QUESTION 74
Which of the following procedures would an auditor most likely perform to obtain assurance that slowmoving and obsolete items included in inventories are properly identified?
A. T esting shipping and receiving cutoff procedures.
B. Confirminginventoriesatlocationsoutsidetheentity'spremises.
C. Examining an analysis of inventory turnover.
D. Tracing inventory observation test counts to perpetual listings.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Examining an analysis of inventory turnover helps identify slow-moving, excess, defective, and obsolete items included in inventories. In order for inventory to be properly valued, these items may need to be written down.
Choice "a" is incorrect. Testing shipping and receiving cutoff provides evidence regarding completeness of inventory and rights and obligations related to inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items. Choice "b" is incorrect. Confirming inventories at locations outside the entity's premises provides evidence regarding existence and completeness of inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items. Choice "d" is incorrect. Tracing inventory observation test counts to perpetual listings provides evidence regarding the completeness of inventory, but it does not provide evidence regarding the identification and valuation of slow-moving and obsolete items.
QUESTION 75
An auditor scans a client's investment records for the period just before and just after the year-end to determine that any transfers between categories of investments have been properly recorded. The primary purpose of this procedure is to obtain evidence about management's financial statement assertions of:
A. Rightsandobligations,andexistence.
B. Valuationandaccuracy,andrightsandobligations.
C. Existence, and understandability and classification.
D. Understandability and classification, and valuation and accuracy.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Investments may be classified as trading, available-for-sale, or held-to-maturity. The classification of each investment into one of these three categories determines how it will be shown on the balance sheet (understandability and classification) and whether it will be valued at market or at amortized cost (valuation and accuracy).
Choices "a", "b", and "c" are incorrect. Reviewing transfers of investments between categories will not provide evidence regarding rights and obligations or existence. Rights and obligations and existence would be concerned with whether the securities actually exist and are owned by the client.
QUESTION 76
Which of the following procedures represents a weakness in internal controls for payroll?
A. Thepayrollclerkdistributessignedpayrollchecks.Undistributedchecksarereturnedtothepayrolldepartment.
B. Theaccountingdepartmentwirestransfersfundstothepayrollbankaccount.Thetransferisbasedontotalsfromthepayrolldepartmentsummary. C. The payroll department prepares checks using a signature plate. The treasurer supervises the process before payroll checks are distributed.
D. The payroll department prepares checks. The chief financial officer signs the payroll checks.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. Unclaimed payroll checks should be returned to an independent party for follow up. Returning such checks (assets) to the payroll department (recordkeeping) represents an inadequate segregation of duties.
Choice "b" is incorrect. It is acceptable for the accounting department to set up the transfer of funds into the payroll account, since the accounting department does not have access to the actual funds. Choice "c" is incorrect. The treasurer's supervision is crucial in this choice, serving to separate the recordkeeping function (payroll department) from the custodial function (the treasurer). Choice "d" is incorrect. It is an appropriate segregation of duties for the payroll department to prepare the checks, while the chief financial officer signs them. This separates the recordkeeping function from the custodial function.
QUESTION 77
In auditing a manufacturing entity, which of the following procedures would an auditor least likely perform to determine whether slow-moving, defective, and obsolete items included in inventory are properly identified?
A. Testthecomputationofstandardoverheadrates.
B. Tourthemanufacturingplantorproductionfacility.
C. Compare inventory balances to anticipated sales volume. D. Review inventory experience and trends.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D)
Explanation Explanation/Reference:
Explanation:
Choice "a" is correct. Testing the computation of standard overhead rates relates to the accumulation of costs during the manufacturing process, and not to whether the inventory is slow-moving, defective, or obsolete after manufacture.
Choice "b" is incorrect. During a tour of the manufacturing plant or production facility, the auditor should be alert for items that appear to be old, obsolete, or defective. Choice "c" is incorrect. Comparisons of inventory balances with anticipated sales volume might indicate higher inventory levels than would be expected, perhaps due to slow-moving, defective, or obsolete inventory items.
Choice "d" is incorrect. Review of inventory experience and trends may indicate slow-moving, defective, or obsolete inventory items. For example, the auditor may notice a particular item that is building up in inventory, or a trend toward reduced sales of that item.
QUESTION 78
When a company's stock record books are maintained by an outside registrar or transfer agent, the auditor should obtain confirmation from the registrar or transfer agent concerning the:
A. Amountofdividendspaidtorelatedparties.
B. Expectedproceedsfromstocksubscriptionsreceivable. C. Number of shares issued and outstanding.
D. Proper authorization of stock rights and warrants.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. If a client uses a stock transfer agent, confirmations should be used to provide evidence of shares authorized, issued, and outstanding, as well as to provide evidence of the individual transactions.
Choice "a" is incorrect. It is the auditor's responsibility to identify, examine, and evaluate the disclosure of related party transactions. The stock transfer agent would not necessarily know which parties are related to the client.
Choice "b" is incorrect. The auditor should recalculate, or should review management's calculations of, stock subscriptions receivable. Confirmation from the stock transfer agent would not be necessary to review this information.
Choice "d" is incorrect. Proper authorization of stock rights and warrants would best be verified by reviewing the minutes of Board of Director meetings. Confirmation from the stock transfer agent would not be necessary to review this information.
QUESTION 79
An auditor usually determines whether dividend income from publicly-held investments is reasonable by computing the amounts that should have been received by referring to:
A. Stockledgersmaintainedbyindependentregistrars. B. DividendrecordsonfilewiththeSEC.
C. Records produced by investment services.
D. Minutes of the investee's board of directors.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Investment income from dividends is generally recalculated by comparing recorded income with dividend record books produced by investment advisory services such as "Moody's Dividend Record." These books state the dividend that was declared and paid by the investee.
Choice "a" is incorrect. Stock ledgers maintained by independent registrars indicate how many shares of stock are issued and outstanding, and identify the shareholders of record, but they do not contain information concerning dividends.
Choice "b" is incorrect. Dividend records on file with the SEC would probably include appropriate information, but it is more efficient to use a single source (such as "Moody's") than it is to obtain and review SEC records for each investee.
Choice "d" is incorrect. Annual audited financial statements of the investee companies give the total dividends paid, but there may not be enough information to determine exactly how much went to each type of stock and hence to each stockholder. In addition, it is more efficient to use a single source (such as "Moody's") than it is to obtain and review the financial statements of each investee.
QUESTION 80
An auditor's inquiries of management disclosed that the entity recently invested in a series of energy derivatives to hedge against the risks associated with fluctuating oil prices. Under these circumstances, the auditor should:
A. Performanalyticalprocedurestodetermineifthederivativesareproperlyvalued.
B. Examinethecontractsforpossibleriskexposureandtheneedtorecognizelosses.
C. Confirm the marketability of the derivatives with a commodity specialist.
D. Document the derivatives in the auditor's communication with those charged with governance.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Generally accepted accounting principles specify that, in order to qualify for hedge treatment, the entity must demonstrate and disclose a
number of transaction features including risk exposure. The auditor would therefore need to examine the contracts to evaluate the character of the hedge and the degree to which losses should be recognized in the determination of income, as well as the character of any disclosures.
Choice "a" is incorrect. Generally accepted accounting principles require this derivative to be valued at fair value. While the auditor does need to test
management's assertions about fair value, analytical procedures are not the most likely way to do this. More likely, the auditor would obtain quoted market prices from financial publications, the exchanges, the National Association of Securities Dealers Automated Quotations System (NASDAQ), or pricing services. If quoted market prices were not available, estimates based on valuation models would be used. Choice "c" is incorrect. The auditor would not generally confirm marketability with a commodity specialist, but rather would test the valuation of such securities by reference to quoted market prices, by using pricing services, or based on a valuation model. Choice "d" is incorrect. There is no requirement that investments in derivatives be communicated to those charged with governance.
QUESTION 81
An auditor's principal objective in analyzing repairs and maintenance expense accounts is to:
A. Determinethatallobsoleteplantandequipmentassetswerewrittenoffbeforetheyear-end. B. Verifythatallrecordedplantandequipmentassetsactuallyexist.
C. Discover expenditures that were expensed but should have been capitalized.
D. Identify plant and equipment assets that cannot be repaired and should be written off.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The auditor reviews repair and maintenance expense accounts to test for completeness of asset additions (i.e., the auditor is looking for items recorded as repairs or maintenance that would more properly have been capitalized as betterment of an asset). Choice "a" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about obsolete assets. The auditor might review asset records for old assets, or observe assets that are not being used, in an effort to determine whether obsolete plant and equipment assets were written off before year-end.
Choice "b" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about the existence of assets. The auditor might select recorded plant and equipment assets, and then physically locate and observe them, in order to verify existence. Choice "d" is incorrect. Analyzing the repairs and maintenance account does not provide evidence about assets that cannot be repaired. The auditor might review asset records for old assets, or observe assets that are not being used, in an effort to determine whether assets that cannot be repaired have been properly written off.
QUESTION 82
The auditor's inventory observation test counts are traced to the client's inventory listing to test for which of the following financial statement assertions?
A. Completeness.
B. Rightsandobligations.
C. Allocation and valuation.
D. Understandabilityandclassification.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The auditor should test the physical inventory report by tracing test counts taken by the auditor to the report, thereby verifying its completeness. Choice "b" is incorrect. Tracing from test counts to the client's inventory listing does not test rights and obligations. Rights and obligations might be tested by examining paid vendors' invoices, inspecting consignment agreements and contracts, or by confirming inventory held at outside locations. Choice "c" is incorrect. Tracing from test counts to the client's inventory listing does not test allocation and valuation. Allocation and valuation might be tested by examining paid vendors' invoices, evaluating direct labor rates, recalculating overhead rates, or examining an analysis of inventory turnover.
Choice "d" is incorrect. Tracing from test counts to the client's inventory listing does not test understandability and classification. Understandability and classification might be tested by confirming inventories pledged under loan agreements, examining drafts of the financial statements for appropriate balance sheet classification, etc.
QUESTION 83
An analysis of which of the following accounts would best aid in verifying that all fixed assets have been capitalized?
A. Cash.
B. Depreciationexpense.
C. Property tax expense.
D. Repairs and maintenance.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. An analysis of the repairs and maintenance account would best aid the auditor in verifying that all fixed assets have been capitalized. This account is generally analyzed to test for completeness of asset additions (i.e., the auditor is looking for items recorded as repairs or maintenance that would more properly have been capitalized as betterment of an asset). Choice "a" is incorrect. An analysis of cash would not identify fixed assets that were not properly capitalized, since cash would be paid for the purchase regardless of whether the item were expensed or capitalized.
Choice "b" is incorrect. An analysis of depreciation expense would not identify fixed assets that were not properly capitalized, since no depreciation would be included for items not already classified as assets.
Choice "c" is incorrect. An analysis of property tax expense would not identify fixed assets that were not properly capitalized, since no property tax would be included for items not already classified as assets.
QUESTION 84
Which of the following strategies most likely could improve the response rate of the confirmations of accounts receivable?
A. Restricttheselectionofaccountstobeconfirmedtothosecustomerswithlargebalances. B. Includealistofitemsorinvoicesthatconstitutethecustomers'accountbalances.
C. Explain to customers that discrepancies will be investigated by an independent third party. D. Askcustomerstorespondtotheconfirmationrequestsdirectlytotheauditorbyfax.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The auditor should consider the types of information respondents will be readily able to confirm. For instance, some accounting systems facilitate the confirmation of single transactions rather than entire balances. In such cases, the auditor might consider including a client- prepared statement of account showing details of the customer's account balance being confirmed. By making it easier for customers to determine which items are included in the balance being confirmed, the auditor also makes it more likely that those customers will respond. Choice "a" is incorrect. Restricting the selection of accounts to be confirmed to those customers with large balances doesn't improve response rates, as customers with large balances are not necessarily more likely to respond than customers with small balances. Choice "c" is incorrect. Explaining to customers that discrepancies will be investigated by an independent third party would not necessarily encourage them to respond, as they might be reluctant to set off this investigation.
Choice "d" is incorrect. Responses received by fax should be verified by calling the senders and requesting that the original confirmations be mailed back. Asking customers to respond by fax might actually reduce the response rate for receiving the original confirmation, since customers may decide that since they already sent the fax, they don't need to send the original back as well.
QUESTION 85
In establishing the existence and ownership of long-term investments in the form of publicly-traded stock, an auditor most likely would inspect the securities or:
A. Correspondwiththeinvesteecompanytoverifythenumberofsharesowned.
B. Confirmthenumberofsharesownedthatareheldbyanindependentcustodian.
C. Applyanalyticalprocedurestothedividendincomeandinvestmentsaccounts.
D. Inspect the cash receipts journal for amounts that could represent the sale of securities.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Confirmations should be requested from the custodian for securities that are in the possession of third parties.
Choice "a" is incorrect. The investee company may not have timely information regarding the ownership of its stock, nor would an investee typically want to correspond with all of its shareholders in this manner.
Choice "c" is incorrect. Analytical procedures might be used to test the reasonableness of dividend income, but this would not provide evidence about the existence and ownership of the investments. Choice "d" is incorrect. Inspecting the cash receipts journal for amounts that could represent the sale of securities might provide evidence regarding sales (and gains or losses on sales), but would not provide evidence about the existence and ownership of the investments.
Audit Evidence: Miscellaneous Items
QUESTION 86
Which of the following best describes the auditor's responsibility with respect to fair values?
A. Theauditorshoulddeterminewhethermanagementhastheintentandabilitytocarryoutcoursesofactionthatmayaffectfairvalues.
B. Theauditorshouldassesstheriskofmaterialmisstatementoffairvaluemeasurements.
C. The auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.
D. The auditor should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The auditor's overall responsibility is to obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.
Choice "a" is incorrect. While it is true that the auditor should determine whether management has the intent and ability to carry out courses of action that may affect fair values, this is just one part of evaluating fair value measurements and not the best description of the auditor's overall responsibility. Choice "b" is incorrect. While it is true that the auditor should assess the risk of material misstatement of fair value measurements, this is done to determine the nature, timing, and extent of audit procedures. It is not the best representation of the auditor's overall responsibility. Choice "d" is incorrect. Management (and not the auditor) should make fair value measurements and disclosures in accordance with GAAP and should identify and support any significant assumptions used.
QUESTION 87
Which of the following would an auditor least likely consider with respect to fair values?
A. Segregationofdutiesbetweenthosecommittingtheentitytocertaintransactionsandthoseresponsibleforundertakingthevaluationsrelatedtothose transactions.
B. Theeffectonfairvaluemeasurementanddisclosuresofinformationavailablesubsequenttotheaudit.
C. The role of information technology in determining fair value measurements and disclosures.
D. Whether the valuation methods used are appropriate in relation to the industry in which the entity operates.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The auditor would consider subsequent events and transactions occurring before the completion of the audit, not after. The auditor is not responsible for predicting the future, and would not be expected to evaluate the effect of conditions arising subsequent to the audit, that, if known at the time of the audit, might have affected fair value measurements and disclosures. Choice "a" is incorrect. The auditor is responsible for understanding relevant controls. Segregation of duties between those committing the entity to certain transactions and those responsible for undertaking the valuations related to those transactions is a relevant control. Choice "c" is incorrect. The auditor is responsible for understanding the entity's process for determining fair value measurements and disclosures. Considering the role of information technology in determining fair value measurements and disclosures is part of understanding this process. Choice "d" is incorrect. The auditor should evaluate whether the valuation model is appropriate given the entity's circumstances. As part of this evaluation, the auditor should consider whether the valuation method is appropriate in relation to the business, industry, and environment in which the entity operates.
QUESTION 88
Which of the following procedures most likely would assist an auditor in determining whether management has identified all accounting estimates that could be material to the financial statements?
A. Inquireabouttheexistenceofrelatedpartytransactions.
B. Determinewhetheraccountingestimatesdeviatefromhistoricalpatterns. C. Confirm inventories at locations outside the entity.
D. Review the lawyer's letter for information about litigation.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The auditor should inquire of management concerning pending or threatened litigation, and should obtain a letter from the client's lawyer to corroborate this information. Included in this letter is either an identification of the omission of any pending or threatened litigation, claims, and assessments, or a statement that the list of such matters (as provided by management) is complete. Choice "a" is incorrect. Accounting estimates generally are not associated with the existence of related party transactions.
Choice "b" is incorrect. Evaluating deviations from historical patterns assists an auditor in determining if a recorded estimate is reasonable, but it does not provide
assurance that management has identified all material accounting estimates.
Choice "c" is incorrect. Accounting estimates generally are not associated with the existence of inventories at locations outside the entity.
QUESTION 89
In evaluating the reasonableness of an entity's accounting estimates, an auditor normally would be concerned about assumptions that are:
A. Susceptibletobias.
B. Consistentwithpriorperiods. C. Insensitive to variations.
D. Similar to industry guidelines.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. An auditor would be concerned about assumptions that are susceptible to bias because it is more likely that estimates based on such assumptions will be misstated. Choice "b" is incorrect. The auditor would not normally be concerned about assumptions that are consistent with prior periods, as estimates based on such assumptions are less likely to be misstated. Choice "c" is incorrect. The auditor would not normally be concerned about assumptions that are insensitive to variation, as estimates based on such assumptions are less likely to be misstated. Choice "d" is incorrect. The auditor would not normally be concerned about assumptions that are similar to industry guidelines, as estimates based on such assumptions are less likely to be misstated.
QUESTION 90
The refusal of a client's attorney to provide information requested in an inquiry letter generally is considered:
A. Groundsforanadverseopinion.
B. Alimitationonthescopeoftheaudit.
C. Reason to withdraw from the engagement.
D. Equivalent to a significant deficiency in internal control.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. A lawyer's refusal to furnish the information requested in an inquiry letter would be a limitation on the scope of the audit sufficient to preclude
an unqualified opinion. Choice "a" is incorrect. An adverse opinion states that the financial statements do not present fairly the financial position or the results of operations or cash flows in conformity with generally accepted accounting principles. A lawyer's refusal to furnish the information requested in an inquiry letter does not necessarily mean that the financial statements are not fairly presented in conformity with GAAP. Choice "c" is incorrect. A lawyer's refusal to furnish the information requested in an inquiry letter is not a reason to withdraw from the engagement, as long as the lawyer's refusal is not based on the client's request. Choice "d" is incorrect. A lawyer's refusal to furnish the information requested in an inquiry letter is not considered to be a significant deficiency in internal control.
QUESTION 91
A client's lawyer is unable to form a conclusion about the likelihood of an unfavorable outcome of pending litigation because of inherent uncertainties. If the litigation's effect on the client's financial statements could be material but it is properly disclosed in the financial statements, the auditor most likely would:
A. Issueaqualifiedopinionintheauditor'sreportbecauseofthelawyer'sscopelimitation.
B. Withdrawfromtheengagementbecauseofthelackofinformationfurnishedbythelawyer.
C. Disclaim an opinion on the financial statements because of the materiality of the litigation's effect. D. Issue an unqualified opinion without modification.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. A lawyer may be unable to respond concerning the likelihood of an unfavorable outcome of litigation, claims, and assessments or the amount or range of potential loss, because of inherent uncertainties. Even if the effect of the matter on the financial statements could be material, if it is properly disclosed (and supported by available evidence), the auditor will ordinarily issue an unqualified opinion without any modification.
Choice "a" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in a qualification. Choice "b" is incorrect. The auditor should consider withdrawing from the engagement only if the lawyer withholds information per the client's request. Given the fact pattern, there is no need for the auditor to withdraw from the engagement.
Choice "c" is incorrect. The inability to form an opinion on the amount or range of potential loss would generally not be classified as a scope limitation resulting in a disclaimer of opinion.
QUESTION 92
When auditing related party transactions, an auditor places primary emphasis on:
A. Ascertainingtherightsandobligationsoftherelatedparties. B. Confirmingtheexistenceoftherelatedparties.
C. Verifying the valuation of the related party transactions.
D. Evaluating the disclosure of the related party transactions.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The auditor should view related party transactions within the framework of existing pronouncements, placing primary emphasis on the adequacy of disclosure. Choice "a" is incorrect. Since related party transactions are (by definition) not considered to be at arm'slength, the auditor generally does not ascertain the rights and obligations of the related parties. Choice "b" is incorrect. The auditor generally does not confirm the existence of the related parties. Choice "c" is incorrect. Since related party transactions are (by definition) not considered to be at arm'slength, the auditor generally does not verify the valuation of the related party transactions.
QUESTION 93
Which of the following procedures would an auditor ordinarily perform first in evaluating management's accounting estimates for reasonableness?
A. Developindependentexpectationsofmanagement'sestimates.
B. Considertheappropriatenessofthekeyfactorsorassumptionsusedinpreparingtheestimates. C. Test the calculations used by management in developing the estimates.
D. Obtain an understanding of how management developed its estimates.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. In evaluating the reasonableness of an accounting estimate, the auditor should first obtain an understanding of how management developed its estimate. Choice "a" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditor should use one or a combination of the following approaches: a) review and test the process used by management to develop the estimate, b) develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate, or c) review subsequent events. Choice "b" is incorrect. After having first obtained an understanding of how management developed its estimate, the auditor should consider testing management's process by assessing the appropriateness of the key factors or assumptions used in preparing the estimate. Choice "c" is incorrect. After first obtaining an understanding of how management developed its estimate, the auditor should use one or a combination of the following approaches: a) review and test the process used by management to develop the estimate, b) develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate, or c) review subsequent events.
QUESTION 94
In evaluating the reasonableness of an accounting estimate, an auditor most likely would concentrate on key factors and assumptions that are: A. Consistentwithpriorperiods.
B. Similartoindustryguidelines.
C. Objective and not susceptible to bias. D. Deviations from historical patterns.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. In evaluating the reasonableness of an estimate, an auditor would normally concentrate on key factors and assumptions that are (1) significant to the accounting estimate, (2) sensitive to variations, (3) deviations from historical patterns, or (4) subjective and susceptible to misstatements and bias. Choice "a" is incorrect. The auditor need not concentrate on key factors or assumptions that are consistent with those of prior periods, since estimates based on such assumptions are less likely to be misstated.
Choice "b" is incorrect. The auditor need not concentrate on key factors or assumptions that are similar to industry guidelines, since estimates based on such assumptions are less likely to be misstated. Choice "c" is incorrect. The auditor need not focus on factors that are objective and not susceptible to bias, since estimates based on such assumptions are less likely to be misstated.
QUESTION 95
The primary reason an auditor requests letters of inquiry be sent to a client's attorneys is to provide the auditor with:
A. Theprobableoutcomeofassertedclaimsandpendingorthreatenedlitigation.
B. Corroborationoftheinformationfurnishedbymanagementaboutlitigation,claims,andassessments.
C. The attorneys' opinions of the client's historical experiences in recent similar litigation.
D. A description and evaluation of litigation, claims, and assessments that existed at the balance sheet date.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. A letter of audit inquiry to the client's lawyer is the auditor's primary means of obtaining corroboration of the information furnished by management concerning litigation, claims, and assessments.
Choice "a" is incorrect. While the attorney is requested to provide the auditor with the likelihood of an unfavorable outcome, the primary source of this information is management. Choice "c" is incorrect. The attorney's opinion of historical experiences may provide some information to the auditor, but it is not the primary goal of audit inquiry letters. Choice "d" is incorrect. While the attorney is asked to comment on management's description and evaluation of litigation, claims, and assessments that existed at the balance sheet date, the primary source of this information is management.
QUESTION 96
After determining that a related party transaction has, in fact, occurred, an auditor should:
A. Addaseparateparagraphtotheauditor'sstandardreporttoexplainthetransaction.
B. Performanalyticalprocedurestoverifywhethersimilartransactionsoccurred,butwerenotrecorded. C. Obtain an understanding of the business purpose of the transaction.
D. Substantiate that the transaction was consummated on terms equivalent to an arm's-length transaction.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. After identifying the occurrence of a related party transaction, the auditor should apply the procedures considered necessary to obtain satisfaction concerning the purpose and nature of the transaction and its effect on the financial statements. Choice "a" is incorrect. While an extra paragraph may be added to emphasize a matter, there is no requirement that related party transactions be disclosed via explanatory language added to the auditor's report. Choice "b" is incorrect. Analytical procedures are generally not effective in the identification of related party transactions.
Choice "d" is incorrect. It will generally not be possible to substantiate representations that the transaction was consummated on terms equivalent to those that would have prevailed in an arm's- length transaction.
QUESTION 97
Which of the following auditing procedures most likely would assist an auditor in identifying related party transactions?
A. Retestingineffectiveinternalcontrolspreviouslyreportedtothosechargedwithgovernance.
B. Sendingsecondrequestsforunansweredpositiveconfirmationsofaccountsreceivable.
C. Reviewing accounting records for nonrecurring transactions recognized near the balance sheet date. D. Inspecting communications with law firms for evidence of unreported contingent liabilities.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Unusual nonrecurring transactions near year-end are characteristic of related party transactions. Since related party transactions are not at arm's-length, management may use such transactions to bolster sales or assets.
Choice "a" is incorrect. Retesting ineffective controls would not assist the auditor in identifying related party transactions.
Choice "b" is incorrect. Confirmation of accounts receivable would not assist the auditor in identifying related party transactions. Choice "d" is incorrect. Finding unrecorded contingent liabilities would not assist the auditor in identifying related party transactions.
QUESTION 98
Which of the following factors most likely would cause a CPA not to accept a new audit engagement?
A. Theprospectiveclient'sunwillingnesstopermitinquiryofitslegalcounsel.
B. Theinabilitytoreviewthepredecessorauditor'sworkingpapers.
C. The CPA's lack of understanding of the prospective client's operations and industry.
D. The indications that management has not investigated employees in key positions before hiring them.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. A direct letter of inquiry to the entity's legal counsel is required, and a client's refusal to permit such inquiry generally will result in a disclaimer of opinion. It is unlikely that a CPA would accept a new audit engagement under such circumstances. Choice "b" is incorrect. Inability to review the predecessor auditor's working papers would not cause a CPA to decline a new audit engagement. The CPA would simply need to perform an appropriate level of work to substantiate the opening financial statement balances. Choice "c" is incorrect. The CPA need not have an understanding of the prospective client's operations and industry before accepting a new audit engagement. Such an understanding may be obtained after acceptance, during the planning phase of the engagement. Choice "d" is incorrect. Indications that management has not investigated employees in key positions before hiring them is a fraud risk factor that the auditor would need to consider in planning the audit, but it would not cause the CPA to decline the engagement.
QUESTION 99
Which of the following procedures most likely could assist an auditor in identifying related party transactions?
A. Performingtestsofcontrolsconcerningthesegregationofduties.
B. Evaluatingthereasonablenessofmanagement'saccountingestimates. C. Reviewing confirmations of compensating balance arrangements.
D. Scanning the accounting records for recurring transactions.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Compensating balance arrangements may be maintained by or for related parties. Choice "a" is incorrect. Performing tests of controls concerning the segregation of duties relates to the allocation of responsibilities among company employees; related party transactions typically relate to transactions with affiliates, owners, or management.
Choice "b" is incorrect. Evaluating the reasonableness of management's accounting estimates would not provide any evidence of transactions with affiliates, owners, or management. Choice "d" is incorrect. Related party transactions are more likely to be nonrecurring than recurring.
QUESTION 100
"In connection with an audit of our financial statements, management has prepared, and furnished to our auditors a description and evaluation of certain contingencies." The foregoing passage most likely is from a(an):
A. Auditinquirylettertolegalcounsel.
B. Managementrepresentationletter.
C. Audit committee's communication to the auditor. D. Financial statement footnote disclosure.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. Legal counsel is best able to corroborate the description and evaluation of contingencies provided by management.
Choice "b" is incorrect. The management representation letter serves to confirm, in writing, representations provided to the auditor. It does not include a statement indicating that management has prepared and furnished a list of contingencies.
Choice "c" is incorrect. The audit committee would not communicate to the auditor regarding the list of contingencies prepared by management.
Choice "d" is incorrect. It would be inappropriate to indicate in the footnotes whether specific information was provided by management to the auditor.
QUESTION 101
Which of the following procedures would an auditor ordinarily perform first in evaluating the reasonableness of management's accounting estimates?
A. Reviewtransactionsoccurringpriortothecompletionoffieldworkthatindicatevariationsfromexpectations. B. Compareindependentexpectationswithrecordedestimatestoassessmanagement'sprocess.
C. Obtain an understanding of how management developed its estimates.
D. Analyze historical data used in developing assumptions to determine whether the process is consistent.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D)
Explanation Explanation/Reference:
Explanation:
Choice "c" is correct. In evaluating the reasonableness of an estimate, the auditor must first obtain an understanding of how management developed its estimate. Choices "a", "b", and "d" are incorrect. After obtaining an understanding of how management developed its estimate, the auditor would perform one or a combination of the following procedures:
1. Review subsequent events and transactions (occurring prior to completion of fieldwork) that corroborate the value of the estimate (choice "a"). 2. Develop an independent estimate of the item for comparative purposes (choice "b").
3. Review and test the procedures used by management to develop the estimate (choice "d").
QUESTION 102
Which of the following parties should request inquiry of a client's lawyer?
A. Theauditor.
B. Thestockholders.
C. Client management. D. The auditor's attorney.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The letter of inquiry to the client's attorneys is a request made by client management. Due to attorney-client privilege, the attorney would not be able to respond to such a request made by any other party. Note that management would request the attorney to respond directly to the auditor.
Choice "a" is incorrect. The auditor may request that the client include certain matters in the letter, but technically speaking, the request itself comes from client management. Choice "b" is incorrect. The stockholders would not have any involvement in the letter of audit inquiry. Choice "d" is incorrect. The auditor's attorney would not have any involvement in the letter of audit inquiry related to specific client engagements.
QUESTION 103
If a client will not permit inquiry of outside legal counsel, the auditor's report ordinarily will contain a(an):
A. Adverseopinion.
B. Disclaimerofopinion.
C. Unqualified opinion with a separate explanatory paragraph.
D. Qualified opinion.
Correct Answer: B
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. Choice "a" is incorrect. Adverse opinions are used when there are very material departures from GAAP, which is not the case here.
Choice "c" is incorrect. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. An unqualified opinion with a separate explanatory paragraph would not be sufficient to address this situation. Choice "d" is incorrect. A client's refusal to permit inquiry of outside legal counsel is a significant scope limitation that generally will result in a disclaimer of opinion. A qualified opinion would not be sufficient to address this situation.
QUESTION 104
The accounts receivable turnover ratio increased significantly over a two-year period. This trend could indicate that:
A. Theaccountsreceivableaginghasdeteriorated.
B. Thecompanyhaseliminateditsdiscountpolicy.
C. The company is more aggressively collecting customer accounts. D. Customer sales have substantially decreased.
Correct Answer: C
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The accounts receivable turnover ratio is calculated as sales / receivables. More aggressive collection policies will result in a decrease in the receivables balance, which in turn causes the turnover ratio to increase.
Choice "a" is incorrect. A deterioration in the aging of receivables implies a greater receivables balance, which would cause the turnover ratio to decline. Choice "b" is incorrect. Elimination of the company's discount policy would increase both the sales figure and the receivables balance. The net effect on the turnover ratio would depend upon the proportionate impact of each increase.
Choice "d" is incorrect. A decline in sales would cause a decrease in both sales and receivables. The net effect on the turnover ratio would depend upon the proportionate impact of each decrease.
QUESTION 105
Which of the following statements extracted from a client's lawyer's letter concerning litigation, claims, and assessments most likely would cause the auditor to
request clarification?
A. "Ibelievethattheplaintiffwillhaveproblemsestablishinganyliability."
B. "Ibelievethatthisactionhasonlyaremotechanceinestablishinganyliability." C. "I believe that the plaintiff's case against the company is without merit."
D. "I believe that the company will be able to defend this action successfully."
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The lawyer's comment that the plaintiff "will have problems establishing any liability" is vague...it does not provide an evaluation of the likelihood of an unfavorable outcome. Does "will have problems" mean a loss is probable, reasonably possible, or remote? The auditor would likely want to request clarification to ensure that the situation has been properly accounted for and disclosed.
Choice "b" is incorrect. When a lawyer asserts that a contingent liability is improbable ("remote chance"), it is unlikely that the auditor would require further clarification. Choice "c" is incorrect. When a lawyer asserts that a contingent liability is improbable ("without merit"), it is unlikely that the auditor would require further clarification. Choice "d" is incorrect. When a lawyer asserts that a contingent liability is improbable ("able to defend this action successfully"), it is unlikely that the auditor would require further clarification.
QUESTION 106
Which of the following events most likely would indicate the existence of related parties?
A. Grantingstockoptionstokeyexecutivesatfavorableprices.
B. Highturnoverofseniormanagementandmembersoftheboardofdirectors. C. Failure to correct internal control weaknesses on a timely basis.
D. Selling real estate at a price significantly different from appraised value.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Transactions based on terms that are significantly different from those that would be expected in an arm's length transaction, such as selling real estate at a price significantly different from appraised value, may be indicative of related party involvement. Choice "a" is incorrect. Executives are considered to be related parties regardless of whether or not stock options at favorable prices are granted.
Choice "b" is incorrect. High turnover of management and/or board members may be caused by any number of circumstances, but is unlikely to be related to the existence of related parties. Choice "c" is incorrect. Failure to correct internal control weaknesses on a timely basis is a management decision that is unlikely to be related to the existence of related parties.
QUESTION 107
In evaluating an entity's accounting estimates, one of the auditor's objectives is to determine whether the estimates are:
A. Preparedinasatisfactorycontrolenvironment. B. Consistentwithindustryguidelines.
C. Based on verifiable objective assumptions.
D. Reasonable in the circumstances.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The auditor has four responsibilities with respect to evaluating estimates: to assess management's practices, to verify that all material estimates have been developed, to determine that accounting estimates are reasonable, and to ensure that accounting estimates are properly recorded and disclosed.
Choice "a" is incorrect. With respect to accounting estimates, the auditor would only be concerned with the entity's control environment in terms of assessing management's policies and practices. It might be the case that the control environment is less than satisfactory, but as long as management has taken this into account, and has properly developed, presented, and disclosed all material estimates, the poor control environment is irrelevant.
Choice "b" is incorrect. The auditor is concerned with making sure that management has properly developed, presented, and disclosed all material estimates. Whether or not those estimates are consistent with industry guidelines is not a concern, as long as the estimates are reasonable in the circumstances. Choice "c" is incorrect. Estimates need not be based on verifiable objective assumptions. In fact, many estimates are subjective, and can be susceptible to misstatement. The auditor should evaluate whether management has properly developed, presented, and disclosed all material estimates.
QUESTION 108
Which of the following factors most likely would cause a CPA to decline to accept a new audit engagement?
A. TheCPAdoesnotunderstandtheentity'soperationsandindustry.
B. Managementacknowledgesthattheentityhashadrecurringoperatinglosses. C. The CPA is unable to review the predecessor auditor's working papers.
D. Management is unwilling to permit inquiry of its legal counsel.
Correct Answer: D
Section: Auditing and Attestation (II) (Volume D)
Explanation Explanation/Reference:
Explanation:
Choice "d" is correct. If a prospective client is unwilling to permit inquiry of its legal counsel, the CPA must consider the implications of this refusal. Such refusal may indicate a lack of cooperativeness on the part of management, or an attempt to be less than forthright with respect to litigation, claims, and assessments. Furthermore, a client's refusal to permit inquiry of its legal counsel ordinarily would result in a disclaimer of opinion. It would be unlikely that a CPA would accept a new engagement under these circumstances.
Choice "a" is incorrect. An understanding of the client's operations and industry should be obtained during the planning stage of the audit. It does not necessarily need to be obtained before acceptance of the engagement.
Choice "b" is incorrect. The fact that the entity has had recurring operating losses may increase the auditor's assessment of risk on the engagement, but it would not preclude acceptance of the engagement.
Choice "c" is incorrect. Although the predecessor's audit documentation provides some audit evidence with respect to opening balances, consistency of accounting principles, and other matters of continuing significance, alternative means of obtaining such evidence generally do exist.
Supplemental Questions
QUESTION 109
An auditor ordinarily uses a working trial balance resembling the financial statements without footnotes, but containing columns for:
A. Reclassificationsandadjustments. B. Reconciliationsandtickmarks.
C. Accruals and deferrals.
D. Expense and revenue summaries.
Correct Answer: A
Section: Auditing and Attestation (II) (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. An auditor's working trial balance generally contains columns for reclassifications and adjustments.
Choice "b" is incorrect. Reconciliations and tickmarks are included within audit documentation, but would not necessarily be shown in columns on the working trial balance. Choice "c" is incorrect. Accruals and deferrals are included within audit documentation, but would not necessarily be shown in columns on the working trial balance. Choice "d" is incorrect. Expense and revenue summaries are included within audit documentation, but would not necessarily be shown in columns on the working trial balance.
Certified Public Accountant CPA Questions + Answers Part 37
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