisition and payment cycle begins with Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 17) 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. A) True B) False Answer: B Terms: Vendor invoice Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 18) 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. A) True B) False Answer: B Terms: Voucher Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills 19) An acquisitions transaction file is a computer generated file that includes all information entered into the system regarding acquisition transactions. A) True B) False Answer: A Terms: Acquisition transaction file Diff: Moderate Objective: LO 18-2 AACSB: Reflective thinking skills

20) Receiving reports are normally only used to document the receipt of goods and are not used to document the receipt of services. A) True B) False Answer: A Terms: Receiving reports Diff: Challenging Objective: LO 18-2 AACSB: Reflective thinking skills 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 master file 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 Diff: Easy Objective: LO 18-3 AACSB: Reflective thinking skills 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 payables. Answer: C Terms: Evidence on completeness assertion to verify all goods received are recorded properly Diff: Easy Objective: LO 18-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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) a binding agreement between purchaser and vendor. D) an acceptance of a vendor's catalog offer to sell. Answer: A Terms: Written purchase order is a legal contractual document Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

6) Which one of the following duties should not be assigned the purchases 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 8) A substantive tests 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' invoice. 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 internal controls and the auditor properly tests those controls. Answer: D Terms: Acquisition and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 11

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 Diff: Easy Objective: LO 18-3 AACSB: Reflective thinking skills 11) A key 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 13) The auditor's 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 12

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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 15) The 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 Diff: Easy Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 13

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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

21) Which of the following should sign checks under conditions of effective internal control? A) Treasurer B) Purchasing agent C) Accounts payable clerk D) Person preparing the checks Answer: A Terms: Effective internal controls; Responsible for signing checks Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 22) 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 than 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 Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 24) For effective internal control purposes, the vouchers 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 internal control, vouchers payable department Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 15

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 Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 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: 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 Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 18-3 AACSB: Analytic skills 29) Authorization for accepting goods in the receiving department should be based on the: A) vendor invoice. B) requisition request. C) purchase order from the purchasing department. D) vendor statement. Answer: C Terms: Authorization for accepting goods Diff: Easy Objective: LO 18-2 and LO 18-3 AACSB: Reflective thinking skills 30) What are the three most important controls over cash disbursements? Answer: • Signing of check 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 Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

31) Discuss the key 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 . A purchasing department that is independent of the authorization or receiving functions is often established by companies to ensure an adequate quantity of goods and services at a minimum price. 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 internal controls for processing purchase orders in the acquisitions and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 32) Discuss the key internal controls that should be present in the receiving goods and services function in the acquisitions and payment cycle. Answer: For good 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 storeroom and another to the accounts payable department for their information needs. To prevent theft, 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 internal controls in receiving goods and services in the acquisitions and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 33) How do auditors determine the extent of testing of internal controls in the acquisition and payment cycle? Answer: When auditors intend to rely on controls to support a preliminary control risk 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 internal control over financial reporting. Terms: Extent of testing of internal controls in the acquisitions and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

34) 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 or 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 vendors' invoice, receiving report, and other supporting documentation or Recompute the clerical accuracy on the vendor's invoice, including discounts and freight Terms: Tests for management assertions for acquisition and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 35) Significant audit efficiencies can be achieved on many audits when controls are operating effectively. A) True B) False Answer: A Terms: Audit efficiency and internal controls Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 36) Failure to record the acquisition of goods and services received overstates both accounts payable and net income. A) True B) False Answer: B Terms: Failure to record acquisition of goods Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

37) 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. A) True B) False Answer: B Terms: Tests of controls and substantive tests of transactions Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 38) 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. A) True B) False Answer: A Terms: Importance of tests of controls and substantive tests of transactions; Attributes sampling Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 39) 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." A) True B) False Answer: A Terms: Substantive test of transactions to test completeness objective for acquisitions Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 40) The audit procedure "Test clerical accuracy by footing the journals and tracing postings to general ledger and to accounts payable and inventory master files" is used to test the posting and summarization objective for acquisitions. A) True B) False Answer: A Terms: Audit procedure to test clerical accuracy to test posting and summarization objective Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills

41) Auditors are normally more concerned about violations of the completeness objective for acquisitions than about violations of the occurrence objective for acquisitions. A) True B) False Answer: A Terms: Auditor more concerned with violation of completeness objective than occurrence objective for acquisitions Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills 42) It is common in the acquisition and payment cycle for transactions to require significant judgment. A) True B) False Answer: A Terms: Acquisition and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 43) 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 income. A) True B) False Answer: A Terms: Acquisition and payment cycle Diff: Moderate Objective: LO 18-3 AACSB: Reflective thinking skills 44) 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. A) True B) False Answer: A Terms: Audit procedure for occurrence objective for cash disbursements Diff: Challenging Objective: LO 18-3 AACSB: Reflective thinking skills

Learning Objective 18-4 1) Auditors need to distinguish between accounts payable and accrued liabilities in designing the appropriate control and substantive tests. 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 Diff: Moderate Objective: LO 18-4 AACSB: Reflective thinking skills 2) When determining the methodology for designing tests of details of balances for accounts payable: A) 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 Diff: Moderate Objective: LO 18-4 AACSB: Reflective thinking skills 3) Auditors are especially concerned about the ________ and ________ balance-related audit objectives 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 Diff: Moderate Objective: LO 18-4 AACSB: Reflective thinking skills

4) 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 client and business risks affecting accounts payable. 2. Set performance materiality and assess inherent risk 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 for the acquisition and payment cycle. 5. Design and perform analytical procedures for accounts payable. 6. Design tests of details of accounts payable balance to satisfy balance-related audit objectives. Decide audit procedures to perform, sample size, items to select, and timing of tests. Terms: Methodology for designing tests of details of balances for accounts payable Diff: Moderate Objective: LO 18-4 AACSB: Reflective thinking skills 5) The auditor's ultimate substantive tests depend on the relative effectiveness of internal controls related to accounts payable. A) True B) False Answer: A Terms: Substantive tests for accounts payable Diff: Easy Objective: LO 18-4 AACSB: Reflective thinking skills Learning Objective 18-5 1) The overall objective in the audit of accounts payable is to determine whether accounts payable: A) is fairly stated and properly disclosed. B) is overstated. C) is understated. D) is accurately stated. Answer: A Terms: Liabilities and balance-related audit objectives Diff: Easy Objective: LO 18-5 AACSB: Reflective thinking skills

2) ________ 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 Diff: Easy Objective: LO 18-5 AACSB: Reflective thinking skills 3) 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: Analytical procedures for accounts payable Diff: Moderate Objective: LO 18-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 18-6 AACSB: Reflective thinking skills

2) Cutoff procedures for inventory purchased should be designed by companies to assure the company 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 26

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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 11) The auditor has decided to use accounts payables confirmations when testing substantive testing for balances. Which two management assertions is she testing? A) Existence and completeness B) Existence and occurrence C) Existence only D) Completeness only Answer: A Terms: Accounts payable confirmations; Substantive testing for balances Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills 13) To test for cutoff errors which overstate liabilities, the auditor should trace, to vendors' invoices, the receiving reports issued: 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 Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 18-6 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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 understatement 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 Diff: Challenging Objective: LO 18-3 and LO 18-6 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 18-6 AACSB: Analytic skills 19) 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 Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills 20) 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 disbursement. • 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 Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills

21) The balance-related audit objective realizable value is not applicable when auditing accounts payable. A) True B) False Answer: A Terms: Balance-related audit objective of realizable value Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 22) When auditing accounts payable, the auditor is more concerned about the possibility of understatements than overstatements. A) True B) False Answer: A Terms: Auditing accounts payable, auditor concerned with understatement Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Test for overstatement cutoff amounts in Accounts Payable Diff: Challenging Objective: LO 18-6 AACSB: Reflective thinking skills 24) The "rights "aspect of the "rights and obligations" objective is not applicable to liabilities. A) True B) False Answer: A Terms: Rights and obligations; accounts payable Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills

25) Auditors primarily emphasize the understatement of liabilities in the audit of accounts payable because they are concerned about potential legal liability. A) True B) False Answer: A Terms: Auditors emphasize understatement of liabilities because of potential legal liability Diff: Moderate Objective: LO 18-6 AACSB: Reflective thinking skills Learning Objective 18-7 1) The documents typically used to reconcile the balance on the accounts payable list with the confirmation or vendor's statements include all of the following except for: A) receiving reports. B) vendor's invoices. C) sales invoices. D) cancelled checks. Answer: C Terms: Account payable reconciliation Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 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: C Terms: Most reliable for verifying correct balance of accounts payable Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 6) Under which of the following circumstances would it be advisable for the auditor to confirm accounts payable with creditors? A) Internal accounting control over accounts payable is adequate, and there is sufficient evidence on hand to minimize the risk of a material misstatement. B) Confirmation response is expected to be favorable, and accounts payable balances are of immaterial amounts. C) Creditor statements are not available and internal control over payables is unsatisfactory. D) The majority of accounts payable balances are with associated companies. Answer: C Terms: Confirm accounts payable with creditors Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 18-7 AACSB: Reflective thinking skills 9) Which of the following documents is best for verifying the correct balance in accounts payable? A) Bills of lading B) Confirmations C) Vendors' invoices D) Vendors' statements Answer: D Terms: Document best for verifying correct balance in accounts payable Diff: Challenging Objective: LO 18-7 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills

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 satisfy 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 Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 12) 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 internal controls are weak, when vendors' statements are not available, or when the auditor questions the client's integrity. Terms: Confirmations Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills 13) A vendor's statement is unreliable and auditors rarely use it. A) True B) False Answer: B Terms: Vendor's statement reliability Diff: Easy Objective: LO 18-7 AACSB: Reflective thinking skills 14) When verifying the correct balance in accounts payable, vendors' invoices are more useful than vendors' statements. A) True B) False Answer: B Terms: Vendors' invoices more useful than vendors' statements Diff: Moderate Objective: LO 18-7 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 19 Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts 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 Diff: Easy Objective: LO 19-1 AACSB: Reflective thinking skills 2) Which of the following expenses is not typically evaluated as part of the audit of the acquisition and payment cycle? A) Depreciation expense B) Insurance expense C) Estimated liability for warranties D) Property tax expense Answer: C Terms: Acquisition and payment cycle Diff: Easy Objective: LO 19-1 AACSB: Reflective thinking skills 3) Accrued payroll taxes are normally considered to be associated with the acquisition and payment cycle. A) True B) False Answer: A Terms: Accrued payroll taxes Diff: Easy Objective: LO 19-1 AACSB: Reflective thinking skills

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) company has a policy of selling relatively new assets. Answer: C Terms: Acquisition and payment cycle; Excessive recurring losses on retired assets Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 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 master file C) Determining the adequacy of the funds available for capital expenditures D) Reperformance of recorded depreciation expense Answer: C Terms: Acquisition and payment cycle Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 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 three of the above. Answer: D Terms: Property, plant, and equipment documentation Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills

4) The auditor must know the client's capitalization policies to determine whether acquisitions are: A) Treated consistently with those of the preceding Recorded at historical cost year Necessary Yes Yes Yes B) Treated consistently with those of the preceding Recorded at historical cost year Yes No

Necessary No

C) Treated consistently with those of the preceding Recorded at historical cost year No No

Necessary No

D) Treated consistently with those of the preceding Recorded at historical cost year No Yes

Necessary No

Answer: D Terms: Acquisitions; Capitalization policy Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 5) To be capitalized as part of property, plant and equipment, assets must: A) have expected useful lives of more than one year. B) not be acquired for resale. C) be useful in multiple productive capacities within the organization. D) A and B, but not C. Answer: D Terms: Property, plant, and equipment; Capitalized Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills

6) The primary accounting record for manufacturing equipment and other fixed assets is the: A) depreciation ledger. B) fixed asset master file. C) asset inventory. D) equipment roster. Answer: B Terms: Primary accounting record for equipment Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 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 master file. 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 Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills

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) Cut-off Answer: B Terms: Audit procedure; Balance-related audit objective; Foot acquisition schedule Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 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 master file. Answer: C Terms: Testing audit related objective of completeness for equipment accounts Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 master file? 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; Fixed asset master file Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 12) The source of debits in the equipment account is the: A) sales journal. B) cash disbursements journal. C) cash receipts journal. D) acquisitions journal. Answer: D Terms: Acquisitions journal and equipment Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 5

13) Failure to capitalize a fixed asset at the correct amount would impact which financial statements until the company disposes of the asset? A) The balance sheet only B) The income statement only 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 schedule totals to the general ledger C) Tracing cost and accumulated depreciation of the disposals to the property master file D) All of the above are necessary. Answer: D Terms: Tests when auditing schedule of recorded disposals Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 15) Which of the following is an 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

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 journal. B) depreciation schedule. C) fixed asset master file. D) file of purchase requisitions. Answer: C Terms: Set of records for each piece of equipment Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 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 as 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 18) Methods used to determine if there are legal encumbrances related to fixed assets include all but which of the following? A) Reading terms of loan and credit agreements B) Reviewing loan confirmations received from banks C) Having discussions with the client or sending 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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: Test of details of balances Diff: Moderate Objective: LO 19-2 AACSB: Analytic skills 7

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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

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, taxes, or insurance coverage. Answer: C Terms: Unrecorded disposals of property, plant, and equipment Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 27) The auditor needs to gain reasonable assurance that the equipment accounts in the fixed asset master file 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 master file are not understated Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 30) The auditor is examining the accounting entries made to the accumulated depreciation account during the year and notices a significant amount 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 were revised Answer: A Terms: Accounting entries (debits) made to accumulated depreciation account Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 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 master file and then physically locate them. B) Examine the repairs and maintenance amount for large debits. C) Compare current years depreciation expense with the previous year's depreciation expense. D) Trace acquisition documents to the fixed asset master file. Answer: A Terms: Testing for unrecorded retirements/disposals of equipment Diff: Challenging Objective: LO 19-2 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Analytic skills 12

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 Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-2 AACSB: Analytic skills 38) Which of the following explanations might satisfy an auditor who discovers significant debits to an accumulated depreciation account? A) Extraordinary repairs have lengthened the life of an asset. 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 Diff: Challenging Objective: LO 19-2 AACSB: Analytic skills 39) The primary accounting record for property, plant, and equipment accounts is the fixed asset master file. What is included for each fixed asset in the master file? 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 master file Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 13

40) 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 master file Terms: Procedures performed on client's schedule of recorded disposals Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 41) 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 Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 42) 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 cost 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 Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

43) 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 Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 44) 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 master file amounts, and the total agrees with the general ledger (detail tie-in).(1) Foot the acquisitions schedule, (2) trace the individual acquisitions to the master file 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 Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills

45) 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 Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 46) Discuss the key internal controls related to the disposal of property, plant, and equipment. Answer: The most important 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. Terms: Equipment disposals; audit procedures Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 47) One of the auditor's primary objectives when auditing manufacturing equipment is completeness. A) True B) False Answer: A Terms: Primary objective in auditing equipment; Completeness Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 48) Completeness and existence are the auditor's primary objectives in auditing manufacturing equipment. A) True B) False Answer: A Terms: Completeness and existence; Primary objectives in auditing equipment Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 16

49) 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. A) True B) False Answer: A Terms: Primary characteristic of property, plant, and equipment Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 50) The emphasis in auditing manufacturing equipment is on the verification of current-period disposals and acquisitions. A) True B) False Answer: A Terms: Auditing equipment; Current-period disposals and acquisitions Diff: Easy Objective: LO 19-2 AACSB: Reflective thinking skills 51) 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. A) True B) False Answer: A Terms: Verification of acquisitions; Client-prepared schedule of acquisitions Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 52) Depreciation amounts are determined by exchange transactions with outside parties. A) True B) False Answer: B Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests of transactions Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

53) 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. A) True B) False Answer: A Terms: Depreciation expense; Tests of details of balances; Tests of controls or substantive tests of transactions Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 54) The most important audit objective for depreciation expense is detail tie-in. A) True B) False Answer: B Terms: Audit objective for depreciation expense Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 55) One of the reasons that auditors verify equipment differently from current assets is the amount of any given equipment acquisition is often material. A) True B) False Answer: A Terms: Auditing current year acquisitions Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 56) The transportation and installation costs for a piece of equipment should be charged to an expense account. A) True B) False Answer: B Terms: Equipment additions; audit procedures Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills

57) 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. A) True B) False Answer: A Terms: Cutoff of acquisitions; Accounts payable cutoff tests Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 58) The company's choices for determining the fixed asset's useful life and residual value impact the amount of depreciation recorded. A) True B) False Answer: A Terms: Asset's useful life and residual value; Impact depreciation recorded Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 59) 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. A) True B) False Answer: B Terms: Audit procedure for completeness objective Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 60) Confirmations are commonly used to verify additions of property, plant, and equipment. A) True B) False Answer: B Terms: Confirmations to verify additions Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 61) One very useful method of auditing depreciation is to use an analytical procedure to test for reasonableness. A) True B) False Answer: A Terms: Auditing depreciation; Analytical procedures to test for reasonableness Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 19

62) The approach to auditing patents and copyrights is similar to that used for property, plant, and equipment accounts. A) True B) False Answer: A Terms: Auditing patents and copyrights Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 63) 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. A) True B) False Answer: B Terms: Recording acquisition at improper amount Diff: Moderate Objective: LO 19-2 AACSB: Reflective thinking skills 64) 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. A) True B) False Answer: A Terms: Accuracy objective; Classification objective; Fixed assets in prior years Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills 65) When auditing acquisitions of property, plant, and equipment, the auditor's review of lease and rental agreements most closely relate to the cutoff objective. A) True B) False Answer: B Terms: Auditing acquisitions; Lease and rental agreements; Cutoff objective Diff: Challenging Objective: LO 19-2 AACSB: Reflective thinking skills

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; Prepaid insurance Diff: Easy Objective: LO 19-3 AACSB: Reflective thinking skills 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) Analytical procedures Answer: D Terms: Audit procedure for auditing prepaid expenses and deferred charges Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 19-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 19-3 AACSB: Reflective thinking skills 9) Describe the two tests auditors can perform to test for the existence and omissions of insurance policies in force. Answer: The verification of existence and tests for omissions 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 Diff: Easy Objective: LO 19-3 AACSB: Reflective thinking skills 10) What are several 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills

11) 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 Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 12) Discuss the key 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 to make sure that the company has adequate insurance at all times. The control should include a provision for periodic review of the adequacy of the insurance coverage by an independent qualified person. The detailed records of the information in the insurance register should be verified by someone independent of the person preparing them. 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 internal controls for prepaid insurance Diff: Challenging Objective: LO 19-3 AACSB: Reflective thinking skills 13) The realizable value audit objective is not applicable when auditing prepaid insurance or insurance expense. A) True B) False Answer: A Terms: Auditing prepaid insurance and insurance expense; Realizable value Diff: Easy Objective: LO 19-3 AACSB: Reflective thinking skills

14) The audit of insurance expense is normally limited to analytical procedures and a brief test of whether charges to insurance expense arose from credits to prepaid insurance. A) True B) False Answer: A Terms: Audit of insurance expense; Analytical procedures Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 15) Cutoff for acquisitions of insurance is normally not a significant problem for the auditors. A) True B) False Answer: A Terms: Tests of cutoff objective for prepaid insurance Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 16) 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. A) True B) False Answer: A Terms: Auditing insurance expense; Analytical procedures Diff: Moderate Objective: LO 19-3 AACSB: Reflective thinking skills 17) The auditor should keep in mind that the amount in insurance expense is a residual amount. A) True B) False Answer: A Terms: Acquisition and payment cycle Diff: Easy Objective: LO 19-3 AACSB: Reflective thinking skills

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 preceeding year is used in the current year. Answer: D Terms: Audit of accrued liabilities Diff: Moderate Objective: LO 19-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 19-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 19-4 AACSB: Reflective thinking skills 5) The audit procedures used to verify accrued liabilities differ from those employed for the verification of accounts payable because: A) accrued liability balances are less material than accounts payable balances. B) accrued liabilities at year end will become accounts payable during the following year. C) evidence supporting accrued liabilities is non-existent, whereas evidence supporting accounts payable is readily available. D) accrued liabilities usually pertain to services of a continuing nature, whereas accounts payable are the result of completed transactions. Answer: D Terms: Audit procedures to verify accrued liabilities Diff: Challenging Objective: LO 19-4 AACSB: Analytic skills 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. A) True B) False Answer: A Terms: Audit of accrued property taxes Diff: Moderate Objective: LO 19-4 AACSB: Reflective thinking skills 7) In the audit of accrued property taxes, the two most important balance-related audit objectives are completeness and accuracy. A) True B) False Answer: A Terms: Audit of accrued property taxes Diff: Challenging Objective: LO 19-4 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 19-5 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 19-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 19-5 AACSB: Analytic skills

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 Diff: Moderate Objective: LO 19-5 AACSB: Reflective thinking skills 5) 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: Allocation is the process of assigning a portion of the cost of an asset to a product or a period. For example, calculating and then recording depreciation expense is an allocation process. It is important to determine when an expenditure is an asset or a current period expense so that the financial statements are fairly stated. 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 Diff: Moderate Objective: LO 19-5 AACSB: Reflective thinking skills 6) In the analysis of expense accounts, the auditor verifies transactions in specific accounts to determine whether the transactions are properly classified and accurately recorded. A) True B) False Answer: A Terms: Audit of income and expense accounts Diff: Moderate Objective: LO 19-5 AACSB: Reflective thinking skills 7) Depreciation expense results from the allocation of accounting data rather than discrete transactions. A) True B) False Answer: A Terms: Tests of details of balances; allocation Diff: Moderate Objective: LO 19-5 AACSB: Reflective thinking skills

8) Tests of controls provide an indication of the likelihood of misstatements in both the income statement and the balance sheet, simultaneously. A) True B) False Answer: A Terms: Tests of controls; Misstatements in income statement and balance sheet Diff: Moderate Objective: LO 19-5 AACSB: Reflective thinking skills 9) Typically, analytical procedures are the primary means of verifying income statement accounts resulting from allocations. A) True B) False Answer: A Terms: Analytical procedures; Verifying income statement accounts resulting from allocations Diff: Challenging Objective: LO 19-5 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 20 Audit of the Payroll and Personnel Cycle 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 within the payroll cycle — Transactions are Internal controls salaried employees, more significant over payroll are hourly employees, and than related effective for almost commissioned balance sheet all companies, even 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

C) There are three classes of transactions within the payroll cycle — salaried employees, hourly employees, and commissioned employees. No

Transactions are more significant than related balance sheet accounts. Yes

Internal controls over payroll are effective for almost all companies, even small ones. Yes

D) There are three classes of transactions within the payroll cycle — salaried employees, hourly employees, and commissioned employees. No

Transactions are more significant than related balance sheet accounts. Yes

Internal controls over payroll are effective for almost all companies, even small ones. No

Answer: C Terms: Payroll and personnel cycle Diff: Easy Objective: LO 20-1 AACSB: Reflective thinking skills 2) 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. • 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 Diff: Moderate Objective: LO 20-1 AACSB: Reflective thinking skills 3) Most companies, with the exception of small ones, have effective controls over the payroll cycle. A) True B) False Answer: B Terms: Effective controls over payroll cycle Diff: Easy Objective: LO 20-1 AACSB: Reflective thinking skills 4) While most cycles include at least two classes of transactions, the payroll and personnel cycle includes only one class of transactions. A) True B) False Answer: A Terms: Payroll and personnel cycle includes one class of transactions Diff: Easy Objective: LO 20-1 AACSB: Reflective thinking skills

5) Auditors typically test details of account balances in the audit of payroll. A) True B) False Answer: B Terms: Audit tests of payroll cycle Diff: Moderate Objective: LO 20-1 AACSB: Reflective thinking skills 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 B) Human Resources C) Treasury D) Controller Answer: B Terms: Department responsible for pay rate changed Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills

4) An imprest payroll account that has a significant balance may indicate the presence of: A) employees have not yet deposited or cashed payroll checks. B) fraudulent transfer of funds by the company. C) lack of controls over payroll distribution. D) the company is overpaying its employees. Answer: A Terms: Imprest payroll account has significant balance Diff: Easy Objective: LO 20-2 AACSB: Analytic skills 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 Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 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 master file. C) payroll bank account reconciliation. D) payroll tax returns. Answer: B Terms: Computer file used for recording payroll transactions Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills

8) The total of the individual employee earnings in the payroll master file should equal the total: A) balance of gross payroll in 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 master file equals Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills 10) What events initiate and terminate the payroll and personnel cycle? Answer: The hiring of an employee initiates the cycle and the payments to employees, governments, and other organizations terminate the cycle. Terms: Events that initiate and terminate the payroll and personnel cycle Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 11) 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, U.S. savings bonds, 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 Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills

12) 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 master file. 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 a factory 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 master file. 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 Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills 13) 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, incomes 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 Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills

14) 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. Human resource recordsb. Deduction authorization form c. Rate authorization form d. Time record e. Job time ticket f. Summary payroll report g. Payroll check h. W-2 form i. Payroll tax returns j. Payroll journal k. Payroll master file ________ 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 document written in exchange for services received from an employee. ________ 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, U.S. savings bonds, 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. g 4. i 5. b 6. c 7. a Terms: Human resource records; Deduction authorization form; Rate authorization form; Time card; Payroll check; Payroll tax returns; Payroll master file Diff: Moderate Objective: LO 20-2 AACSB: Reflective thinking skills

15) Hiring personnel initiates the payroll and personnel cycle. A) True B) False Answer: A Terms: Initiates payroll and personnel cycle Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 16) Firing personnel terminates the payroll and personnel cycle. A) True B) False Answer: B Terms: Terminates payroll and personnel cycle Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 17) Paying employees for their services ends the payroll and personnel cycle. A) True B) False Answer: A Terms: Terminates payroll and personnel cycle Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 18) The deduction authorization form authorizes the rate of pay and the deductions for taxes, dues, etc. A) True B) False Answer: B Terms: Deduction authorization form Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 19) The job time ticket indicates the starting and stopping times of work during the pay period. A) True B) False Answer: B Terms: Job time ticket Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills

20) An imprest payroll account limits the client's exposure to payroll fraud. A) True B) False Answer: A Terms: Imprest payroll account Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 21) Imprest accounts usually carry a significant balance. A) True B) False Answer: B Terms: Imprest accounts Diff: Easy Objective: LO 20-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-1 and 20-3 AACSB: Reflective thinking skills 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 pay checks 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 Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills

3) An auditor is vouching a sample of hourly employees from the payroll master file 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 master file to approved time sheets Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills

6) Which of the following internal control objectives is likely to be the most important in the audit of the payroll cycle? A) Payroll transactions are properly disclosed and presented in the notes to the financial statements. B) Payroll transactions are processed by an outside service provider. C) Recorded transactions represent valid payments. D) Recorded transactions are recorded in the proper accounting period. Answer: C Terms: Internal control objectives most important in audit of payroll cycle Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-2 and LO 20-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 11

9) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 10) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 11) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

12) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 13) 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 file. Answer: C Terms: Individual with access to time cards, payroll records, or checks should not have access to Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 14) Many companies use outside payroll services to process payroll. Which of the following regarding the auditor's responsibilities is most correct regarding their reliance on the internal controls of these outside payroll services? A) Must B) Cannot C) Rarely D) Can often Answer: D Terms: Use of outside payroll services and responsibility regarding reliance on internal control Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

15) Many audits have a ________ risk of misstatement for the payroll cycle. A) high B) minimal C) moderate D) zero Answer: B Terms: Payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 16) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 17) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 18) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 14

19) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 20) 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 test completeness transaction-related audit objective in payroll and personnel cycle, a test of control Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 15

21) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 22) 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 internal controls Answer: D Terms: Auditor's responsibility and review of preparation of at least one type of payroll tax form Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 23) Verifying that an adequate chart of accounts is used is a key 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

24) When labor is a material factor in inventory valuation, the auditor should place special emphasis on testing the 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 is material factor in inventory valuation Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 25) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

26) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 27) Which of the following errors gives the auditor the least 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

28) Auditors may extend their tests of payroll in which of the following circumstances? A) Payroll materially affects the The auditor is concerned valuation of inventory. there 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 29) ________ 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

30) A surprise payroll payoff in which employees must pick-up and sign for their pay check 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 31) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 32) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 33) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 20

34) Which of the following best describes effective 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 internal control over payroll Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 35) 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 36) In auditing payroll, which of the following procedures will normally require the least amount of auditor time under normal circumstances? A) Tests of controls B) Substantive tests of transactions C) Analytical procedures D) Tests of details of balances Answer: D Terms: Procedure which requires least amount of time when auditing payroll Diff: Challenging Objective: LO 20-3 AACSB: Reflective thinking skills

37) 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 master file. 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 internal control system; Fraud of fictitious employee Diff: Challenging Objective: LO 20-3 AACSB: Reflective thinking skills 38) 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 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 39) 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 Diff: Challenging Objective: LO 20-3 AACSB: Reflective thinking skills

40) 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 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 41) The auditor, in auditing payroll, wants to determine that the individuals included in her 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 master file 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 42) Generally, is the inherent risk level for the audit of the payroll and personnel set at low, moderate, or high? Explain. Answer: Generally set low since there is only one class of transactions for payroll and internal controls are effective because of strict federal, state, and local regulations over withholding and preparing payroll taxes. Terms: Inherent risk level for audit of payroll and personnel Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 43) 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 Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills

44) 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: Controls over payroll checks should include limiting the authorization for signing the checks to a responsible employee who does not have access to timekeeping or the preparation of the payroll, and the immediate return of unclaimed checks for redeposit. If a check-signing machine is used to replace a manual signature, the machine must be carefully controlled. An imprest payroll account can be used to prevent the payment of unauthorized payroll transactions. Also, access to unsigned payroll checks should be restricted. Terms: Internal controls over payment of payroll function Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 45) 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. Terms: Circumstances for auditors to extend procedures in audit of payroll Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 46) 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 personnel 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 Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

47) An auditor is verifying that the recorded payroll payments are for work actually performed by existing employees, the occurrence transaction-related audit objective. List three key 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 internal controls in occurrence transaction-related audit objective for payroll Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 48) 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 additional payroll processing should be separate from the custody of signed payroll checks. Terms: Key separation of duties in payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 49) Auditors should determine whether the client has fulfilled its legal obligation in submitting payments of all payroll withholdings as part of their payroll tests. A) True B) False Answer: A Terms: Payroll and personnel cycle Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 50) Payroll checks should be distributed by someone independent of the payroll and timekeeping functions. A) True B) False Answer: A Terms: Payroll checks distributed by someone independent Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 25

51) Auditors seldom expect to find misstatements when testing payroll transactions. A) True B) False Answer: A Terms: Misstatements when testing payroll transactions Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 52) The nature, extent, and timing of substantive tests of payroll transactions vary depending, in part, on assessed control risk. A) True B) False Answer: A Terms: Substantive tests of payroll transactions; Assessed control risk Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 53) "Physical control over assets" is not a type of control that is applicable to the payroll cycle. A) True B) False Answer: B Terms: Physical control over assets control applicable to payroll cycle Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 54) When auditing the payroll and personnel cycle, tests of controls are routinely performed. A) True B) False Answer: A Terms: Audit of payroll and personnel cycle and test of controls Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 55) When labor is a material part of inventory valuation, auditors should emphasize testing internal controls over proper classification of payroll transactions. A) True B) False Answer: A Terms: Labor material part of inventory Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 26

56) 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. A) True B) False Answer: B Terms: Payroll and personnel cycle Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 57) For proper 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. A) True B) False Answer: A Terms: Proper internal control Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 58) It is usually very easy for an auditor to determine if an employee has overstated their hours worked. A) True B) False Answer: B Terms: Payroll and personnel cycle Diff: Easy Objective: LO 20-3 AACSB: Reflective thinking skills 59) For most clients, the balance sheet accounts related to payroll are normally insignificant, except for labor charged to inventory. A) True B) False Answer: A Terms: Payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

60) Stock-based compensation plans may increase the inherent risks related to the accounting and disclosure requirements. A) True B) False Answer: A Terms: Stock-based compensation plans and inherent risk Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 61) For good internal control, the payroll function should be independent of the human resources department. A) True B) False Answer: A Terms: Good internal control; Payroll function independent of human resources department Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 62) If an audit client is a public company, the understanding of internal control must be sufficient to identify opportunities to increase audit effectiveness. A) True B) False Answer: B Terms: Understanding of internal control in public company Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills Topic: Public 63) 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. A) True B) False Answer: B Terms: Tests of controls and tests of details of balances Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills

64) The primary purpose of a surprise payroll payoff is to detect employees who have reported more time than was actually worked (fraudulent hours). A) True B) False Answer: B Terms: Purpose of surprise payroll payoff Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 65) Because of confidentiality requirements and potential losses of payroll funds, outside service center systems are rarely used by companies for payroll-related functions. A) True B) False Answer: B Terms: Outside service centers for payroll-related functions Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 66) Internal control over payroll is normally highly structured and well controlled. A) True B) False Answer: A Terms: Internal control over payroll Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 67) Most monetary misstatements of payroll are corrected by internal verification controls or by the PCAOB. A) True B) False Answer: B Terms: Payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 68) Despite the large dollar amounts involved in the payroll and personnel cycle, auditors typically spend less time auditing this cycle than others. A) True B) False Answer: A Terms: Time spent auditing payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 29

69) It is generally more difficult for the auditor to detect payment of fraudulent hours than payment of fictitious employees. A) True B) False Answer: A Terms: Detect payment of fraudulent hours and payment of fictitious employees Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 70) Examining payroll records for an indication of authorization is part of the timing transactionrelated audit objective. A) True B) False Answer: B Terms: Payroll and personnel cycle Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 71) The audit procedure "recompute hours worked from time cards" is normally performed when testing the completeness objective for payroll. A) True B) False Answer: B Terms: Testing completeness objective for payroll Diff: Moderate Objective: LO 20-3 AACSB: Reflective thinking skills 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) Analytical procedures D) Tests of details of balances Answer: D Terms: Audit procedure emphasized least in auditing payroll Diff: Easy Objective: LO 20-3 and 20-4 AACSB: Reflective thinking skills

2) What types of audit procedures are typically emphasized during the audit of the payroll cycle? Answer: Auditors typically emphasize tests of controls, tests of transactions and analytical procedures. Terms: Types of audit procedures in audit of payroll cycle Diff: Easy Objective: LO 20-3 and 20-4 AACSB: Reflective thinking skills 3) An analytical procedure to determine a possible misstatement of commission expense is to compare commission expense to salaries payable. A) True B) False Answer: B Terms: Analytical procedures for payroll cycle Diff: Easy Objective: LO 20-4 AACSB: Reflective thinking skills Learning Objective 20-5 1) 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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills 2) 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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills

3) 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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills 4) 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 company's federal income the SEC's 10-K report. tax return. Yes Yes B) the SEC's 10-K report. No

the company's federal income tax return. No

the SEC's 10-K report. Yes

the company's federal income tax return. No

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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills Topic: Public

5) 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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills 6) 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 Diff: Challenging Objective: LO 20-5 AACSB: Reflective thinking skills 7) 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 Diff: Challenging Objective: LO 20-5 AACSB: Reflective thinking skills 8) 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 Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills

9) An auditor traces a sample of electronic time cards before and after the bi-weekly payroll report and then traces to the payroll master file 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) Cut-off D) Accuracy Answer: C Terms: Tracing to determine payroll transactions are reported in correct period is testing which audit objective Diff: Challenging Objective: LO 20-5 AACSB: Analytic skills 10) 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 o 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 Diff: Moderate Objective: LO 20-5 AACSB: Analytic skills 11) 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, then the auditor will likely select a sample of employees to examine separately on a monthly or annual basis. Terms: Auditors verify sales commission expense Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills 12) The two major balance-related audit objectives in testing payroll liabilities are accuracy and cutoff. A) True B) False Answer: A Terms: Balance-related audit objectives in testing payroll liabilities; Accuracy and cutoff Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills

13) 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. A) True B) False Answer: A Terms: Audit of payroll tax expense Diff: Moderate Objective: LO 20-5 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 21 Audit of the Inventory and Warehousing Cycle 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 generate completion of form Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 3) Inventory is a complex area to audit for all but 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 Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills

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 of an order. Answer: D Terms: Inventory and warehousing cycle begins with Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 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 order cost systems C) Process cost systems D) Manufacturing systems Answer: B Terms: Accumulate costs by individual jobs Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 6) Master files, 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: Master files, worksheets, and reports that accumulate material, labor and overhead as costs Diff: Moderate Objective: LO 21-1 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-1 AACSB: Reflective thinking skills 2

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) internal control over those goods. D) prevention of waste, obsolescence, and theft. Answer: A Terms: Inventory and warehousing cycle; Separate but closely related systems Diff: Moderate Objective: LO 21-1 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-1 AACSB: Reflective thinking skills 10) 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. • Diverse items in inventory are often difficult to value. • Inventory valuation is difficult due to the estimates involved. • There are several acceptable methods of valuing inventory and some entities use different methods for different parts of the inventory, which is acceptable under accounting standards. Terms: Factors affecting complexity of audit of inventory Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills

11) State the six functions that make up the inventory and warehousing cycle and, for each function, identify the related documents and/or records 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 the vendor's invoice. • Store raw materials. Related record is the raw materials perpetual inventory master file. • Process the goods. Related documents and records are the raw materials requisition and the cost accounting records. • Store finished goods. Related records are the finished goods perpetual inventory master file and the cost accounting records. • Ship finished goods. Related documents and records are the shipping document, the finished goods perpetual inventory master file, and the cost accounting records. Terms: Functions that make up the inventory and warehousing cycle and related documents/records Diff: Challenging Objective: LO 21-1 AACSB: Reflective thinking skills 12) In process cost systems, costs are accumulated by individual jobs. A) True B) False Answer: B Terms: Process cost system Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 13) In job cost systems, costs are accumulated by individual jobs. A) True B) False Answer: A Terms: Job cost systems Diff: Easy Objective: LO 21-1 AACSB: Reflective thinking skills 14) While separate perpetual inventory records are normally kept for raw materials and finished goods, most companies do not use perpetual records for work-in-process. A) True B) False Answer: A Terms: Perpetual inventory records for inventories Diff: Challenging Objective: LO 21-1 AACSB: Reflective thinking skills 4

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 Diff: Easy Objective: LO 21-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-2 and 21-1 AACSB: Reflective thinking skills 4) 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: Acquire and record raw materials, labor, overhead Sale and collection: Ship goods and record revenue and the appropriate costs Terms: Audit of inventory and warehousing cycle affected by other business cycles Diff: Moderate Objective: LO 21-2 AACSB: Reflective thinking skills

5) 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 Diff: Challenging Objective: LO 21-2 AACSB: Reflective thinking skills 6) Inventory compilation tests are used to verify that the inventory is recorded at the lower of cost or market. A) True B) False Answer: B Terms: Inventory compilation tests Diff: Easy Objective: LO 21-2 AACSB: Reflective thinking skills 7) An approved purchase requisition form authorizes shipment of goods to customers. A) True B) False Answer: B Terms: Approved purchase requisition authorizes shipment of goods Diff: Easy Objective: LO 21-2 AACSB: Reflective thinking skills 8) The receipt of raw materials is a part of the acquisition and payment cycle. A) True B) False Answer: A Terms: Acquisition and payment cycle Diff: Easy Objective: LO 21-2 AACSB: Reflective thinking skills

9) The physical observation of the inventory and the acquisition of raw materials are part of the inventory and warehousing cycle. A) True B) False Answer: B Terms: Inventory and warehousing cycles Diff: Moderate Objective: LO 21-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills 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 master files 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 Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills 3) The reliability of perpetual inventory master files 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 master file Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills 7

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 Diff: Easy Objective: LO 21-3 AACSB: Analytic skills 5) Which of the following controls would be appropriate regarding the release of materials from a stockroom? A) Production employees request materials be delivered to their work areas as they need them. B) Stockroom employees deliver materials to work areas throughout the day to maintain acceptable levels of safety stock — no written records are maintained. C) Production employees submit approved requisition forms to the stockroom for materials needed. D) Production employer in need of materials should personally pick up needed materials from the stockroom. Answer: C Terms: Control appropriate regarding release of materials from stockroom Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 6) To assure proper segregation of duties, who should maintain the perpetual inventory master files? A) Production personnel B) Inventory storeroom personnel C) Inventory receiving personnel D) Accounting department personnel Answer: D Terms: Segregation of duties; Maintain perpetual inventory master files Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills

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 master files by examining documentation that supports additions and reductions of inventory amounts in the master files. 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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 8) A well-designed computerized system of perpetual inventory master files includes information about the: A) units of inventory purchased, sold, and on hand. B) unit costs of inventory purchased, sold, and on hand. C) units of raw materials, work-in-process, and finished goods. D) units and unit costs of inventory purchased, sold, and on hand. Answer: D Terms: Well-designed computerized system of perpetual inventory master files Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 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 hourly rate. B) raw material per unit cost. C) manufacturing overhead costs. D) number of direct labor hours applied. Answer: C Terms: Difficulty in verification of inventory cost records for valuation Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 13) If the perpetual inventory master files 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 master file shows lower quantities of inventory than physical count Diff: Challenging Objective: LO 21-3 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 21-3 AACSB: Reflective thinking skills 11

15) In order to strengthen controls over cost accounting information, a company should consider implementing: A) perpetual inventory master files. 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 internal controls over accounting for materials used in production Diff: Challenging Objective: LO 21-3 AACSB: Reflective thinking skills 16) Which of the following is an internal control weakness for a company whose inventory of supplies consists of a large number of individual items? A) The cycle basis is used for physical counts. B) Supplies of relatively little value are expensed when purchased. C) Perpetual inventory records are maintained only for items of significant value. D) The storekeeper is responsible for maintenance of perpetual inventory records. Answer: D Terms: Internal control weakness when inventory consists of large number of items Diff: Challenging Objective: LO 21-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills

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 master files. D) retail sales. Answer: B Terms: Audit of cost accounting for inventory Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills 19) 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, the transfers that have actually taken place are recorded, and the quantity, description, and date of all recorded transfers are accurate. • Perpetual inventory master files. The adequacy of perpetual inventory master files 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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 20) 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 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 Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills

21) Management typically allocates overhead using total raw materials as the basis for the allocation. A) True B) False Answer: B Terms: Audit of cost accounting for inventory Diff: Easy Objective: LO 21-3 AACSB: Reflective thinking skills 22) 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. A) True B) False Answer: A Terms: Transfer of inventory; Occurrence, completeness, and accuracy Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 23) Production personnel should ordinarily be responsible for maintaining perpetual inventory records. A) True B) False Answer: B Terms: Responsible for maintaining perpetual inventory records Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: A Terms: Extent and timing of auditor's physical examination of inventory Diff: Moderate Objective: LO 21-3 AACSB: Reflective thinking skills

Learning Objective 21-4 1) Which one of the following analytical procedures would be most useful in alerting the auditor to the possibility of obsolete inventory? A) Compare gross margin percentage with 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 Diff: Moderate Objective: LO 21-4 AACSB: Reflective thinking skills 2) In addition to performing analytical procedures that examine the relationship of inventory account balances with related financial statement accounts, auditor's will often use non-financial 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 Storage capacity Terms: Non-financial measures to determine reasonableness of inventory Diff: Easy Objective: LO 21-4 AACSB: Reflective thinking skills 3) Given the following information about your audit client, perform analytical procedures and comment on your findings.

Inventory Cost of Sales

2010 $20,000 $240,000

2011 $32,000 $320,000

Industry Average $25,000 $400,000

Answer: Inventory turnover for 2010 is 12, and for 2011 is 10, industry average is 16. (Basic accounting information that should be known applied to the inventory chapter) Inventory is increasing with lower inventory turns, and much below industry average. Principal audit concern would be that inventory is over-valued on the balance sheet. A concern will be the realizable value of the inventory. Terms: Analytical procedures Diff: Moderate Objective: LO 21-4 AACSB: Analytic skills

4) A comparison of the current year's inventory turnover ratio with previous years' may indicate the presence of obsolete inventory. A) True B) False Answer: A Terms: Comparison of inventory turnover ratios Diff: Easy Objective: LO 21-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 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 internal control over the physical count. C) one of the key determinants that must be considered is the time 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 17

7) It is frequently possible to test the physical inventory prior to the balance sheet date when: A) there are accurate perpetual inventory master files. 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 8) Comparing the physical counts with the perpetual inventory master files satisfies the balancerelated audit objective of: A) classification. B) observation. C) completeness. D) accuracy. Answer: D Terms: Tests of perpetual inventory master files Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

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 setting up the The auditor is responsible The auditor is responsible procedures for taking an for taking and compiling for observing the physical accurate physical the inventory. counting of inventory. inventory. Yes No No B) The auditor is responsible for setting up the The auditor is responsible The auditor is responsible procedures for taking an for taking and compiling for observing the physical accurate physical the inventory. counting of inventory. inventory. No No Yes C) The auditor is responsible for setting up the The auditor is responsible The auditor is responsible procedures for taking an for taking and compiling for observing the physical accurate physical the inventory. counting of inventory. inventory. Yes No Yes D) The auditor is responsible for setting up the The auditor is responsible The auditor is responsible procedures for taking an for taking and compiling for observing the physical accurate physical the inventory. counting of inventory. inventory. No Yes No Answer: B Terms: Auditor's responsibility for year-end inventory procedures Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 year-end. 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 21

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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Analytic skills

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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 23

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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 master files. C) client convenience. D) audit staff availability. Answer: B Terms: Basis that auditor decides whether inventory count can be taken before year-end Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills

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) to determine if the client has adequately priced the inventory item. D) to verify that the client has not changed the recorded counts after the auditor left the premises. Answer: B Terms: Physical counting of inventory Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 25

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 Diff: Moderate Objective: LO 21-3 and LO 21-5 AACSB: Reflective thinking skills 32) 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

33) 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 instructions for the physical count 2. supervision by responsible personnel 3. independent internal verification of the counts 4. independent reconciliations of the physical counts with perpetual inventory master files 5. adequate control over count sheets or tags. Terms: Control procedures related to physical count of inventory Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 34) 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 below. Answer: • Be present at the time the client counts the inventory • 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 Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 35) Auditing standards recommend that auditors observe physical inventory counts by the client. A) True B) False Answer: B Terms: Audit standards; Auditors observe physical inventory Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 36) 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. A) True B) False Answer: B Terms: Responsibility for making and recording count of physical inventory count Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills

37) A common source of business risk for inventory is the reliance on a few key suppliers. A) True B) False Answer: A Terms: Inventory and risk Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 38) 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. A) True B) False Answer: A Terms: Test for proper sales cutoff Diff: Easy Objective: LO 21-5 AACSB: Reflective thinking skills 39) When the client's perpetual inventory master files are inadequate, the auditor will probably choose to test the physical inventory prior to the balance sheet date. A) True B) False Answer: B Terms: Client's perpetual inventory master files are inadequate Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 40) 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. A) True B) False Answer: A Terms: Client's inventory in pubic warehouse Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills

41) The adequacy of internal controls over the physical count of inventory is one of the key determinants of the amount of time needed to test inventory. A) True B) False Answer: A Terms: Audit of inventory Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 42) Inherent risk is typically assessed at a low level for inventory due to the nature of the asset. A) True B) False Answer: B Terms: Inherent risk for inventory Diff: Moderate Objective: LO 21-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 21-6 AACSB: Reflective thinking skills 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 cut-off procedures have been adhered to prior to counting inventory. Answer: B Terms: Second step in verifying the valuation of purchased inventory Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills

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 tag 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 Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 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 internal controls. C) compilation internal controls. D) count quantity internal controls. Answer: C Terms: Controls which provide means of ensuring physical counts are properly summarized Diff: Challenging Objective: LO 21-6 AACSB: Reflective thinking skills 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) Diff: Challenging Objective: LO 21-6 AACSB: Analytic skills

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 Diff: Moderate Objective: LO 21-6 AACSB: Analytic skills 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 internal control for accurate unit costs is external verification by an outside consultant. D) Inventory compilation internal controls are needed to ensure that the physical counts are correctly summarized and priced. Answer: D Terms: Audit of inventory Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 21-6 AACSB: Reflective thinking skills 12) 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 Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 32

13) 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. A) True B) False Answer: A Terms: Pricing manufactured inventory Diff: Easy Objective: LO 21-6 AACSB: Reflective thinking skills 14) 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. A) True B) False Answer: A Terms: Assurance for realizable value objective for inventory pricing and compilation Diff: Easy Objective: LO 21-6 AACSB: Reflective thinking skills 15) 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. A) True B) False Answer: B Terms: Performing price tests for purchased inventory; FIFO valuation method Diff: Easy Objective: LO 21-6 AACSB: Reflective thinking skills 16) When a client has standard cost records, an efficient and useful method of determining valuation is to review and analyze variances. A) True B) False Answer: A Terms: Audit of inventory Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills

17) The major concerns in performing inventory valuation tests are compliance with GAAP and consistency with prior years. A) True B) False Answer: A Terms: Considerations in evaluating reasonableness of cost allocations Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 18) 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. A) True B) False Answer: B Terms: Accuracy objective for inventory pricing and compilation Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 19) The audit procedure "Account for unused tag numbers shown in the auditor's working papers to make sure no tags have been added" provides assurance mainly for the existence objective for inventory pricing and compilation. A) True B) False Answer: A Terms: Existence objective for inventory pricing and compilation Diff: Moderate Objective: LO 21-6 AACSB: Reflective thinking skills 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: A) inventory and warehousing cycle. B) payroll and personnel cycle. C) acquisitions and payments cycle. D) cash cycle. Answer: B Terms: Labor a significant part of inventory Diff: Easy Objective: LO 21-7 AACSB: Reflective thinking skills

2) 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 cycle that affect the audit of inventory. Answer: Tests of details of balances for inventory are affected by the results of tests of controls and substantive tests of transactions in the sales and collection cycle, acquisition and payment cycle, and payroll and personnel cycle, as well as the inventory and warehousing cycle. Terms: Cycles that affect inventory Diff: Moderate Objective: LO 21-7 AACSB: Reflective thinking skills 3) Internal controls over the ship finished goods function in the inventory and warehousing cycle are not normally tested by the auditor as a part of performing tests of controls and substantive tests of transactions in the sales and collection cycle. A) True B) False Answer: B Terms: Internal controls over ship finished goods function Diff: Easy Objective: LO 21-7 AACSB: Reflective thinking skills 4) Cost of goods sold is generally a residual of beginning inventory less acquisitions plus ending inventory. A) True B) False Answer: B Terms: Cost of goods sold as a residual Diff: Easy Objective: LO 21-7 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 22 Audit of the Capital Acquisition and Repayment Cycle 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 Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 3) Which of the following statements regarding the capital acquisition and repayment cycle is most correct? A) Relatively few transactions affect the cycle, and most are smaller amounts. B) Large numbers of transactions affect the cycle, and most are smaller amounts. C) Relatively few transactions affect the cycle, and most are highly material. D) Large number of transaction affect the cycle, and most are highly material. Answer: C Terms: Capital acquisition and repayment cycle Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills

4) The primary audit objectives to focus on when auditing debt 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 Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 5) Performance materiality is often set at a(n) ________ level for notes payable. A) high B) moderate C) low D) unknown Answer: C Terms: Tolerable misstatement level for notes payable Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-1 AACSB: Reflective thinking skills

8) In the audit of the transactions and amounts in the capital acquisitions and repayments 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 acquisitions and repayments cycle Diff: Moderate Objective: LO 22-1 AACSB: Reflective thinking skills 9) All corporations must have a ________ account. A) preferred stock B) common stock C) paid-in capital in excess of par D) dividends payable Answer: B Terms: Capital acquisition and repayment cycle Diff: Moderate Objective: LO 22-1 AACSB: Reflective thinking skills 10) Discuss 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 Diff: Challenging Objective: LO 22-1 AACSB: Reflective thinking skills

11) 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 • 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 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 Diff: Challenging Objective: LO 22-1 AACSB: Reflective thinking skills 12) 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. A) True B) False Answer: A Terms: Characteristic of capital acquisitions and repayment cycle Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills

13) Auditors seldom learn about the capital acquisition and repayment cycle when gaining an understanding of the client's business and industry. A) True B) False Answer: B Terms: Capital acquisition and repayment cycle Diff: Easy Objective: LO 22-1 AACSB: Reflective thinking skills 14) 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. A) True B) False Answer: A Terms: Auditing capital acquisition and repayment cycle; Verify transactions Diff: Moderate Objective: LO 22-1 AACSB: Reflective thinking skills 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 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 5

3) An auditor is determining whether an issuance of notes payable for cash was correctly recorded. Her 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 Diff: Challenging Objective: LO 22-2 AACSB: Analytic skills 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 6

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 accounting for the discount of bonds payable account. D) properly recorded interest income. Answer: A Terms: Substantive analytical procedures results in interest expense higher than actually recorded Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 22-2 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 22-2 AACSB: Analytic skills 17) To determine if notes payable are 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 master file. Answer: B Terms: Balance-related audit objective to examine duplicate copies of notes payable Diff: Challenging Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 22-2 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 22-2 AACSB: Analytic skills 20) The audit procedure "examine duplicate copies of notes payable to determine whether the notes payable were dated on or before the balance sheet date" is done for which of the following balance-related audit objective? A) Completeness B) Cutoff C) Detail tie-in D) Existence Answer: B Terms: Balance-related audit objective to examine duplicate copies of notes payable Diff: Challenging Objective: LO 22-2 AACSB: Reflective thinking skills 21) The two most important balance related objectives in notes payable are: A) completeness and accuracy. B) existence and completeness. C) accuracy and classification. D) existence and occurrence. Answer: A Terms: Audit of bond seeking fund transactions Diff: Moderate Objective: LO 22-2 AACSB: Analytic skills 22) Why are 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 Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills

23) What are the two most important balance-related audit objectives in notes payable? Answer: • Existing notes payable are included (completeness). • Notes payable are accurately recorded (accuracy). Terms: Balance-related audit objectives in notes payable Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 24) Identify three 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 25) 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 Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 26) 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 master file. 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 balancerelated audit objectives Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 12

27) 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 two 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. Terms: Key controls over notes payable Diff: Challenging Objective: LO 22-2 AACSB: Reflective thinking skills 28) 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 internal controls over notes payable are adequate. • Transactions for principal and interest involving notes payable are properly authorized and recorded as defined by the six transaction-related audit objectives. • The liability for notes payable and the related interest expense and accrued liability are properly stated as defined by eight of the nine balance-related audit objectives (realizable value is excluded). • Disclosures related to notes payable and the related interest expense satisfy the four presentation and disclosure audit objectives. Terms: Objectives of audit of notes payable Diff: Challenging Objective: LO 22-2 AACSB: Reflective thinking skills 29) Notes payable are generally for a period of sixty days or less. A) True B) False Answer: B Terms: Notes payable time Diff: Easy Objective: LO 22-2 AACSB: Reflective thinking skills

30) When performing 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. A) True B) False Answer: A Terms: Analytical procedures for notes payable Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 31) The balance-related audit objective realizable value is not applicable when auditing notes payable. A) True B) False Answer: A Terms: Auditing notes payable and balance-related audit objective realizable value Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 32) The three most important balance-related audit objectives for notes payable are existence, realizable value, and accuracy. A) True B) False Answer: B Terms: Balance-related audit objectives for notes payable; Existence, realizable value and accuracy Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 33) 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. A) True B) False Answer: B Terms: Verifying accuracy objective for notes payable audit procedure Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills

34) 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. A) True B) False Answer: A Terms: Audit procedure to verify classification objective for notes payable Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 35) The evidence obtained during the tests of details of balances helps the auditor satisfy the notes payable presentation and disclosure objectives. A) True B) False Answer: B Terms: Notes payable and disclosure requirements Diff: Moderate Objective: LO 22-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills

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 stock stock Declaration of dividends Yes Yes Yes B) Repurchase of common stock Yes

Issuance of common stock Yes

Declaration of dividends No

C) Repurchase of common stock No

Issuance of common stock Yes

Declaration of dividends No

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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 3) When a company maintains its own records of stock transactions and outstanding stock, 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 master file. B) capital stock certificate record. C) schedule of stock owners. D) corporate directory. Answer: B Terms: Record of issuance and repurchase of capital stock Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 master file. Answer: D Terms: Record of outstanding shares Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 17

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 master file. 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills

12) When a company maintains its own records of stock transactions and capital stock outstanding its internal controls must be adequate to accomplish three objectives. List them below. Answer: Actual owners of the stock are recognized in the corporate records. The correct amount of dividends is paid to stockholders owning the stock as of the dividend record date. The potential for misappropriation of assets is minimized. Terms: Internal controls and objectives when records maintained of stock transactions and capital stock outstanding Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 13) 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 is properly authorized 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. Transfer agents may also disburse cash dividends to shareholders. Terms: Independent registrar and stock transfer agent differences Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 14) What are two important 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: Companies should develop: 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 Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills

15) Discuss the 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. Many companies use a capital stock certificate book and a shareholders' capital stock master file 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 Diff: Challenging Objective: LO 22-3 AACSB: Reflective thinking skills

16) Match six of the terms (a-i) used in the capital acquisitions and repayment cycle with the descriptions provided below (1-6): a. b. c. d. e. f. g. h. i.

Capital acquisition and repayment cycle Capital stock certificate book Closely held corporation Independent registrar Note payable Publicly held corporation Stock transfer agent Schedule of notes payable and accrued interest 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 Diff: Moderate Objective: LO 22-1, LO 22-2, and LO 22-3 AACSB: Reflective thinking skills

17) The Securities and Exchange Commission requires companies listed on exchanges to employ stock transfer agents. A) True B) False Answer: B Terms: Securities and Exchange Commission; Stock transfer agents Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 18) Public companies whose stock is listed on a stock exchange must employ an independent registrar. A) True B) False Answer: A Terms: Public companies with stock listed on stock exchange; Independent registrar Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 19) The shareholders' capital stock master file 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. A) True B) False Answer: A Terms: Shareholders' capital master file use Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 20) Independent registrars commonly disburse cash dividends to shareholders. A) True B) False Answer: B Terms: Independent registrars Diff: Easy Objective: LO 22-3 AACSB: Reflective thinking skills 21) Few large companies employ stock transfer agents, but small companies commonly do so. A) True B) False Answer: B Terms: Stock transfer agents Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 22

22) Most closely held corporations have numerous transactions during the year for capital stock accounts. A) True B) False Answer: B Terms: Closely held company Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 23) A shareholders' capital stock master file is a record of the issuance and repurchase of capital stock over the life of the corporation. A) True B) False Answer: B Terms: Shareholders' capital stock master file Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 24) The board of directors must authorize the amount of the dividend per share and the dates of record and payment of the dividend. A) True B) False Answer: A Terms: Board of directors and dividends Diff: Moderate Objective: LO 22-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

2) The audit of owners' equity of public and private companies is very different. Which of the following is not one of these differences? A) The number of transactions (private companies have fewer transactions) B) Payment of dividends (public companies rarely pay dividends) C) Complexity of transactions (public companies generally have more complex transactions) D) Type of noncurrent debt (public companies issue more bonds) Answer: B Terms: Audit of owners' equity of public and private companies Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 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 balances Tests of transactions Tests of controls No Yes Yes B) Tests of details of balances Yes

Tests of transactions No

Tests of controls Yes

Tests of details of balances No

Tests of transactions Yes

Tests of controls No

Tests of details of balances Yes

Tests of transactions No

Tests of controls No

Answer: D Terms: Capital stock transactions accurately recorded Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

7) When a company has treasury stock certificates on hand, a year-end count of the certificates by the auditor is: A) always required. B) not required if treasury stock is a deduction from stockholders' equity. C) required when the company classifies treasury stock with other assets. D) required when the company had treasury stock transactions during the year. Answer: A Terms: Treasury stock certificates Diff: Challenging Objective: LO 22-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 22-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

10) 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 Diff: Challenging Objective: LO 22-4 AACSB: Reflective thinking skills 11) Auditing capital stock transactions as part of a merger is challenging because judgment is often involved. A) True B) False Answer: A Terms: Audit of capital stock Diff: Easy Objective: LO 22-4 AACSB: Reflective thinking skills 12) A prior period adjustment may result in a debit or credit to a company's retained earnings account. A) True B) False Answer: A Terms: Prior period adjustment and retained earnings Diff: Easy Objective: LO 22-4 AACSB: Reflective thinking skills

13) Any restrictions on the payment of dividends must be disclosed in the footnotes to the financial statements. A) True B) False Answer: A Terms: Restrictions on payment of dividends disclosed in footnotes Diff: Easy Objective: LO 22-4 AACSB: Reflective thinking skills 14) 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. A) True B) False Answer: A Terms: Accuracy of dividend declaration audit procedure Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 15) For most companies, the only transactions involving retained earnings are net earnings for the year and dividends declared. A) True B) False Answer: A Terms: Transactions involving retained earnings Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 16) Examining the minutes of the board of directors' meetings for proper authorization ordinarily tests the existence objective for capital stock transactions. A) True B) False Answer: B Terms: Test existence objective for capital stock transactions; Examine minutes of board of directors' meetings Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

17) Examining the minutes of the board of directors' meetings for proper authorization ordinarily tests the occurrence objective for capital stock transactions. A) True B) False Answer: A Terms: Test occurrence objective for capital stock transactions; Examine minutes of board of directors' meetings Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills 18) The emphasis in the audit of dividends is on the ending balance rather than the transactions. A) True B) False Answer: B Terms: Emphasis in audit of dividends Diff: Moderate Objective: LO 22-4 AACSB: Reflective thinking skills

Auditing and Assurance Services, 15e (Arens) Chapter 23 Audit of Cash and Financial Instruments 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 Diff: Moderate Objective: LO 23-1 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-1 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 23-1 AACSB: Analytic skills

4) 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 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 is drawn on the general cash account to deposit the total amount of the net payroll in the imprest payroll account. • Branch bank account. For a company operating in multiple locations, 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 Diff: Moderate Objective: LO 23-1 AACSB: Reflective thinking skills 5) Companies may purchase marketable securities as a way to temporarily invest excess cash. A) True B) False Answer: A Terms: Financial instruments; marketable securities Diff: Moderate Objective: LO 23-1 AACSB: Reflective thinking skills 6) Examples of cash equivalents include time deposits, certificates of deposit, and marketable securities. A) True B) False Answer: B Terms: Cash equivalents Diff: Challenging Objective: LO 23-1 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 23-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-2 AACSB: Reflective thinking skills 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 worked Answer: B Terms: Bank reconciliation Diff: Easy Objective: LO 23-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-2 AACSB: Reflective thinking skills 5) All of the following would not be uncovered by a bank reconciliation except for: A) duplicate payment of a vendor's invoice. B) improper payments of officers' personal expenditures. C) payments on notes payable debited directly to the the bank account by the bank but not recorded on the books. D) payment to an employee for more hours than he worked. Answer: C Terms: Acquisitions and payments cycle Diff: Moderate Objective: LO 23-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-2 AACSB: Reflective thinking skills

7) Bank reconciliation audit tests are designed to detect misstatements other than through the improper payment of cash or failure to receive cash normally would not be detected as part of the tests of the bank reconciliation. List below at least THREE misstatements that are designed to be detected by bank reconciliation. Answer: 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 Cash received by the client subsequent to the balance sheet date, but recorded as cash receipts in the current year 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 Payments on notes payables debited directly to the bank balance by the bank but not entered in the client's records Terms: Bank reconciliation audit tests; Detected misstatements Diff: Easy Objective: LO 23-2 AACSB: Reflective thinking skills 8) "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 interception of 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 in excess of the going 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 Diff: Challenging Objective: LO 23-2 AACSB: Reflective thinking skills

Learning Objective 23-3 1) The test of details of balances procedure that requires the auditor to foot the outstanding check 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 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) Footing the outstanding checks list and the list of deposits in transit 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 4) Which of the following statements is correct? A) Auditors must obtain bank confirmations for audits of non-public 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 6

5) A partial-period bank statement and the related canceled 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 11) In an effort to satisfy the completeness objective, the auditor could perform which of the following test 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 are 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 9

16) If a bank does not respond to a bank confirmation request, the auditor would most likely: A) Ask the client to communicate with the bank Perform alternative Send a second to ask them to complete and procedures request return the confirmation No Yes Yes B)

Perform alternative procedures No

Send a second request No

Ask the client to communicate with the bank to ask them to complete and return the confirmation Yes

Send a second request No

Ask the client to communicate with the bank to ask them to complete and return the confirmation Yes

Send a second request Yes

Ask the client to communicate with the bank to ask them to complete and return the confirmation No

Perform alternative procedures Yes D)

Perform alternative procedures Yes Answer: A Terms: Bank confirmation request Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills

17) The most important balance-related audit objectives in the audit of cash include all but which of the following? A) Existence B) Accuracy C) Completeness D) Occurrence Answer: D Terms: Balance-related audit objectives in the audit of cash Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 10

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 reconciliation Diff: Moderate Objective: LO 23-3 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills 11

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 Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 25) 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 transactions cycle affecting the recording of cash receipts and cash disbursements 2. Independent bank reconciliations Terms: Internal controls over year-end cash balances Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 26) 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 canceled checks, duplicate deposit slips, and other documents included in bank statements, mailed by the bank directly to the CPA firm's office. The purpose of the cutoff bank statements is to verify the reconciling items on the client's year-end bank reconciliation with evidence that is not accessible to the client. Terms: Cutoff bank statement; Audit of cash Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills

27) Explain the purpose of testing the client's bank reconciliation, and discuss the major audit procedures involved. Answer: The purpose of testing the client's reconciliation is to verify whether the client's recorded bank balance is the same amount as the actual cash in the bank. Procedures include: • Verify that the client's bank reconciliation is mathematically accurate. • Trace the balance on the bank confirmation and/or the beginning balance on 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 Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills 28) Instead of receiving a cutoff bank statement, 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. The audit procedures include footing 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 Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills 29) The bank reconciliation control is enhanced when a qualified employee reviews the monthly reconciliation as soon as possible after its completion. A) True B) False Answer: A Terms: Bank reconciliation Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills

30) Many of the auditor's audit procedures in the audit of cash center around the client's bank confirmations. A) True B) False Answer: B Terms: Audit of cash; Bank confirmations Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 31) Tracing outstanding checks to subsequent period bank statements tests the cutoff audit objective. A) True B) False Answer: A Terms: Tracing outstanding checks; Cutoff audit objective Diff: Easy Objective: LO 23-3 AACSB: Reflective thinking skills 32) When auditing the year-end cash balance, one of the areas of focus is on the accuracy objective. A) True B) False Answer: A Terms: Auditing year-end cash balance; Accuracy objective Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 33) The three most important audit objectives for cash are accuracy, existence, and classification. A) True B) False Answer: B Terms: Audit objectives for cash Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills

34) The starting point for the verification of the balance in the general bank account is to obtain a bank cut-off statement. A) True B) False Answer: B Terms: General bank account; Bank cut-off statement Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 35) 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. A) True B) False Answer: B Terms: General cash account; Standard bank confirmation Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 36) 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. A) True B) False Answer: B Terms: Outstanding checks on bank reconciliation for completeness; Cutoff bank statement Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 37) 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. A) True B) False Answer: B Terms: Bank confirmation Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 38) Auditors usually design bank confirmations that address the client's specific circumstances. A) True B) False Answer: B Terms: Bank confirmation Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 16

39) Ordinarily, all deposits-in-transit listed on the year-end bank reconciliation should appear as deposits on the cutoff bank statement. A) True B) False Answer: A Terms: Deposits-in-transit; Year-end bank reconciliation; Cutoff bank statement Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills 40) Auditors are not always required to obtain bank confirmations. A) True B) False Answer: A Terms: Bank confirmation Diff: Challenging Objective: LO 23-3 AACSB: Reflective thinking skills 41) The auditor is generally concerned about the realizable value and the rights to cash. A) True B) False Answer: B Terms: Audit of cash Diff: Moderate Objective: LO 23-3 AACSB: Reflective thinking skills Learning Objective 23-4 1) Auditors are likely to prepare a proof of cash when the client has: A) material control weaknesses in cash receipts and cash disbursements. B) material control weaknesses in accounts receivable and revenue. C) material control weaknesses in accounts payable and inventory. D) material control weaknesses in payroll. Answer: A Terms: Proof of cash Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills

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 internal controls. Answer: D Terms: Material fraud; Extend procedures in audit of year-end cash Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 6) A proof of cash is effective at identifying which of the following misstatements? A) Checks written for incorrect amounts 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 19

8) Which of the following is a correct statement? A) A 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 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 2013 and early January 2014:

1. 2. 3. 4.

Bank Account One Disbursing Date (Month/Day) Per Bank Per Books 12/31 12/30 1/2 12/30 1/3 12/31 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, 2013? A) 1 B) 2 C) 3 D) 4 Answer: C Terms: Interbank cash transfers Diff: Challenging Objective: LO 23-4 AACSB: Analytic skills

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, 2013 bank reconciliation? A) 1 B) 2 C) 3 D) 4 Answer: D Terms: Interbank cash transfers Diff: Challenging Objective: LO 23-4 AACSB: Analytic skills 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, 2013 bank reconciliation? A) 1 B) 2 C) 3 D) 4 Answer: A Terms: Interbank cash transfers Diff: Challenging Objective: LO 23-4 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 23-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 23-4 AACSB: Reflective thinking skills 21

14) 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 Diff: Challenging Objective: LO 23-4 AACSB: Analytic skills 15) 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 a 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 Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 16) Auditors will often prepare a proof of cash when the client has material internal control weaknesses in cash receipts and cash disbursements. The purpose of the proof of cash is to determine 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: All recorded cash receipts were deposited All deposits in the bank were recorded in the accounting records All recorded cash disbursements were paid by the bank All amounts that were paid by the bank were recorded Terms: Proof of cash requirements Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills

17) 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 18) 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. Disbursement 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 19) Explain kiting, and discuss how it is performed. Answer: Kiting is the transfer of money from one bank to another and improperly 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 Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills

20) Auditors sometimes prepare a proof of cash when the client has material internal control weaknesses in cash. List two procedures that the proof of cash determines were or were not done. Answer: • All recorded cash receipts were deposited • All deposits in the bank were recorded in the accounting records • All recorded cash disbursements were paid by the bank • All amounts that were paid by the bank were recorded Terms: Proof of cash Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills

21) Match six of the terms (a-k) with the descriptions/definitions provided below (1-6): a. Bank reconciliation b. Branch cash account c. Cash equivalents d. Cutoff bank statement e. General cash account f. Imprest payroll account g. Imprest petty cash fund h. Kiting i. Proof of cash j. Standard bank confirmation form k. 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 Diff: Moderate Objective: LO 23-2, LO 23-3, and LO 23-4 AACSB: Reflective thinking skills

22) A proof of cash involves a combination of substantive tests of transactions and tests of details of balances. A) True B) False Answer: A Terms: Proof of cash; Substantive tests of transactions and tests of details of balances Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 23) A proof of cash includes a reconciliation of cash receipts deposited in the bank with the cash disbursements records for a given period. A) True B) False Answer: B Terms: Proof of cash; Reconciliation of cash receipts deposited in the bank with cash disbursements Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: A Terms: Kiting Diff: Easy Objective: LO 23-4 AACSB: Reflective thinking skills 25) Tests for kiting are performed using only a schedule of intrabank transfers. A) True B) False Answer: B Terms: Tests for kiting Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills

26) 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. A) True B) False Answer: A Terms: Proof of cash Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills 27) 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. A) True B) False Answer: A Terms: Proof of cash receipts; Theft of cash receipts Diff: Challenging Objective: LO 23-4 AACSB: Reflective thinking skills 28) 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. A) True B) False Answer: A Terms: Proof of cash disbursements Diff: Challenging Objective: LO 23-4 AACSB: Reflective thinking skills 29) The auditor must extend the audit procedures in the audit of year-end cash when there are inadequate internal controls. A) True B) False Answer: A Terms: Audit procedures; Inadequate internal controls Diff: Moderate Objective: LO 23-4 AACSB: Reflective thinking skills

Learning Objective 23-5 1) All of the following are correct statements regarding business risk and financial instruments except for: A) Business risks associated with financial instruments will vary depending of 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 5) When an audit client uses a service organization to manage their investment activity: A) the auditor can always rely on the 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 internal controls of the service organization if the service organization's auditor issues a report on their 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 6) As part of their internal control procedures, management needs to have procedures in place to properly classify financial instruments as trading, available-for-sale, or held-to-maturity, based on: A) cost. B) intent. C) maturity. D) probable future gain or loss. Answer: B Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 29

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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

12) A schedule of investment activity will include all but: 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 13) When auditing financial instruments , a confirmation is sent to the broker-dealer: A) only if the client has poor 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

19) 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: Verify quoted market prices Test management classifications Test management's assumptions related to valuation Consider using a specialist for testing fair value estimates Consider whether an impairment loss is required Terms: Audit of financial instruments accounts Diff: Challenging Objective: LO 23-5 AACSB: Reflective thinking skills 20) The majority of financial instruments are valued at the lower of cost or market. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Easy Objective: LO 23-5 AACSB: Reflective thinking skills 21) Business risks associated with financial instruments are the same for all companies. A) True B) False Answer: B Terms: Audit of financial instruments accounts; risk Diff: Easy Objective: LO 23-5 AACSB: Reflective thinking skills 22) The starting point for testing the ending balance of financial instruments accounts is to obtain a gain or loss schedule for the year. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

23) The auditor needs to have an understanding of the client's internal controls over determining fair value estimates. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 24) A factor that increases inherent risk for financial instruments is the complexity of the relevant accounting standards. A) True B) False Answer: A Terms: Audit of financial instruments accounts; risk Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 25) Level 1 estimates require more management judgment than level 2 or level 3 estimates. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Easy Objective: LO 23-5 AACSB: Reflective thinking skills 26) There is significant potential for misstatements and misclassification of financial instruments. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Easy Objective: LO 23-5 AACSB: Reflective thinking skills 27) Assessing internal controls related to financial instruments may be necessary in order to reduce audit risk to an acceptable level. A) True B) False Answer: A Terms: Audit of financial instruments accounts; risk Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 34

28) When auditing financial instruments, interest income and dividends can be recomputed and compared to a public source. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 29) Analytical procedures may be used to assess the year-end balances for financial instruments. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 30) Completeness is an important objective for derivative financial instruments. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 31) The most important objectives for financial instruments are existence and consistency. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 32) Presentation and disclosure objectives are important when auditing financial instruments. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills

33) Tests related to realizable value will vary according to the type of security and the associated accounting standard. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 34) Auditing guidance is provided for auditing accounting estimates specifically for fair values estimates as considerable auditor judgment is involved. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 35) Cutoff is more 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. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 36) When an auditor is verifying quoted market prices, they are concerned about the balancerelated audit objective of accuracy. A) True B) False Answer: B Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 37) Securities and contracts will typically be held by the broker-dealer. A) True B) False Answer: A Terms: Audit of financial instruments accounts Diff: Moderate Objective: LO 23-5 AACSB: Reflective thinking skills 36

Auditing and Assurance Services, 15e (Arens) Chapter 24 Completing the Audit Learning Objective 24-1 1) Auditors often integrate procedures for presentation and disclosure objectives with: A) Tests for planning objectives Tests for balance-related objectives Yes Yes B) Tests for planning objectives No

Tests for balance-related objectives No

Tests for planning objectives Yes

Tests for balance-related objectives No

Tests for planning objectives No

Tests for balance-related objectives Yes

Answer: D Terms: Procedures for presentation and disclosure objectives Diff: Easy Objective: LO 24-1 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-1 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills

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 that a remote chance of occurrence, accrue the $10 million. Answer: B Terms: Potential loss for noncompliance Diff: Moderate Objective: LO 24-2 AACSB: Analytic skills 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills

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

C) 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills

10) If an auditor concludes there are contingent liabilities, then he or she must evaluate the: A) Nature of the disclosure to be included in Materiality of the potential liability. the financial statements. Yes Yes B) Materiality of the potential liability. No

Nature of the disclosure to be included in the financial statements. No

Materiality of the potential liability. Yes

Nature of the disclosure to be included in the financial statements. No

Materiality of the potential liability. No

Nature of the disclosure to be included in the financial statements. Yes

Answer: A Terms: Contingent liabilities Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills 11) One of the primary approaches in dealing with uncertainties in loss contingencies uses a ________ threshold. A) monetary B) materiality C) probability D) analytical Answer: C Terms: Contingent liabilities Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 14) When dealing with contingencies: A) all material 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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 24-2 AACSB: Reflective thinking skills 17) 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills

18) Define the term contingent liability and discuss the criteria accountants and auditors use to classify these accounting events. Answer: Contingent liability: 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 Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 19) With what types of contingencies might an auditor be concerned? Answer: The auditor is generally concerned with contingencies arising from: pending litigation for patent infringement, product liability or other actions, income tax disputes product warranties notes receivable discounted guarantees of obligations of others unused balances of outstanding letters of credit Terms: Types of contingencies Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 20) 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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills

21) 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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills 22) 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 Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills

23) 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. A) True B) False Answer: A Terms: Lawsuit is remote; financial statement accrual or disclosure Diff: Easy Objective: LO 24-2 AACSB: Reflective thinking skills 24) 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. A) True B) False Answer: A Terms: Auditing standards; contingent liabilities Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills 25) 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. A) True B) False Answer: A Terms: Existence of contingent liabilities Diff: Moderate Objective: LO 24-2 AACSB: Reflective thinking skills Learning Objective 24-3 1) Auditors will generally send a standard inquiry 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) those attorneys whom the client relies on for advice related to substantial legal matters. D) only the attorney who represents the client in proceeding where the client is defendant. Answer: B Terms: Standard inquiry letter Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills

2) What needs to be included in a letter of inquiry sent to a client's legal counsel? A) Any pending threatened litigation with which the attorney has had significant The amount of legal fees paid involvement by the client to the attorney Yes Yes B) Any pending threatened litigation with which the attorney has had significant The amount of legal fees paid involvement by the client to the attorney No No C) Any pending threatened litigation with which the attorney has had significant The amount of legal fees paid involvement by the client to the attorney Yes No D) Any pending threatened litigation with which the attorney has had significant The amount of legal fees paid involvement by the client to the attorney No Yes Answer: C Terms: Letter of inquiry Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills

3) Auditors, as part of completing the audit, will request the client to send a letter of inquiry 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) corroborate of information supplied by management concerning litigation, claims, and assessments. C) outside opinion of probability of losses in determining accruals for contingencies. D) outside opinion of probability of losses in determining the proper footnote disclosure. Answer: B Terms: Completing the audit; Letter of inquiry Diff: Moderate Objective: LO 24-3 AACSB: Reflective thinking skills 4) The standard letter of inquiry to the client's legal counsel 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 stationery and signed by a company official. Answer: D Terms: Letter of inquiry Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills

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 to a lack disclose information they of knowledge about matters involving consider confidential. contingent liabilities. Yes Yes B) The attorneys refuse to The attorneys refuse to respond due to a lack disclose information they of knowledge about matters involving consider confidential. contingent liabilities. No No C) The attorneys refuse to The attorneys refuse to respond due to a lack disclose information they of knowledge about matters involving consider confidential. contingent liabilities. Yes No D) The attorneys refuse to The attorneys refuse to respond due to a lack disclose information they of knowledge about matters involving consider confidential. contingent liabilities. No Yes Answer: A Terms: Letter of inquiry Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills 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: Letter of inquiry Diff: Moderate Objective: LO 24-3 AACSB: Analytic skills

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 letter of inquiry 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 Diff: Challenging Objective: LO 24-3 AACSB: Reflective thinking skills 8) An attorney is responding to an independent auditor as a result of the client's letter of inquiry. The attorney may appropriately limit the response to: A) asserted claims and litigation. B) asserted, overtly threatened, or pending claims and litigation. C) items which have an extremely high probability of being resolved to the client's detriment. D) matters to which the attorney has given substantive attention in the form of legal consultation or representation. Answer: D Terms: Response to client's letter of inquiry Diff: Challenging Objective: LO 24-3 AACSB: Reflective thinking skills 9) 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 Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills Topic: Public

10) State three items that should be included in a standard "inquiry of 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 by the client 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 Diff: Challenging Objective: LO 24-3 AACSB: Reflective thinking skills 11) When preparing a standard inquiry of client's attorney letter, the client's letterhead should be used, and the letter should be signed by the client company's officials. A) True B) False Answer: A Terms: Standard inquiry of client's attorney letter Diff: Moderate Objective: LO 24-3 AACSB: Reflective thinking skills 12) In a standard inquiry of client's attorney letter, the attorney is requested to communicate about contingencies up to the balance sheet date. A) True B) False Answer: B Terms: Standard inquiry of client's attorney letter Diff: Moderate Objective: LO 24-3 AACSB: Reflective thinking skills

13) 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. A) True B) False Answer: A Terms: Attorney refuses to provide auditor with information about material existing lawsuits Diff: Easy Objective: LO 24-3 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-4 AACSB: Reflective thinking skills

2) Which type of subsequent event requires consideration by management and evaluation by the auditor? A) Subsequent events that have a direct Subsequent events that do not have a direct effect on the financial statements and effect on the financial statements but for require adjustment. which disclosure may be required. Yes Yes B) Subsequent events that have a direct Subsequent events that do not have a direct effect on the financial statements and effect on the financial statements but for require adjustment. which disclosure may be required. No No C) Subsequent events that have a direct Subsequent events that do not have a direct effect on the financial statements and effect on the financial statements but for require adjustment. which disclosure may be required. Yes No D) Subsequent events that have a direct Subsequent events that do not have a direct effect on the financial statements and effect on the financial statements but for require adjustment. which disclosure may be required. No Yes Answer: A Terms: Subsequent events requiring consideration by management Diff: Easy Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-4 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-4 AACSB: Analytic skills 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 Diff: Easy Objective: LO 24-4 AACSB: Analytic skills

7) The auditor has completed her 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 financial statement 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills 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) Subsequent period sales and purchases transactions are examined 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills 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) Subsequent period sales and purchases transactions are examined 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-4 AACSB: Analytic skills 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 Diff: Moderate Objective: LO 24-4 AACSB: Analytic skills

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 Diff: Challenging Objective: LO 24-4 AACSB: Analytic skills 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 event 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 Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills

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 Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills 18) Subsequent events affecting the realization of assets ordinarily will require adjustments 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 Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills

20) After an auditor has issued an audit report on a nonpublic entity, there is no obligation to make any further audit tests or inquiries with respect to the audited financial statements covered by that report unless: A) material adverse events occur after the date of the auditor's report. B) final determination or resolution was made of a contingency which had been disclosed in the financial statements. C) final determination or resolution was made on matters which had resulted in a qualification in the auditor's report. D) new information comes to the auditor's attention concerning an event that occurred prior to the date of the auditor's report that may have affected the auditor's report. Answer: D Terms: Issued audit report; further audit tests or inquiries Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 24-4 AACSB: Analytic skills 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 Diff: Challenging Objective: LO 24-4 AACSB: Reflective thinking skills

23) The fieldwork for the December 31, 2013 audit of Schmidt Corporation ended on March 17, 2014. The financial statements and auditor's report were issued on March 29, 2014. 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, 2013 financial statements. b. Disclose the information in a footnote in the December 31, 2013 financial statements. c. No action is required. The situations are as follows: ________ 1. On March 1, 2014, one of Schmidt Corporation's major customers declared bankruptcy. The customer's financial condition in 2013 was deteriorating and they owed Schmidt Corporation a large sum of money as of the balance sheet date. ________ 2. On February 17, 2014, Schmidt Corporation sold some machinery for its book value. ________ 3. On February 20, 2014, a flood destroyed the entire uninsured inventory in one of Schmidt's warehouses. ________ 4. On January 5, 2014, 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, 2014, 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 Diff: Challenging Objective: LO 24-2 and LO 24-4 AACSB: Analytic skills

24) 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: • Type 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. 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. • Type 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 Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills 25) 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. A) True B) False Answer: A Terms: Issuance of bonds by client subsequent to year-end Diff: Easy Objective: LO 24-4 AACSB: Reflective thinking skills 26) 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. A) True B) False Answer: B Terms: Subsequent events Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills

27) 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. A) True B) False Answer: A Terms: Subsequent events Diff: Moderate Objective: LO 24-4 AACSB: Reflective thinking skills Learning Objective 24-5 1) The date of the management representation letter received from the client should coincide with which of the following? A) Date of latest subsequent event disclosed in the notes to the financial statements B) Date of the auditor's report C) Balance sheet date D) Engagement agreement Answer: B Terms: Management representation letter Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 5) Which of the following would the auditor expect to find in the client's management representation letter? A) Management's recommendations for 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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 7) Auditing standards require auditors to evaluate whether there is a 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) inquiries of client and its legal counsel. Answer: A Terms: Audit procedures to assess going concern Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 30

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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 9) Refusal by a client to prepare and sign the representation letter would require the auditor to issue a: 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 Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 10) A client 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: Client representation letter Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 31

12) Which of the following is not one of the categories of items included in the client letter of representation? A) Subsequent events B) Completeness of information C) Recognition, measurement, and disclosure D) Materiality Answer: D Terms: Client letter of representation Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 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 of the lack of independence of the preparers. 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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills

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 Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Challenging Objective: LO 24-5 AACSB: Reflective thinking skills

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 Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 19) What two steps must an auditor do if they have reservations about the audit client continuing as a going concern? Answer: 1. Evaluate management's plan to avoid bankruptcy 2. Feasibility of management achieving those plans Terms: Going concern Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 20) State the three purposes of the client letter of representation. 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: Client representation letter Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills

21) List four specific matters that should be included in a client representation letter. Answer: • Management's acknowledgment of its responsibility for the fair presentation of the financial statements • Management's belief that the financial statements are fairly presented in conformity with applicable accounting standards. • Availability of all financial records and related data • Completeness and availability of all minutes of meetings of stockholders, directors, and committees of directors • Absence of unrecorded transactions • Management's belief that the effects of any uncorrected financial statement misstatements are immaterial to the financial statements • Information concerning fraud involving (a) management, (b) employees who have significant roles in internal control, or (c) others where fraud could have a material effect on the financial statements • An acknowledgment by management of its responsibility to design and implement internal control to prevent and detect fraud • Information concerning related-party transactions and amounts receivable or payable to related parties • Unasserted claims or assessments that the entity's lawyer has advised are probable of assertion and must be disclosed in accordance with accounting standards • Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date. • A merger or acquisition after the balance sheet date. Terms: Client representation letter Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 22) Besides the search for contingent liabilities and the review for subsequent events, the auditor has four important final evidence accumulation responsibilities, all of which are required by current professional auditing standards. Discuss each of these four 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 included in published annual reports pertaining directly to the financial statements. Terms: Final evidence accumulation responsibilities required by professional auditing standards Diff: Challenging Objective: LO 24-5 AACSB: Reflective thinking skills

23) Current professional auditing standards require the performance of analytical procedures during the planning and completion phases of the audit. A) True B) False Answer: A Terms: Analytical procedures; Planning and completion phases of the audit Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 24) Current professional auditing standards mandate the use of analytical procedures during the testing phase of the audit. A) True B) False Answer: B Terms: Professional auditing standards; Analytical procedures; Testing phase of audit Diff: Easy Objective: LO 24-5 AACSB: Reflective thinking skills 25) Auditing standards require the auditor's assessment of going-concern issues. A) True B) False Answer: A Terms: Auditing standards; Going-concern issues Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 26) Results from the final analytical procedures may indicate that additional audit evidence is necessary. A) True B) False Answer: A Terms: Analytical procedures in stages of audit Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 27) 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. A) True B) False Answer: A Terms: Letter of representation Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 36

28) Auditors of public companies must obtain certain representations from management regarding internal control over financial reporting. A) True B) False Answer: A Terms: Representations from management regarding internal control Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills Topic: Public 29) 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. A) True B) False Answer: B Terms: Completion of audit; written statement by management; undisclosed liabilities Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 30) Auditors are required to obtain a letter of representation that describes management's planned solutions to all internal control weaknesses identified during an audit. A) True B) False Answer: B Terms: Letter of representation Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 31) 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. A) True B) False Answer: B Terms: Letter of representation Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills

32) 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. A) True B) False Answer: A Terms: Letter of representation; issue opinion Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 33) Because a management representation letter is a written statement from a nonindependent source, it cannot be regarded as reliable evidence. A) True B) False Answer: A Terms: Client representation letter; reliable evidence Diff: Moderate Objective: LO 24-5 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-6 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-6 AACSB: Reflective thinking skills 38

3) 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 Diff: Moderate Objective: LO 24-2 through LO 24-6 AACSB: Reflective thinking skills 4) 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 for audit Diff: Moderate Objective: LO 24-6 AACSB: Reflective thinking skills 5) An independent review must be performed of all audits. A) True B) False Answer: B Terms: Independent review Diff: Easy Objective: LO 24-6 AACSB: Reflective thinking skills 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. A) True B) False Answer: B Terms: Sufficient evidence to draw a conclusion Diff: Moderate Objective: LO 24-6 AACSB: Reflective thinking skills

7) After performing all audit procedures in each area, the auditor must integrate the results into an overall conclusion about the financial statements. A) True B) False Answer: A Terms: Sufficient evidence to draw a conclusion Diff: Moderate Objective: LO 24-6 AACSB: Reflective thinking skills Learning Objective 24-7 1) The auditor is responsible for communicating significant 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 internal control deficiencies Diff: Easy Objective: LO 24-7 AACSB: Reflective thinking skills 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) 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 Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills

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) a written record of discussions between auditor and client concerning the auditor's observations and suggestions for improvements. D) a summary of the auditor's observations that resulted from the auditor's special study of internal control. Answer: C Terms: Management letter purpose Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills 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 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 Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills 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 Diff: Easy Objective: LO 24-7 AACSB: Reflective thinking skills

6) Discuss 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 Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills Topic: SOX 7) Auditors are required to communicate either orally or in writing with the audit committee about internal control weaknesses. A) True B) False Answer: B Terms: Auditors required to communicate with audit committee; Internal control weaknesses Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills 8) Auditors must communicate in writing about internal control weaknesses to the audit committee or those charged with governance. A) True B) False Answer: A Terms: Auditors communicate internal control weaknesses Diff: Moderate Objective: LO 24-7 AACSB: Reflective thinking skills 9) Client representation letters are required by professional auditing standards, whereas management letters are optional. A) True B) False Answer: A Terms: Client representation letters; Management letters; Auditing standards Diff: Moderate Objective: LO 24-5 and LO 24-7 AACSB: Reflective thinking skills

Learning Objective 24-8 1) The audit firm issues an audit report for its client. The auditor's 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 as a company. 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 Diff: Moderate Objective: LO 24-8 AACSB: Analytic skills

2) The fieldwork for the December 31, 2013 audit of Treble Corporation ended on March 17, 2014. The financial statements and auditor's report were issued and mailed to stockholders on March 29, 2014. 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, 2013 financial statements. b. Disclose the information in a footnote in the December 31, 2013 financial statements. c. Request the client revise and reissue the December 31, 2013 financial statements. The revision should involve an adjustment to the December 31, 2013 financial statements. d. Request the client revise and reissue the December 31, 2013 financial statements. The revision should involve the addition of a footnote, but no adjustment, to the December 31, 2013 financial statements. e. No action is required. The situations are as follows: ________ 1. On January 16, 2014 a lawsuit was filed against Treble for a patent infringement action that allegedly took place in early 2010. 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, 2014, Treble settled a lawsuit out of court that had originated in 2009 and is currently listed as a contingent liability. ________ 3. On March 30, 2014, Treble settled a lawsuit out of court that had originated in 2007 and is currently listed as a contingent liability. ________ 4. On February 2, 2014, you discovered an uninsured lawsuit against Treble that had originated on August 30, 2010. ________ 5. On April 7, 2014, you discovered that a debtor of Treble went bankrupt on January 22, 2014, due to a major uninsured fire that occurred on January 2, 2014. Answer: 1. b 2. a 3. e 4. b 5. d Terms: Actions for subsequent events Diff: Challenging Objective: LO 24-2, LO 24-6, and LO 24-8 AACSB: Analytic skills

3) 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. A) True B) False Answer: A Terms: Auditor discovers that previously issued financial statements are misleading Diff: Easy Objective: LO 24-8 AACSB: Reflective thinking skills 4) Subsequent discoveries of facts requiring the reissuance of financial statements arise from events occurring after the date of the auditor's report. A) True B) False Answer: B Terms: Events that occur after the date of the auditor's report Diff: Moderate Objective: LO 24-8 AACSB: Reflective thinking skills