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Auditing Questions andAnswers

Audit Reports
1) Explain why auditors’ reports are important to users of financial statements and why it is desirable to have
standard wording.
&: Auditor’s reports are important to users of financial statements because they inform users of the auditor’s opinion as
to whether or not the statements are fairly stated or whether no conclusion can be made with regard to the fairness of
their presentation. Users especially look for any deviation from the wording of the standard unqualified report and the
reasons and implications of such deviations. Having standard wording improves communications for the benefit of users
of the auditor’s report. When there are departures from the standard wording, users are more likely to recognize and
consider situations requiring a modification or qualification to the auditor’s report or opinion.
2) List the seven parts of a standard unqualified audit report and explain the meaning of each part. How do
the parts compare with those found in qualified report?
&: The unqualified audit report consists of:
1. Report title Auditing standards require that the report be titled and that the title includes the word independent.
2. Audit report address The report is usually addressed to the company, its stockholders, or the board of directors.
3. Introductory paragraph The first paragraph of the report does three things: first, it makes the simple statement
that the CPA firm has done an audit. Second, it lists the financial statements that were audited, including the bal-
ance sheet dates and the accounting periods for the income statement and statement of cash flows. Third, it states
that the statements are the responsibility of management and that the auditor’s responsibility is to express an
opinion on the statements based on an audit.
4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the audit. The remain
der briefly describes important aspects of an audit.
5. Opinion paragraph. The final paragraph in the standard report states the auditor’s conclusions based on the results
of the audit.
6. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the audit.
7. Audit report date. The appropriate date for the report is the one on which the auditor has completed the most im
portant auditing procedures in the field.
The same seven parts are found in a qualified report as in an unqualified report. There are also often one or more addi
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tional paragraphs explaining reasons for the qualifications.
3) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important infor
mation included in the scope paragraph.
&: The purposes of the scope paragraph in the auditor’s report are to inform the financial statement users that the audit
was conducted in accordance with generally accepted auditing standards, in general terms what those standards mean,
and whether the audit provides a reasonable basis for an opinion.
The information in the scope paragraph includes:
1. The auditor followed generally accepted auditing standards.

2. The audit is designed to obtain reasonable assurance about whether the statements are free of material misstate
ment.
3. Discussion of the audit evidence accumulated.
4. Statement that the auditor believes the evidence accumulated was appropriate for the circumstances to express
the opinion presented.
4) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important infor
mation included in the opinion paragraph.
&: The purpose of the opinion paragraph is to state the auditor’s conclusions based upon the results of the audit evi-
dence. The most important information in the opinion paragraph includes:
1. The words “in our opinion” which indicate that the conclusions are based on professional judgment.
2. A restatement of the financial statements that have been audited and the dates thereof or a reference to the intro
ductory paragraph.
3. A statement about whether the financial statements were presented fairly and in accordance with generally ac-
cepted accounting principles.
5) On February 17, 2006, a CPA completed the field work on the financial statements for the Buckheizer Tech
nology Corporation for the year ended December 31, 2005. The audit in satisfactory in all respects except for the
existence of a change in accounting principle from FIFO to LIFO inventory valuation., which results in an ex-
planatory paragraph to consistency. On February 26, the auditor completed the tax return and the draft of the
financial statements. The final audit report was completed, attached to the financial statements, and delivered
to the client on March 7. What is the appropriate date on the auditor’s report?
&: The auditor’s report should be dated February 17, 2006, the date on which the auditor completed the most important
auditing procedures in the field.
6) What five circumstances are required for a standard unqualified report to be issued?
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&: An unqualified report may be issued under the following five circumstances:
1. All statements—balance sheet, income statement, statement of retained earnings, and statement of cash
flows—are included in the financial statements.
2. The three general standards have been followed in all respects on the engagement.
3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a manner that en-
ables him or her to conclude that the three standards of field work have been met.
4. The financial statements are presented in accordance with generally accepted accounting principles. This also
means that adequate disclosures have been included in the footnotes and other parts of the financial statements.
5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the wording of
the report.
7) Describe the additional information included in the introductory, scope, and opinion paragraphs in a com
bined audit report on financial statements and the effectiveness of internal control over financial reporting.
What is the nature of the additional paragraphs in the audit report?
&: The introductory, scope and opinion paragraphs are modified to include reference to management’s report on internal
control over financial reporting, and the scope of the auditor’s work and opinion on internal control over financial report
ing. The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. Two addi-
tional paragraphs are added between the scope and opinion paragraphs that define internal control and describe the in
herent limitations of internal control.
8) What type of opinion should an auditor issue when the financial statements are not in accordance with
GAAP because such adherence would result in misleading statements?
&: When adherence to generally accepted accounting principles would result in misleading financial statements there
should be a complete explanation in a separate paragraph. The separate paragraph should fully explain the departure
and the reason why generally accepted accounting principles would have resulted in misleading statements. The opinion
should be unqualified, but it should refer to the separate paragraph during the portion of the opinion in which generally
accepted accounting principles are mentioned.
9) Distinguish between an unqualified report with explanatory paragraph or modified wording and a qualifi
report. Give examples when an explanatory paragraph or modified wording should be used in an unqualified
opinion.
&: An unqualified report with an explanatory paragraph or modified wording is the same as a standard unqualified report
except that the auditor believes it is necessary to provide additional information about the audit or the financial state-
ments. For a qualified report, either there is a scope limitation (condition 1) or a failure to follow generally accepted ac
counting principles (condition 2). Under either condition, the auditor concludes that the overall financial statements are
fairly presented.
Two examples of an unqualified report with an explanatory paragraph or modified wording are:
1. The entity changed from one generally accepted accounting principle to another generally accepted accounting
principle.
2. A shared report involving the use of other auditors.
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10) Describe what is meant by a reports involving the use of other auditors. What are the three options avail-
able to the principal auditor and when should each be used?
&: When another CPA has performed part of the audit, the primary auditor issues one of the following types of reports
based on the circumstances.
1. No reference is made to the other auditor. This will occur if the other auditor audited an immaterial portion of the
statement, the other auditor is known or closely supervised, or if the principal auditor has thoroughly reviewed the
other auditor’s work.
2. Issue a shared opinion in which reference is made to the other auditor. This type of report is issued when it is im
practical to review the work of the other auditor or when a portion of the financial statements audited by the other
CPA is material in relation to the total.
3. The report may be qualified if the principal auditor is not willing to assume any responsibility for the work of the
other auditor. A disclaimer may be issued if the segment audited by the other CPA is highly material.
11) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should be this
reflected in the auditor’s report?
&: Even though the prior year statements have been restated to enhance comparability, a separate explanatory para-
graph is required to explain the change in generally accepted accounting principles in the first year in which the change
took place.
12) Distinguish between changes that affect consistency and those that may affect comparability but not con
sistency. Give an example of each.
&: Changes that affect the consistency of the financial statements may involve any of the following:
1. Change in accounting principle

2. Change in reporting entity
3. Corrections of errors involving accounting principles.
An example of a change that affects consistency would be a change in the method of computing depreciation from
straight line to an accelerated method. A separate explanatory paragraph is required if the amounts are material.
Comparability refers to items such as changes in estimates, presentation, and events rather than changes in accounting
principles. For example, a change in the estimated life of a depreciable asset will affect the comparability of the state-
ments. In that case, no explanatory paragraph for lack of consistency is needed, but the information may require disclo
sure in the statements.
13) List the three conditions that require a departure from unqualified opinion and give one specific example of
each those conditions.
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&: The three conditions requiring a departure from an unqualified opinion are:
1. The scope of the audit has been restricted. One example is when the client will not permit the auditor to confirm ma
terial receivables. Another example is when the engagement is not agreed upon until after the client’s year-end
when it may be impossible to physically observe inventories.
2. The financial statements have not been prepared in accordance with generally accepted accounting principles. An ex
ample is when the client insists upon using replacement costs for fixed assets.
3. The auditor is not independent. An example is when the auditor owns stock in the client’s business.
14) Distinguish between a qualified opinion, adverse opinion, and a disclaimer of opinion, and explain the cir-
cumstances under which each is appropriate.
&: A qualified opinion states that there has been either a limitation on the scope of the audit or a departure from GAAP in
the financial statements, but that the auditor believes that the overall financial statements are fairly presented. This type
of opinion may not be used if the auditor believes the exceptions being reported upon are extremely material, in which
case a disclaimer or adverse opinion would be used.
An adverse opinion states that the auditor believes the overall financial statements are so materially misstated or mis-
leading that they do not present fairly in accordance with GAAP the financial position, results of operations, or cash
flows.
A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as to whether or not the overall
nancial statements are fairly presented because of a significant limitation of the scope of the audit, or a non-independent
relationship under the Code of Professional Conduct between the auditor and the client.
Examples of situations that are appropriate for each type of opinion are as follows:
OPINION EXAMPLE SITUATION
TYPE
Disclaimer Material physical inventories not observed and the inventory cannot be verified through other proce-
dures.

Lack of independence by the auditor.
Adverse A highly material departure from GAAP.
Qualified Inability to confirm the existence of an asset which is material but not extremely material in value.
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15) Define materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of
materiality?
&: The common definition of materiality as it applies to accounting and, therefore, to audit reporting is:
A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a
decision of a reasonable user of the statements.
Conditions that affect the auditor’s determination of materiality include:
< Potential users of the financial statements
< Dollar amounts of the following items: net income before taxes, total assets, current assets, current liabilities, and
owners’ equity
Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more important to users of
the financial statements than other misstatements.
16) Explain how materiality differs for failure to follow GAAP and for lack of independence.
&: Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks independence as defined
by the Code of Professional Conduct, it is always considered highly material and therefore a disclaimer of opinion is always
necessary. That is, either the CPA is independent or not independent. For failure to follow GAAP, there are three levels of
materiality: immaterial, material, and highly material.
17) How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations
resulting from conditions beyond the client’s control? Under which of these two would the auditor be most likely
to issue a disclaimer of opinion? Explain.
&: The auditor’s opinion may be qualified by scope limitations caused by client restrictions or by limitations resulting
from conditions beyond the client’s control. The former occurs when the client will not, for example, permit the auditor to
confirm material receivables or physically observe inventories. The latter may occur when the engagement is not agreed
upon until after the client’s year-end when it may not be possible to physically observe inventories or confirm receivables.
A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot determine if the overall fi
nancial statements are fairly presented. If the scope limitation is caused by the client’s restriction the auditor should be
aware that the reason for the restriction might be to deceive the auditor. For this reason, a disclaimer is more likely for
client restrictions than for conditions beyond anyone’s control.
When there is a scope restriction that results in the failure to verify material, but not pervasive accounts, a qualified opin
ion may be issued. This is more likely when the scope limitation is for conditions beyond the client’s control than for re
strictions by the client.
18) Distinguish between a report qualified as to opinion only and one with both a scope and opinion qualifica
tion.
&: A report with a scope and an opinion qualification is issued when the auditor can neither perform procedures that he
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or she considers necessary nor satisfy him or herself by using alternative procedures, due to the existence of conditions
beyond the client’s or the auditor’s control, but the amount involved in the financial statements is not highly material. An
important part of a scope and opinion qualification is that it results from not accumulating sufficient audit evidence, ei
ther because of the client’s request or because of circumstances beyond anyone’s control.
A report qualified as to opinion only results when the auditor has accumulated sufficient competent evidence but has
concluded that the financial statements are not correctly stated. The only circumstance in which an opinion only qualifi
cation is appropriate is for material, but not highly material, departures from GAAP.
19) Identify the three alternative opinion that may be appropriate when the client’s financial statements are
not accordance with GAAP. Under what circumstances is each appropriate.
&: The three alternative opinions that may be appropriate when the client’s financial statements are not in accordance
with GAAP are an unqualified opinion, qualified as to opinion only and adverse opinion. Determining which is appropriate
depends entirely upon materiality. An unqualified opinion is appropriate if the GAAP departure is immaterial (standard
unqualified) or if the auditor agrees with the client’s departure from GAAP (unqualified with explanatory paragraph). A
qualified opinion is appropriate when the deviation from GAAP is material but not highly material; the adverse opinion is
appropriate when the deviation is highly material.
20) Discuss why the AICPA has such strict requirements on audit opinions when the auditor is not independent.
&: The AICPA has such strict requirements on audit opinions when the auditor is not independent because it is important
that stockholders and other third parties be absolutely assured that the auditor is unbiased throughout the entire en-
gagement. If users develop the attitude that auditors are not independent of management, the value of the audit function
will be greatly reduced, if not eliminated.
21) When an auditor discovers more than one condition that requires departure from or modification of stan
dard unqualified report, what should the auditor’s report include?
&: When the auditor discovers more than one condition that requires a departure from or a modification of a standard
unqualified report, the report should be modified for each condition. An exception is when one condition neutralizes the
other condition. An example would be when the auditor is not independent and there is also a scope limitation. In this sit
uation the lack of independence overshadows the scope limitation. Accordingly, the scope limitation should not be men
tioned.
22) What responsibility does the auditor have for information on the company’s web site that may be inked to
electronic versions of the company’s annual financial statements and auditor’s report? How does this differ
from the auditor’s responsibility for other information in the company’s annual report that includes the finan
cial statements and auditor’s report?
&: Under current auditing standards, auditors are not required to read information contained in electronic sites, such as
the company’s Web site, that also contain the company’s audited financial statements and the auditor’s report. Auditing
standards do not consider electronic sites to be “documents.” This is different from the auditor’s responsibility for pub
lished (hard copy) documents that contain information in addition to audited financial statements and the auditor’s re
port. In this latter example, the auditor is responsible for reading other information that is published with audited finan
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cial statements and the auditor’s report to determine whether it is materially inconsistent with information in the audited
financial statements.
The Audit Process-Audit Responsibilities and objectives
1) State the objective of the audit of financial statements. In general terms, how do auditors meet that objec
tive?
J: The objective of the audit of financial statements by the independent auditor is the expression of an opinion on the fair
ness with which the financial statements present financial position, results of operations, and cash flows in conformity
with generally accepted accounting principles.
The auditor meets that objective by accumulating sufficient competent evidence to determine whether the financial
statements are fairly stated.
2) Distinguish between management’s and auditor’s responsibility for the financial statements being audited.
J: It is management’s responsibility to adopt sound accounting policies, maintain adequate internal control and make fair
representations in the financial statements. The auditor’s responsibility is to conduct an audit of the financial statements
in accordance with auditing standards and report the findings of the audit in the auditor’s report.
3) Distinguish between the terms errors and fraud. What is the auditor’s responsibility for finding each?
J: An error is an unintentional misstatement of the financial statements. Fraud represents intentional misstatements. The
auditor is responsible for obtaining reasonable assurance that material misstatements in the financial statements are de
tected, whether those misstatements are due to errors or fraud.
An audit must be designed to provide reasonable assurance of detecting material misstatements in the financial state
ments. Further, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the
engagement. Because there is an attempt at concealment of fraud, material misstatements due to fraud are usually
more difficult to uncover than errors. The auditor’s best defense when material misstatements (either errors or fraud)
are not uncovered in the audit is that the audit was conducted in accordance with auditing standards.
4) Distinguish between fraudulent financial reporting and misappropriation of assets. Discuss the likely diff
fference between those two types of fraud on the fair presentation of financial statements.
J: Misappropriation of assets represents the theft of assets by employees. Fraudulent financial reporting is the intentional
misstatement of financial information by management or a theft of assets by management, which is covered up by mis
stating financial statements.
Misappropriation of assets ordinarily occurs either because of inadequate internal controls or a violation of existing con
trols. The best way to prevent theft of assets is through adequate internal controls that function effectively. Many times
theft of assets is relatively small in dollar amounts and will have no effect on the fair presentation of financial state-
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ments. There are also the cases of large theft of assets that result in bankruptcy to the company. Fraudulent financial re
porting is inherently difficult to uncover because it is possible for one or more members of management to override in
ternal controls. In many cases the amounts are extremely large and may affect the fair presentation of financial state-
ments
5) “It is well accepted in auditing that throughout the conduct of the ordinary audit, it is essential to obtain
large amounts of information from management and to rely heavily on management’s judgments. After all, the
financial statements are management’s representations, and simple, it is extremely difficult, if not impossible,
for the auditor to evaluate the obsolescence inventory as well as management can in a highly complex business.
Similarly, the collectability of accounts receivable and the continued usefulness of machinery and equipment
are heavily dependent on management’s willingness to provide truthful responses to questions.” Reconcile the
auditor’s responsibility for discovering material misrepresentations by management with these comments.
J: True, the auditor must rely on management for certain information in the conduct of his or her audit. However, the au
ditor must not accept management’s representations blindly. The auditor must, whenever possible, obtain competent ev
idential matter to support the representations of management. As an example, if management represents that certain in
ventory is not obsolete, the auditor should be able to examine purchase orders from customers that prove part of the in
ventory is being sold at a price that is higher than the company’s cost plus selling expenses. If management represents
an account receivable as being fully collectible, the auditor should be able to examine subsequent payments by the cus
tomer or correspondence from the customer that indicates a willingness and ability to pay.
6) List two major characteristics that are useful in predicting the likelihood of fraudulent financial reporting
in an audit. For each of the characteristics, state two things that the auditor can do to evaluate its significance
in the engagement.
J:
CHARACTERISTIC AUDIT STEPS
1. Management’s characteristics and in- < Investigate the past history of the firm and its management.
fluence over the control environment.
< Discuss the possibility of fraudulent financial reporting with previous auditor
and company legal counsel after obtaining permission to do so from management.
1. Industry conditions. < Research current status of industry and compare industry financial ratios to the
company’s ratios. Investigate any unusual differences.

< Read AICPA’s Industry Audit Risk Alert for the company’s industry, if available.
Consider the impact of specific risks that are identified on the conduct of the audit.
1. Operating characteristics and financial < Perform analytical procedures to evaluate the possibility of business failure.
stability.
< Investigate whether material transactions occur close to year-end.
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7) Describe what is meant by the cycle approach to auditing. What are the advantages of dividing the audit
into different cycles?
J: The cycle approach is a method of dividing the audit such that closely related types of transactions and account bal-
ances are included in the same cycle. For example, sales, sales returns, and cash receipts transactions and the accounts
receivable balance are all a part of the sales and collection cycle. The advantages of dividing the audit into different cycles
are to divide the audit into more manageable parts, to assign tasks to different members of the audit team, and to keep
closely related parts of the audit together.
8) Identify the cycle to which each of the following ledger accounts would ordinarily be assigned: sales, ac-
count payable, retained earnings, account receivable, inventory and repairs and maintenance.
J:
GENERAL LEDGER ACCOUNT CYCLE
Sales Sales & Collection
Accounts Payable Acquisition & Payment
Retained Earnings Capital Acquisition & Repayment
Accounts Receivable Sales & Collection
Inventory Inventory & Warehousing
Repairs & Maintenance Acquisition & Payment
9) Why are sales, sales R&A, bad debts, cash discounts, AR, and allowance for uncollectible accounts all in-
cluded in the same cycle?
J: There is a close relationship between each of these accounts. Sales, sales returns and allowances, and cash discounts
all affect accounts receivable. Allowance for uncollectible accounts is closely tied to accounts receivable and should not
be separated. Bad debt expense is closely related to the allowance for uncollectible accounts. To separate these accounts
from each other implies that they are not closely related. Including them in the same cycle helps the auditor keep their
relationships in mind.
10) Define what is meant by a management assertion about financial statements. Identify the five board cate
gories of management assertions.
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J: Management assertions are implied or expressed representations by management about classes of transactions and
the related accounts in the financial statements. These assertions are part of the criteria management uses to record and
disclose accounting information in financial statements. SAS 31 (AU 326) classifies five broad categories of assertions:
1. Existence or occurrence
2. Completeness
3. Valuation or allocation
4. Rights and obligations
5. Presentation and disclosure
11) Distinguish between the general audit objectives and management assertions. Why are the general audit
objectives more useful to auditors?
J: General audit objectives follow from and are closely related to management assertions. General audit objectives, how
ever, are intended to provide a framework to help the auditor accumulate sufficient competent evidence required by the
third standard of field work. Audit objectives are more useful to auditors than assertions because they are more detailed
and more closely related to helping the auditor accumulate sufficient competent evidence.
12) An acquisition of fixed-asset repair by a construction company is recorded on the wrong date. Which trans
action-related audit objective has been violated? Which transaction-related audit objective has been violated if
the acquisition had been capitalized as a fixed asset rather than expensed?
J:
TRANSACTION-RELATED AUDIT
RECORDING MISSTATEMENT OBJECTIVE VIOLATED
Fixed asset repair is recorded on the wrong date. Timing

Repair is capitalized as a fixed asset instead of an expense.
Classification
13) Distinguish between the existence and completeness balance-related audit objectives. State the effect on
nancial statements (overstatement or understatement) of a violation of each in the audit of accounts receiv-
able.
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J: The existence objective deals with whether amounts included in the financial statements should actually be included.
Completeness is the opposite of existence. The completeness objective deals with whether all amounts that should be in
cluded have actually been included.
In the audit of accounts receivable, a nonexistent account receivable will lead to overstatement of the accounts receiv-
able balance. Failure to include a customer’s account receivable balance, which is a violation of completeness, will lead to
understatement of the accounts receivable balance.
14) What are specific audit objectives? Explain their relationship to the general audit objectives.
J: Specific audit objectives are the application of the general audit objectives to a given class of transactions or account
balance. There must be at least one specific audit objective for each general audit objective and in many cases there
should be more. Specific audit objectives for a class of transactions or an account balance should be designed such that,
once they have been satisfied, the related general audit objective should also have been satisfied for that class of trans
actions or account.
15) Identify the management assertion and general balance-related audit for the specific balance-related audit
objective: All recorded fixed assets exist at the balance sheet date.
J: For the specific balance-related audit objective, all recorded fixed assets exist at the balance sheet date, the manage-
ment assertion and the general balance-related audit objective are both “existence.”
16) Explain how management assertions, general balance-related audit objectives, and specific balance-related
audit objectives are developed for an account balance such as accounts receivable.
J: Management assertions and general balance-related audit objectives are consistent for all asset accounts for every au
dit. They were developed by the Auditing Standards Board, practitioners, and academics over a period of time. One or
more specific balance-related audit objectives are developed for each general balance-related audit objective in an audit
area such as accounts receivable. For any given account, a CPA firm may decide on a consistent set of specific balance-
related audit objectives for accounts receivable, or it may decide to use different objectives for different audits.
17) Identify the four phases of the audit. What is the relationship of the four phases to the objective of the au
dit of financial statements?
J: The four phases of the audit are:
1. Plan and design an audit approach.

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.
The auditor uses these four phases to meet the overall objective of the audit, which is to express an opinion on the fair
ness with which the financial statements present fairly, in all material respects, the financial position, results of opera-
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tions and cash flows in conformity with GAAP. By accumulating sufficient competent evidence for each audit objective,
the overall objective is met. The accumulation of evidence is accomplished by performing the four phases of the audit.
The Audit Process-Audit Evidence
1) Discuss the similarities and differences between evidence in a legal case and evidence in an audit of finan
cial statements.
@: In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclu-
sions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example,
if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely
on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defen
dant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient competent evi
dence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is
correct, but rather must obtain a high level of assurance.
The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on
testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reli
able types of evidence such as confirmation with third parties, physical examination, and documentation are also used
extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge
or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after
evaluating the evidence.
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2) List the four major evidence decisions that must be made on every audit.
@: The four major audit evidence decisions that must be made on every audit are:
1. Which audit procedures to use.

2. What sample size to select for a given procedure.
3. Which items to select from the population.
4. When to perform the procedure.
3) Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully
worded?
@: An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Be
cause audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to
make sure the instructions are clear.
4) Describe what is meant by an audit program for accounts receivable. What four things should be included
in an audit program?
@: An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for
a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.
5) State the third standard of field work. Explain the meaning of each of the major phrases of the standard.
@: Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmations
to afford a reasonable basis for an opinion regarding the financial statements under audit. There are three major phrases
of the standard.
PHRASE MEANING OF PHRASE
Sufficient competent evidence The auditor must obtain evidence that is reliable and there must be a reasonable quantity of
that evidence.

Through inspection, observation, These are the major types of evidence available for the auditor to use.
inquiries and confirmations

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To afford a reasonable basis for The auditor cannot expect to be completely certain that the financial statements are fairly pre
an opinion regarding the financial sented but there must be persuasive evidence. The collection of evidence gathered by the au
statements ditor provides the basis for the auditor’s opinion.
6) Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced,
that the financial statements are correct.
@: There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather
than be convinced that the financial statements are correct:
1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be
completely convinced.
2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confi
mations from customers may come back with erroneous information, which is the fault of the customer rather
than the client.
7) Identify the two factors, that determine the persuasiveness of evidence. How are these two factors related
to audit procedures, sample size, items to select, and timing?
@: The two determinants of the persuasiveness of evidence are competency and sufficiency. Competency refers to the
degree to which evidence can be considered believable or worthy of trust. Competency relates to the audit procedures
selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and
it is related to sample size and items to select.
8) Identify the seven characteristics that determine the competence of evidence. For each characteristics,
provide one example of a type of evidence that is likely to be competent.
7-8 @: Following are seven characteristics that determine competence and an example of each.
FACTOR EXAMPLE OF
DETERMINING COMPETENCE COMPETENT EVIDENCE
Relevance Trace inventory items located in the warehouse to their inclusion in the inventory sub-
sidiary records

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Independence of provider Confirmation of a bank balance

Effectiveness of client’s internal con- Use of duplicate sales invoices for a large well-run company
trols

Auditor’s direct knowledge Physical examination of inventory by the auditor
Qualifications of provider Letter from an attorney dealing with the client’s affairs

Degree of objectivity Count of cash on hand by auditor
Timeliness Observe inventory on the last day of the fiscal year
9) List the seven types of audit evidence included in this chapter and give two examples of each.
@:
TYPES OF AUDIT EVI- EXAMPLES

DENCE
1. Physical examina- < Count petty cash on hand

tion
< Examine fixed asset additions
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1. Confirmation < Confirm accounts receivable balances of a sample of client customers
< Confirm client’s cash balance with bank
1. Documentation < Examine cancelled checks returned with cutoff bank statement
< Examine vendors’ invoices supporting a sample of cash disbursement transactions throughout the
year
1. Analytical proce- < Evaluate reasonableness of receivables by calculating and comparing ratios
dures
< Compare expenses as a percentage of net sales with prior year’s percentages
TYPES OF AUDIT EVIDENCE EXAMPLES
1. Inquiries of the client < Inquire of management whether there is obsolete inventory
< Inquire of management regarding the collectibility of large accounts receivable balances
1. Re-performance < Re-compute invoice total by multiplying item price times quantity sold
< Food the sales journal for a one-month period and compare all totals to the general ledger

1. Observation < Observe client employees in the process of counting inventory
< Observe whether employees are restricted from access to the check signing machine
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10) What are the four characteristics of the definition of a confirmation? Distinguish between a confirmation
and external documentation.
@: The four characteristics of the definition of a confirmation are:
1. Receipt
2. Written or oral response
3. From independent third party
4. Requested by the auditor
A confirmation is prepared specifically for the auditor and comes from an external source. External documentation is in
the hands of the client at the time of the audit and was prepared for the client’s use in the day-to-day operation of the
business.
11) Distinguish between internal documentation and external documentation as audit evidence and give three
examples of each.
@: Internal documentation is prepared and used within the client’s organization without ever going to an outside party,
such as a customer or vendor.
Internal documentation is prepared and used within the client’s organization without ever going to an outside party, such
as a customer or vendor.
Examples:
< check request form
< receiving report
< payroll time card
< adjusting journal entry
External documentation either originated with an outside party or was an internal document that went to an outside party
and is now either in the hands of the client or is readily accessible.
Examples:
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< vendor’s invoice
< cancelled check
< cancelled note
< validated deposit slip
12) Explain the importance of analytical procedures as evidence in determining the fair presentation of the fi
nancial statements.
@: Analytical procedures are useful for indicating account balances that may be distorted by unusual or significant trans
actions and that should be intensively investigated. They are also useful in reviewing accounts or transactions for reason
ableness to corroborate tentative conclusions reached on the basis of other evidence.
13) Identify the most important reasons for performing analytical procedures.
@: The most important reasons for performing analytical procedures are the following:
1. Understanding the client’s industry and business

2. Assessment of the entity’s ability to continue as a going concern
3. Indication of the presence of possible misstatements in the financial statements
4. Reduction of detailed audit tests
14) Your client, Harper Company, has a contractual commitment as a part of a bond indenture to maintain a
current ratio of 2.0. if the ratio falls below that level on the balance sheet date, the entire bond becomes
payable immediately. In the current year, the client’s financial statements show that the ratio has dropped
from 2.6 to 2.05 over the past year. How should this situation affect your audit plan?
@: The decrease of the current ratio indicates a liquidity problem for Harper Company since the ratio has dropped to a
level close to the requirements of the bond indenture. Special care should be exercised by the auditor to determine that
the 2.05 ratio is proper since management would be motivated to hide any lower ratio. The auditor should expand proce
dures to test all current assets for proper cutoff and possible overstatement and to test all current liabilities for proper
cutoff and possible understatement.
15) Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce
detailed substantive procedures.
@: Attention directing analytical procedures occur when significant, unexpected differences are found between current
year’s unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must de
termine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or mis
statement due to fraud.
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When an analytical procedure reveals no unusual fluctuations, the implication is minimized. In that case, the analytical
procedure constitutes substantive evidence in support of the fair statement of the related account balances, and it is
possible to perform fewer detailed substantive tests in connection with those accounts.
Frequently, the same analytical procedures can be used for attention directing and for reducing substantive tests, de-
pending on the outcome of the tests. Simple procedures such as comparing the current year account balance to the prior
year account balance is more attention directing (and provides less assurance) than more complex analytical procedures;
i.e., those which rely on regression analysis. More sophisticated analytical procedures help the auditor examine relation
ships between several information variables simultaneously. The nature of these tests may provide greater assurance
than simple procedures.
16) Explain why the statement “Analytical procedures are essential in every part of an audit, but these tests are
rarely sufficient by themselves for any audit area” is correct or incorrect.
@: The statement is correct. Except for certain accounts with small dollar balances, analytical procedures are essential to
help the auditor identify trends in a client’s business and to see the relationship between the client’s performance and in
dustry averages. However, the auditor is responsible for gathering sufficient competent evidential matter through inspec
tion, observation and confirmation in addition to the evidence obtained as a result of the analytical procedures.
17) List the purposes of audit documentation and explain why each purpose is important.
@: The purposes of audit documentation are as follows:
1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in or
der to plan this year’s audit, such as the evaluation of internal control, the time budget, etc.
2. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of docu-
menting that an adequate audit was performed.
3. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit
and the fairness with which the financial statements are stated.
4. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evalu
ate whether sufficient competent evidence was accumulated to justify the audit report.
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the
uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to
demonstrate that the auditor has accumulated sufficient competent evidence if there’s a need to defend the audit at a
later date. For these uses, it is important that the audit documentation provide sufficient information so that the person
reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared
the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
The purposes of audit documentation are as follows:
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1. To provide a basis for planning the audit. The auditor may use reference information from the previous year in or
der to plan this year’s audit, such as the evaluation of internal control, the time budget, etc.
1. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of
documenting that an adequate audit was performed.
2. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the
audit and the fairness with which the financial statements are stated.
3. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to
evaluate whether sufficient competent evidence was accumulated to justify the audit report.
Audit documentation are used for several purposes, both during the audit and after the audit is completed. One of the
uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to
demonstrate that the auditor has accumulated sufficient competent evidence if there’s a need to defend the audit at a
later date. For these uses, it is important that the audit documentation provide sufficient information so that the person
reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared
the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.
18) What are the two criteria that auditors of public companies consider when determining whether memos,
correspondence, and other documents must be maintained in the audit files?
@: The two criteria used by auditors of public companies when determining whether memos, correspondence, and other
documents must be maintained in the audit files are as follows:
1. The materials are created, sent, or received in connection with the audit or review.
2. The materials contain conclusions, opinions, analyses, or financial data related to the audit or review.
19) For how long does the Sarbanes-Oxley Act require auditors of public companies to retain audit documenta
tion?
@: The Sarbanes-Oxley Act of 2002 requires auditors of public companies to prepare and maintain audit schedules and
other information related to any audit report in sufficient detail to support the auditor’s conclusions, for a period of not
less than 7 years.
20) Explain why it is important for audit documentation to include each of the following: identification of the
name of the client, period covered, description of the contents, initial of the preparer, date of the preparation,
and an index code.
@: Audit schedules should include the following:
Name of the client Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from
the files.
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Period covered Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is
removed from the files.
Description of the contents A list of the contents enables the reviewer to determine whether all important parts of the au
dit schedule have been included. The contents description is also used as a means of identifying audit files in the same
manner that a table of contents is used.
Initials of the preparer Indicates who prepared the audit schedule in case there are questions by the reviewer or someone
who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit
documentation if the audit must be defended.
Date of preparation Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also use
ful for the subsequent year in planning the sequence of preparing audit schedules.
Indexing Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of
the audit documentation.
21) Define what is meant by a permanent file, and list several types of information typically included. Why does
the auditor not include the contents of the permanent file with the current year’s audit file?
@: The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of
items included in the file are:
1. Articles of incorporation
2. Bylaws, bond indentures, and contracts
3. Analysis of accounts that have continuing importance to the auditor
4. Information related to the understanding of internal control:
5. flowcharts
6. internal control questionnaires
7. Results of previous years’ analytical procedures, such as various ratios and percentages compiled by the auditors
By separating this information from the current year’s audit files, it becomes easily accessible for the following year’s au
ditors to obtain permanent file data.
22) Distinguish between the following types of current period supporting schedules and state the purpose of
each: analysis, trial balance, and tests of reasonableness.
@: The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, ty
ing together the beginning and ending balances. The trial balance includes the detailed make-up of an ending balance. It
differs from an analysis in that it includes only those items comprising the end of the period balance. A test of reasonable
ness schedule contains information that enables the auditor to evaluate whether a certain account balance appears to be
misstated. One example of a test of reasonableness schedule is a schedule that compares current year expenses to prior
years’ amounts. This type of schedule is intended to show which accounts need investigation due to significant variances.
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23) Why is it essential that the auditor not leave questions or exceptions in the audit documentation without
an adequate explanation?
@: Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial state
ments. These should be investigated and resolved to make sure that financial statements are fairly presented.
The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate
lack of due care by the auditor.
24) Define what is meant by a tick mark. What is its purpose?
@: Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed
by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what was
done and who did it.
25) Who owns the audit files? Under what circumstances can they be used by other people?
@: Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a careful
consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court
and thereby become the property of the court. They can be released to another CPA firm without the client’s permission
if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of
Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from
the client.
26) A CPA sells his auditing practice to another CPA firm and includes all audit files as part of the purchase
price. Under what circumstances is this a violation of the code of professional conduct?
@: It is a violation unless the CPA obtains permission from each client before the audit files for that client are released.
27) How does the auditor read and evaluate information that is available only in machine-readable form?
@: When evidence can be examined only in machine-readable form, auditors use computers to read and examine evi-
dence. There are commercial audit software programs designed specifically for use by auditors, such as ACL Software
and Interactive Data Extraction and Analysis (IDEA). Spreadsheet software packages can also be used by auditors to per
form audit tests on data that is available only in machine-readable form.
28) Explain the purposes and benefits of audit documentation software.
@: The purposes of audit documentation software are to convert traditional paper-based documentation into electronic
files and to organize the audit documentation. The benefits of audit documentation software, such as Automated Client
Engagement (ACE), are as follows:
< The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial
statements, and ratio analysis using the computer rather than by hand.
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< The effects of adjusting journal entries are automatically carried through to the trial balance and financial state-
ments, making last-minute adjustments easier to make.
< Tick marks and review notes can be entered directly into computerized files.
< Data can be imported and exported to other applications. For example, a client’s general ledger can be downloaded
into ACE and tax information can be downloaded into a commercial tax preparation package after the audit is completed.
The Audit Process-Audit Planning and Analytical Procedures
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1) what benefits does the auditor derive from planning audits?
$: There are three primary benefits from planning audits: it helps the auditor obtain sufficient competent evidence for the
circumstances, helps keep audit costs reasonable, and helps avoid misunderstandings with the client.
2) Identify the eight major steps in planning audits.
$: Eight major steps in planning audits are:
1. Accept client and perform initial planning

2. Understand the client’s business and industry
3. Assess client business risk
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent risk
6. Understand internal control and assess control risk
7. Gather information to assess fraud risks
8. Develop overall audit plan and audit program
3) What are the responsibilities of the successor and predecessor auditors when a company is changing audi
tors?
$: The new auditor (successor) is required by SAS 84 (AU 315) to communicate with the predecessor auditor. This enables
the successor to obtain information about the client so that he or she may evaluate whether to accept the engagement.
Permission must be obtained from the client before communication can be made because of the confidentiality require
ment in the Code of Professional Conduct. The predecessor is required to respond to the successor’s request for informa
tion; however, the response may be limited to stating that no information will be given. The successor auditor should be
wary if the predecessor is reluctant to provide information about the client.
4) What factors should an auditor consider prior to accepting an engagement? Explain.
$: Prior to accepting a client, the auditor should investigate the client. The auditor should evaluate the client’s standing in
the business community, financial stability, and relations with its previous CPA firm. The primary purpose of new client
investigation is to ascertain the integrity of the client and the possibility of fraud. The auditor should be especially con-
cerned with the possibility of fraudulent financial reporting since it is difficult to uncover. The auditor does not want to
needlessly expose himself or herself to the possibility of a lawsuit for failure to detect such fraud.
5) What is the purpose of an engagement letter? What subjects should be covered in such a letter?
$: An engagement letter is an agreement between the CPA firm and the client concerning the conduct of the audit and re
lated services. It should state what services will be provided, whether any restrictions will be imposed on the auditor’s
work, deadlines for completing the audit, and assistance to be provided by client personnel. The engagement letter may
also include the auditor’s fees. In addition, the engagement letter informs the client that the auditor cannot guarantee
that all acts of fraud will be discovered.
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6) Who is considered “the client” when auditing public companies?
$: Because the Sarbanes-Oxley Act of 2002 explicitly shifts responsibility for hiring and firing of the auditor from manage
ment to the audit committee for public companies, the audit committee is viewed as “the client” in those engagements.
7) Which services must be preapproved by the audit committee a public company?
$: All audit and non-audit services must be preapproved in advance by the audit committee for public companies.
8) Explain why auditors need an understanding of the client’s industry. What sources are commonly used by
auditors to learn about the client’s industry?
$: Auditors need an understanding of the client’s business and industry because the nature of the business and industry
affect business risk and the risk of material misstatements in the financial statements. Auditors use the knowledge of
these risks to determine the appropriate extent of audit evidence to accumulate.
The five major aspects of understanding the client’s business and industry, along with potential sources of information
that auditors commonly use for each of the five areas are as follows:
1. Industry and External Environment – Read industry trade publications, AICPA Industry Audit Guides, and regulatory
requirements.
2. Business Operations and Processes – Tour the plant and offices, identify related parties, and inquire of management.
3. Management and Governance – Read the corporate charter and bylaws, read minutes of board of directors and
stockholders, and inquire of management.
4. Client Objectives and Strategies – Inquire of management regarding their objectives for the reliability of financial re
porting, effectiveness and efficiency of operations, and compliance with laws and regulations; read contracts and
other legal documents, such as those for notes and bonds payable, stock options, and pension plans.
5. Measurement and Performance – Read financial statements, perform ratio analysis, and inquire of management
about key performance indicators that management uses to measure progress toward its objectives.
9) When a CPA has accepted an engagement from a new client who is manufacturer, it is customary for the
CPA to tour the client’s plant facilities. Discuss the ways in which the CPA’s observations made during the course
of the plant tour will be of help in planning and conducting the audit.
$: During the course of the plant tour the CPA will remember that an important aspect of the audit will be an effective
analysis of the cost system. Therefore, the auditor will observe the nature of the company’s products, the manufacturing
facilities and processes, and the flow of materials so that the information obtained can later be related to the functions
of the cost system.
The nature of the company’s products and the manufacturing facilities and processes will reveal the features of the cost
system that will require close audit attention. For example, the audit of a company engaged in the custom-manufacture
of costly products such as yachts would require attention to the correct charging of material and labor to specific jobs,
whereas the allocation of material and labor charges in the audit of a beverage-bottling plant would not be verified on the
same basis. The CPA will note the stages at which finished products emerge and where additional materials must be
added. He or she will also be alert for points at which scrap is generated or spoilage occurs. The auditor may find it advis
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able, after viewing the operations, to refer to auditing literature for problems encountered and solved by other CPAs in
similar audits.
The auditor’s observation of the manufacturing processes will reveal whether there is idle plant or machinery that may
require disclosure in the financial statements. Should the machinery appear to be old or poorly maintained, the CPA
might expect to find heavy expenditures in the accounts for repairs and maintenance. On the other hand, if the auditor
determines that the company has recently installed new equipment or constructed a new building, he or she will expect
to find these new assets on the books.
In studying the flow of materials, the auditor will be alert for possible problems that may arise in connection with the ob
servation of the physical inventory, and he or she may make preliminary estimates of audit staff requirements. In this re
gard, the auditor will notice the various storage areas and how the materials are stored. The auditor may also keep in
mind for further investigation any apparently obsolete inventory.
The auditor’s study of the flow of materials will disclose the points at which various documents such as material requisi
tions arise. He or she will also meet some of the key manufacturing personnel who may give the auditor an insight into
production problems and other matters such as excess or obsolete materials, and scrap and spoilage. The auditor will be
alert for the attitude of the manufacturing personnel toward accounting controls. The CPA may make some inquiries
about the methods of production scheduling, timekeeping procedures and whether work standards are employed. As a
result of these observations, the internal documents that relate to the flow of materials will be more meaningful as ac
counting evidence.
The CPA’s tour of the plant will give him or her an understanding of the plant terminology that will enable the CPA to
communicate fluently with the client’s personnel. The measures taken by the client to safeguard assets, such as protec
tion of inventory from fire or theft, will be an indication of the client’s attention to internal control measures. The location
of the receiving and shipping departments and the procedures in effect will bear upon the CPA’s evaluation of internal
control. The auditor’s overall impression of the client’s plant will suggest the accuracy and adequacy of the accounting
records that will be audited.
10) An auditor often tries to acquire background knowledge of the client’s industry as an aid to audit work. How
does the acquisition of this knowledge aid the auditor in distinguishing between obsolete and current inven-
tory?
$: One type of information the auditor obtains in gaining knowledge about the clients’ industry is the nature of the client’s
products, including the likelihood of their technological obsolescence and future salability. This information is essential in
helping the auditor evaluate whether the client’s inventory may be obsolete or have a market value lower than cost.
11) Define what is meant by a related party. What are the auditor’s responsibilities for related parties and re
lated party transactions?
$: A related party is defined in SAS 45 (AU 334) as 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.
Material related party transactions must be disclosed in the financial statements by management. Therefore, the auditor
must identify related parties and make a reasonable effort to determine that all material related party transactions have
been properly disclosed in the financial statements.
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12) Which types of loans to executives are permitted by the Sarbanes-Oxley Act?
$: Because of the lack of independence between the parties involved, the Sarbanes-Oxley Act prohibits related party
transactions that involve personal loans to executives. It is now unlawful for any public company to provide personal
credit or loans to any director or executive officer of the company. Banks or other financial institutions are permitted to
make normal loans to their directors and officers using market rates, such as residential mortgages.
13) Your firm has performed the audit of Rogers Company for several years and you have been assigned the au
dit responsibility for the current audit. How would you review of the corporate charter and bylaws for this audit
differ from that of the audit of a client who was audited by a different CPA firm in the preceding year?
$: In the audit of a client previously audited by a different CPA firm, it would be necessary to obtain a copy of the corpo
rate charter and bylaws for the permanent files and to read these documents and prepare a summary abstract of items
to test for compliance. In an ongoing engagement, this work has been performed in the past and is unnecessary each
year. The auditor’s responsibility is to determine what changes have been made during the current year and to update
and review the summary abstract prepared in previous years for compliance.
14) For the audit of Radline Manufacturing Company, the audit partner asks you to carefully read the new mort
gage contract with the First National Bank and abstract all pertinent information. List the information in a
mortgage that is likely to be relevant to the auditor.
The information in a mortgage that is likely to be relevant to the auditor includes the following:
1. The parties to the agreement

2. The effective date of the agreement
3. The amounts included in the agreement
4. The repayment schedule required by the agreement
5. The definition and terms of default
6. Prepayment options and penalties specified in the agreement
7. Assets pledged or encumbered by the agreement
8. Liquidity restrictions imposed by the agreement
9. Purchase restrictions imposed by the agreement
10. Operating restrictions imposed by the agreement
11. Requirements for audit reports or other types of reports on compliance with the agreement
12. The interest rate specified in the agreement
13. Any other requirements, limitations, or agreements specified in the document
15) Identify two types of information in the client’s minutes of the board of directors meetings that are likely to
be relevant to the auditor. Explain why it is important to read the minutes early in the engagement.
$: Information in the client’s minutes that is likely to be relevant to the auditor includes the following:
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1. Declaration of dividends
2. Authorized compensation of officers
3. Acceptance of contracts and agreements
4. Authorization for the acquisition of property
5. Approval of mergers
6. Authorization of long-term loans
7. Approval to pledge securities
8. Authorization of individuals to sign checks
9. Reports on the progress of operations
It is important to read the minutes early in the engagement to identify items that need to be followed up on as a part of
conducting the audit. For instance, if a long-term loan is authorized in the minutes, the auditor will want to make certain
that the loan is recorded as part of long-term liabilities.
16) Identify the three categories of client objectives. Indicate how each objective may affect the auditor’s as-
sessment of inherent risk and evidence accumulation.
$: The three categories of client objectives are (1) reliability of financial reporting, (2) effectiveness and efficiency of opera
tions, and (3) compliance with laws and regulations. Each of these objectives affects the auditor’s assessment of inherent
risk and evidence accumulation as follows:
1. Reliability of financial reporting – If management sees the reliability of financial reporting as an important objective,
and if the auditor can determine that the financial reporting system is accurate and reliable, then the auditor can
often reduce inherent risk and planned evidence accumulation for material accounts. In contrast, if management
has little regard for the reliability of financial reporting, the auditor must increase inherent risk assessments and
gather more evidence during the audit.
2. Effectiveness and efficiency of operations – This area is of primary concern to most clients. Auditors need knowledge
about the effectiveness and efficiency of a client’s operations in order to assess client business risk and inherent
risk in the financial statements. For example, if a client is experiencing inventory management problems, this would
most likely increase both the auditor’s assessment of inherent risk for the planned evidence accumulation for in
ventory.
3. Compliance with laws and regulations – It is important for the auditor to understand the laws and regulations that
affect an audit client, including significant contracts signed by the client. For example, the provisions in a pension
plan document would significantly affect the auditor’s assessment of inherent risk and evidence accumulation in
the audit of unfunded liability for pensions. If the client were in violation of the provisions of the pension plan docu
ment, inherent risk and planned evidence for pension-related accounts would increase.
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17) What is the purpose of the client’s performance measurement system? Give examples of key performance
indicators for the following business: (1) a chain of retail clothing stores; (2) an internet portal; (3) a hotel chain.
$: The purpose of a client’s performance measurement system is to measure the client’s progress toward specific objec
tives. Performance measurement includes ratio analysis and benchmarking against key competitors.
Performance measurements for a chain of retail clothing stores could include gross profit by product line, sales returns
as a percentage of clothing sales, and inventory turnover by product line. An Internet portal’s performance measure-
ments might include number of Web site hits or search engine speed. A hotel chain’s performance measures include va
cancy percentages and supply cost per rented room.
18) Define client business risk and describe several sources of client business risk. What is the auditor’s primary
concern when evaluating client business risk?
$: Client business risk is the risk that the client will fail to achieve its objectives. Sources of client business risk include any
of the factors affecting the client and its environment, including competitor performance, new technology, industry con
ditions, and the regulatory environment. The auditor’s primary concern when evaluating client business risk is the risk of
material misstatements in the financial statements due to client business risk. For example, if the client’s industry is ex
periencing a significant and unexpected downturn, client business risk increases. This increase would most likely in-
crease the risk of material misstatements in the financial statements. The auditor’s assessment of the risk of
material misstatements is then used to classify risks using the audit risk model to determine the appropriate extent of
audit evidence.
19) Describe top management controls and their relation to client business risk. Give examples of effective
management and governance controls.
$: Management establishes the strategies and business processes followed by a client’s business. One top management
control is management’s philosophy and operating style, including management’s attitude toward the importance of in
ternal control. Other top management controls include a well-defined organizational structure, an effective board of di
rectors, and an involved and effective audit committee. If the board of directors is effective, this increases management’s
ability to appropriately respond to risks. An effective audit committee can help management reduce the likelihood of
overly aggressive accounting.
20) What are the purposes of preliminary analytical procedures? What types of comparisons are useful when
performing preliminary analytical procedures?
$: Analytical procedures are performed during the planning phase of an engagement to assist the auditor in determining
the nature, extent, and timing of work to be performed. Preliminary analytical procedures also help the auditor identify
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accounts and classes of transactions where misstatements are likely. Comparisons that are useful when performing pre
liminary analytical procedures include:
< Compare client and industry data
< Compare client data with similar prior period data
< Compare client data with client-determined expected results
< Compare client data with auditor-determined expected results
< Compare client data with expected results, using nonfinancial data
21) When are analytical procedures required to be performed during the audit? What is the primary purpose of
analytical procedures performed during the completion phase of the audit?
$: Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in
determining the nature, extent, and timing of work to be performed and (2) during the completion phase, as a final re-
view for material misstatements or financial problems. Analytical procedures are also often done during the testing
phase of the audit, but they are not required in this phase.
22) Gale Gordon, CPA, has found ratio and trend analysis relatively useless as a tool in conducting audits. For
several engagement, he computed the industry ratios included in publications by Robert Morris Associates and
compared them with industry standards. For most engagements, the client’s business was significantly differ
ent from the industry data in the publication and the client would automatically explain away any discrepancies
by attributing them to the unique nature of its operations. In cases in which the client had more than one
branch in different industries, Gordon found the ratio analysis no help at all. How could Gordon improve the
quality of his analytical procedures?
$: Gordon could improve the quality of his analytical tests by:
1. Making internal comparisons to ratios of previous years.

2. In cases where the client has more than one branch in different industries, computing the ratios for each branch
and comparing these to the industry ratios.
23) At the completion of every audit, Roger Morris, CPA, calculates a large number of ratios and trends for com
parison with industry averages and prior-year calculations. He believes the calculations are worth the relatively
small cost of doing them because they provide him with an excellent overview of the client’s operations. If the
ratios are out of line, Morris discusses the reasons with the client and often make suggestions on how to bring
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the ratio back in line in the future. In some cases, these discussions with management have been the basis for
management consulting engagements. Discuss the major strengths and shortcomings in Morris’s use of ratio
and trend analysis.
$: Roger Morris performs his ratio and trend analysis at the end of every audit. By that time, the audit procedures are
completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the
findings. SAS 56 (AU 329) requires that analytical procedures be performed in the planning phase of the audit and near
the completion of the audit.
The use of ratio and trend analysis appears to give Roger Morris an insight into his client’s business and affords him an
opportunity to provide excellent business advice to his client.
24) Name the four categories of financial ratios and give an example of a ratio in each category. What is the pri
mary information provided by each financial ratio category?
$: The four categories of financial ratios and examples of ratios in each category are as follows:
1. Short-term debt-paying ability – Cash ratio, quick ratio, and current ratio.
2. Liquidity activity – Accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell in
ventory.
3. Ability to meet long-term debt obligations – Debt to equity and times interest earned.
4. Profitability – Earnings per share, gross profit percent, profit margin, return on assets, and return on common eq
uity
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The Audit Process-Materiality and Risk
1) Chapter 8 introduced the eight parts of the planning phase of an audit. Which part is the evaluation of ma
teriality and risk?
B: The planning phases are: accept client and perform initial planning, understand the client’s business and industry, as
sess client business risk, perform preliminary analytical procedures, set materiality and assess acceptable audit risk and
inherent risk, understand internal control and assess control risk, gather information to assess fraud risk, and develop
overall audit plan and audit program. Evaluation of materiality is part of phase five. Risk assessment is part of phase
three (client business risk), phase five (acceptable audit risk and inherent risk), phase six (control risk), and phase seven
(fraud risk).
2) Define the meaning of the term materiality as it is used in accounting and auditing. What is the relation-
ship between materiality and the phrase obtain reasonable assurance used in the auditor’s report?
B: Materiality is defined as: the magnitude of an omission or misstatement of accounting information that, in light of the
surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information
would have been changed or influenced by the omission or misstatement.
“Obtain reasonable assurance,” as used in the audit report, means that the auditor does not guarantee or insure the fair
presentation of the financial statements. There is some risk that the financial statements contain a material misstate-
ment.
3) Explain why materiality is important but difficult to apply in practice.
B: Materiality is important because if financial statements are materially misstated, users’ decisions may be affected, and
thereby cause financial loss to them. It is difficult to apply because there are often many different users of the financial
statements. The auditor must therefore make an assessment of the likely users and the decisions they will make. Materi
ality is also difficult to apply because it is a relative concept. The professional auditing standards offer little specific guid
ance regarding the application of materiality. The auditor must, therefore, exercise considerable professional judgment
in the application of materiality.
4) What is meant by setting a preliminary judgment about materiality? Identify the most important factors
affecting the preliminary judgment.
B: The preliminary judgment about materiality is the maximum amount by which the auditor believes the financial state
ments could be misstated and still not affect the decisions of reasonable users. Several factors affect the preliminary
judgment about materiality and are as follows:
1. Materiality is a relative rather than an absolute concept.
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2. Bases are needed for evaluating materiality.
3. Qualitative factors affect materiality decisions.
4. Expected distribution of the financial statements will affect the preliminary judgment of materiality. If the
nancial statements are widely distributed to users, the preliminary judgment of materiality will probably be set lower
than if the financial statements are not expected to be widely distributed.
5. The level of acceptable audit risk will also affect the preliminary judgment of materiality.
5) What is meant by using bases for setting a preliminary judgment about materiality? How would those
bases differ for the audit of a manufacturing company and a government unit such as school district?
B: Because materiality is relative rather than absolute, it is necessary to have bases for establishing whether misstate-
ments are material. For example, in the audit of a manufacturing company, the auditor might use as bases: net income
before taxes, total assets, current assets, and working capital. For a governmental unit, such as a school district, there is
no net income before taxes, and therefore that would be an unavailable base. Instead, the primary bases would likely be
fund balances, total assets, and perhaps total revenue.
6) Assume that Rosanne Madden, CPA, is using 5% of net income before tax, current assets, or current liabili
ties as her major guidelines for evaluating materiality. What qualitative factors should she also consider in de
ciding whether misstatements maybe material?
B: The following qualitative factors are likely to be considered in evaluating materiality:
a. Amounts involving fraud are usually considered more important than unintentional errors of equal dollar
amounts.
b. Misstatements that are otherwise minor may be material if there are possible consequences arising from contrac
tual obligations.
c. Misstatements that are otherwise immaterial may be material if they affect a trend in earnings.
7) Distinguish between the terms tolerable misstatement and preliminary judgment about materiality. How
are they related to each other?
B: A preliminary judgment about materiality is set for the financial statements as a whole. Tolerable misstatement is the
maximum amount of misstatement that would be considered material for an individual account balance. The amount of
tolerable misstatement for any given account is dependent upon the preliminary judgment about materiality. Ordinarily,
tolerable misstatement for any given account would have to be lower than the preliminary judgment about materiality. In
many cases, it will be considerably lower because of the possibility of misstatements in different accounts that, in total,
cannot exceed the preliminary judgment about materiality.
8) Assume a company with the following balance sheet accounts:
Account Amount
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Cash $10,000
Fixed Assets $60,000
$70,000
Long-Term loans $30,000
M. Johnson Proprietor $40,000
$70,000

You are concerned only about overstatement of owner’s equity. Set tolerable misstatement for the three
relevant accounts such that the preliminary judgment about materiality does not exceed $5,000. Justify your an
swer.
B: There are several possible answers to the question. One example is:
Cash $500 Overstatement
Fixed assets $3,000 Overstatement
Long-term loans $1,500 Understatement
Note: Cash and fixed assets are tested for overstatement and long-term loans for understatement because the audi-
tor’s objective in this case is to test for overstatements of owner’s equity.
The least amount of tolerable misstatement was allocated to cash and long-term loans because they are relatively easy
to audit. The majority of the total allocation was to fixed assets because there is a greater likelihood of misstatement of
fixed assets in a typical audit.
9) Explain what is meant by making an estimate of the total misstatement in a segment and in the overall fi
nancial statements. Why is it important to make these estimates? What is done with them?
B: An estimate of the total misstatement in a segment is the estimate of the total misstatements based upon the sample
results. If only a sample of the population is selected and audited, the auditor must project the total sample misstate-
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ments to a total estimate. This is done audit area by audit area. The misstatements in each audit area must be totaled to
make an estimate of the total misstatements in the overall financial statements. It is important to make these estimates
so the auditor can evaluate whether the financial statements, taken as a whole, may be materially misstated. The esti-
mate for each segment is compared to tolerable misstatement for that segment and the estimate of the overall misstate
ment on the financial statements is compared to the preliminary judgment about materiality.
10) How would the conduct of an audit of a medium-sized company be affected by the company’s being a small
part of a large conglomerate as compared with it being a separate entity?
B: If an audit is being performed on a medium-sized company that is part of a conglomerate, the auditor must make a
materiality judgment based upon the conglomerate. Materiality may be larger for a company that is part of a conglomer
ate because even though the financial statements of the medium-sized company may be misstated, the financial state
ments of the large conglomerate might still be fairly stated. If, however, the auditor is giving a separate opinion on the
medium-sized company, the materiality would be lower than for the audit of a conglomerate.
11) Define the audit risk model and explain each term in the model.
B: The audit risk model is as follows:
PDR = AAR
IR x CR
Where PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding
a tolerable amount, should such misstatements exist.
Acceptable audit risk 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.
Inherent risk A measure of the auditor’s assessment of the likelihood that there are material misstatements in a segment
before considering the effectiveness of internal control.
Control risk A measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in
a segment will not be prevented or detected by the client’s internal controls.
12) What is meant by planned detection risk? What is the effect on the amount of evidence the auditor must ac
cumulate when planned detection risk is increased from medium to high?
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B: Planned detection risk is a measure of the risk that the audit evidence for a segment will fail to detect misstatements
exceeding a tolerable amount, should such misstatements exist. When planned detection risk is increased from medium
to high, the amount of evidence the auditor must accumulate is reduced.
13) Explain the causes of an increased or decreased planned detection risk.
B: An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either con
trol risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit
risk or an increase in control risk or inherent risk.
14) Define what is meant by inherent risk. Identify four factors that make for high inherent risk in audits.
B: Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in a seg
ment before considering the effectiveness of internal control.
Factors affecting assessment of inherent risk include:
< Nature of the client’s business
< Results of previous audits
< Initial vs. repeat engagement
< Related parties
< Non-routine transactions
< Judgment required to correctly record transactions and
< Makeup of the population
15) Explain why inherent risk is set for segments rather than for overall audit. What is the effect on the amount
of evidence the auditor must accumulate when inherent risk is increased from medium to high for a segment?
Compare your answer with the one for question 12.
B: Inherent risk is set for segments rather than for the overall audit because misstatements occur in segments. By identi
fying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for
misstatements in those segments.
When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to de
termine whether the expected misstatement actually occurs. The audit evidence goes in the opposite direction in Review
Question 9-12.
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16) Explain the effect of extensive misstatements found in the prior year’s audit on inherent risk, planned de
tection risk, and planned audit evidence.
B: Extensive misstatements in the prior year’s audit would cause inherent risk to be set at a high level (maybe even 100%).
An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor in
crease the level of planned audit evidence.
17) Explain what is meant by term acceptable audit risk. What is its relevance to evidence accumulation?
B: Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materi
ally misstated after the audit is completed and an unqualified opinion has been issued.
Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should
increase.
18) Explain the relationship between acceptable audit risk and the legal liability of auditors.
B: When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the acceptable
audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is lit
tle exposure to legal liability, there is still a minimum acceptable audit risk that should be met.
19) State the three categories of factors that affect acceptable audit risk and list the factors that auditor can
use to indicate the degree to which each category exists.
B: The first category of factors that determine acceptable audit risk is the degree to which users rely on the financial
statements. The following factors are indicators of this:
< Client’s size
< Distribution of ownership
< Nature and amount of liabilities
The second category of factors is the likelihood that a client will have financial difficulties after the audit report is issued.
Factors affecting this are:
< Liquidity position
< Profits (losses) in previous years
< Method of financing growth
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< Nature of the client’s operations
< Competence of management
The third category of factors is the auditor’s evaluation of management’s integrity. Factors that may affect this are:
< Relationship with current or previous auditors
< Frequency of turnover of key financial or internal audit personnel
< Relationship with employees and labor unions
20) Auditors have not been successful in measuring the components of the audit risk model. How is it possible
to use the model in a meaningful way without a precise way of measuring risk?
B: Exact quantification of all components of the audit risk model is not required to use the model in a meaningful way. An
understanding of the relationships among model components and the effect that changes in the components have on
the amount of evidence needed will allow practitioners to use the audit risk model in a meaningful way.
21) Explain the circumstances when the auditor should revise the components of the audit risk model and the
effect of the revisions on planned detection risk and planned evidence.
B: The auditor should revise the components of the audit risk model when the evidence accumulated during the audit in
dicates that the auditor’s original assessments of inherent risk or control risk are too low or too high or the original as-
sessment of acceptable audit risk is too low or too high.
The auditor should exercise care in determining the additional amount of evidence that will be required. This should be
done without the use of the audit risk model. If the audit risk model is used to determine a revised planned detection risk,
there is a danger of not increasing the evidence sufficiently.
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The Audit Process-Audits of Internal Control and Control Risk
1) Describe the three broad objectives management has when designing effective internal control.
F: Management typically has three broad objectives in designing an effective internal control system.
1. 1. Reliability of Financial Reporting Management is responsible for preparing financial statements for in-
vestors, creditors, and other users. Management has both a legal and professional responsibility to be sure that the
information is fairly presented in accordance with reporting requirements such as GAAP. The objective of effective
internal control over financial reporting is to fulfill these financial reporting responsibilities.
1. 2. Efficiency and Effectiveness of Operations Controls within an organization are meant to encourage effi-
cient and effective use of its resources to optimize the company’s goals. An important objective of these controls is
accurate financial and non-financial information about the entity’s operations for decision making.
1. 3. Compliance with Laws and Regulations Section 404 of the Sarbanes-Oxley Act requires all public compa
nies to issue a report about the operating effectiveness of internal control over financial reporting. In addition to
the legal provisions of Section 404, public, nonpublic, 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 fraud.
2) Describe which of the three categories of broad objectives for internal controls would be considered by the
auditor in an audit of both financial statements and internal control over financial reporting.
F: Management designs systems of internal control to accomplish three categories of objectives: financial reporting, op
erations, and compliance with laws and regulations. The auditor’s focus in both the audit of financial statements and the
audit of internal controls is on those controls related to the reliability of financial reporting plus those controls related to
operations and to compliance with laws and regulations objectives that could materially affect financial reporting.
3) Section 404 of the Sarbanes-Oxley Act requires management to issue a report on internal control over fi-
nancial reporting. Identify the specific section 404 reporting requirements for management.
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F: Section 404 requires management of all public companies to issue an internal control report that includes the follow
ing:
A statement that management is responsible for establishing and maintaining an adequate internal control struc
ture and procedures for financial reporting and
An assessment of the effectiveness of the internal control structure and procedures for financial reporting as of the
end of the company’s fiscal year.
4) What two components of internal control must management assess when reporting on internal control to
comply with section 404 of the Sarbanes-Oxley Act?
F: Management’s assessment of internal control over financial reporting consists of two key components. First, manage
ment must evaluate the design of internal control over financial reporting. Second, management must test the operating
effectiveness of those controls.When evaluating the design of internal control over financial reporting, management evalu
ates whether the controls are designed to prevent or detect material misstatements in the financial statements. When
testing the operating effectiveness of those controls, the objective is to determine whether the control is operating as de
signed and whether the person performing the control possesses the necessary authority and qualifications to perform
the control effectively.
5) Chapter eight introduced the eight parts of the planning phase of audits. Which part is understanding in
ternal control and assessing control risk? What parts precede and follow that understanding and assessing?
F: There are eight parts of the planning phase of audits: accept client and perform initial planning, understand the client’s
business and industry, assess client business risk, perform preliminary analytical procedures, set materiality and assess
acceptable audit risk and inherent risk, understand internal control and assess control risk, gather information to assess
fraud risk, and develop an overall audit plan and audit program. Understanding internal control and assessing control
risk is therefore part six of planning. Only gathering information to assess fraud risk and developing an overall audit plan
and audit program follow understanding internal control and assessing control risk.
6) What is the auditor’s responsibility for obtaining an understanding of internal control? How does the re-
sponsibility differ for audits of public and nonpublic companies?
F: The second GAAS field work standard states “A sufficient understanding of internal control is to be obtained to plan the
audit and to determine the nature, timing, and extent of tests to be performed.” The auditor obtains the understanding of
internal control to assess control risk in every audit and that responsibility is the same for audits of both public and non
public companies. Auditors are primarily concerned about controls related to the reliability of financial reporting and con
trols over classes of transactions.
7) When auditing a public company, what are the auditor’s responsibilities related to internal control as re-
quired by PCAOB standard 2?
F: Section 404 requires that the auditor attest to and issue a report on management’s assessment of internal control over
financial reporting. To express an opinion on internal controls, the auditor obtains an understanding of and performs
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tests of controls related to all significant account balances, classes of transactions, and disclosures and related asser-
tions in the financial statements. PCAOB Standard 2 requires that the audit report on internal control over financial re-
porting under Sarbanes-Oxley include the auditor’s opinion as to whether management’s assessment of the design and
operating effectiveness of internal control over financial reporting is fairly stated in all material respects. This involves
both evaluating management’s assessment process and arriving at the auditor’s independent assessment of the internal
controls’ design and operating effectiveness.
8) State the six transaction-related audit objectives.
F: The six transaction-related audit objectives are:
1. Recorded transactions exist (existence).
2. Existing transactions are recorded (completeness).
3. Recorded transactions are stated at the correct amounts (accuracy).
4. Transactions are properly classified (classification).
5. Transactions are recorded on the correct dates (timing).
6. Recorded transactions are properly included in the master files and correctly summarized (posting and summa
rization).
9) Management must identify the framework used to evaluate the effectiveness of internal control over fi-
nancial reporting. What framework is used by most U.S. public companies?
F: COSO’s Internal Control–Integrated Framework is the most widely accepted internal control framework in the U.S. The
COSO framework describes internal control as consisting of five components that management designs and implements
to provide reasonable assurance that its control objectives will be met. Each component contains many controls, but au
ditors concentrate on those designed to prevent or detect material misstatements in the financial statements.
10) What are the five components of internal control in the COSO internal control framework?
F: The COSO Internal Control – Integrated Framework consists of the following five components:
1. Control environment
2. Risk assessment
3. Control activities
4. Information and communication
5. Monitoring
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The control environment serves as the umbrella for the other four components. Without an effective control environ-
ment, the other four are unlikely to result in effective internal control, regardless of their quality.
11) What is meant by the control environment? What are the factors the auditor must evaluate to understand
it?
F: The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top man
agement, directors, and owners of an entity about internal control and its importance to the entity. The following are the
most important subcomponents the control environment:
< Integrity and ethical values
< Commitment to competence
< Board of directors or audit committee participation
< Management’s philosophy and operating style
< Organizational structure
< Assignment of authority and responsibility
< Human resource policies and practices
12) What is the relationship among the five components of internal control?
F: Internal control includes five categories of controls that management designs and implements to provide reasonable
assurance that its control objectives will be met. These are called the components internal control, and are:
< The control environment
< Risk assessment
< Control activities
< Information and communication
< Monitoring
The control environment is the broadest of the five and deals primarily with the way management implements its atti-
tude about internal controls. The other four components are closely related to the control environment. Risk assessment
is management’s identification and analysis of risks relevant to the preparation of financial statements in accordance
with GAAP. To respond to this risk assessment, management implements control activities and creates the accounting
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information and communication system to meet its objectives for
financial reporting. Finally, management periodically assesses the quality of internal control performance to determine
that controls are operating as intended and that they are modified as appropriate for changes in conditions (monitoring).
13) List the types of specific control activities and provide one specific illustration of a control in sales area for
each control activity.
F: The five categories of control activities are:
< Adequate separation of duties
Example: The following two functions are performed by different people: processing customer orders and billing of cus
tomers.
< Proper authorization of transactions and activities
Example: The granting of credit is authorized before shipment takes place.
< Adequate documents and records
Example: Recording of sales is supported by authorized shipping documents and approved customer orders.
< Physical control over assets and records
Example: A password is required before entry into the computerized accounts receivable master file can be made.
< Independent checks on performance
Example: Accounts receivable master file contents are independently verified.
14) The separation of operational responsibility from record keeping is meant to prevent different types of mis
statements than the separation of the custody of assets from accounting. Explain the difference in the purposes
of these two types of separation of duties.
F: Separation of operational responsibility from record keeping is intended to reduce the likelihood of operational person
nel biasing the results of their performance by incorrectly recording information.
Separation of the custody of assets from accounting for these assets is intended to prevent misappropriation of assets.
When one person performs both functions, the possibility of that person’s disposal of the asset for personal gain and ad
justment of the records to relieve himself or herself of responsibility for the asset without detection increases.
15) For each of the following, give an example of a physical control the client can use to protect the asset or
record:
1. 1. Petty cash

2. 2. Cash received by retail clerks
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3. 3. Accounts receivable records

4. 4. Raw material inventory
5. 5. Perishable tools
6. 6. Manufacturing equipment
7. 7. Marketable securities
F: An example of a physical control the client can use to protect each of the following assets or records is:
1. Petty cash should be kept locked in a fireproof safe.
2. Cash received by retail clerks should be entered into a cash register to record all cash received.
3. Accounts receivable records should be stored in a locked, fireproof safe. Adequate backup copies of computerized
records should be maintained and access to the master files should be restricted via passwords.
4. Raw material inventory should be retained in a locked storeroom with a reliable and competent employee control
ling access.
5. Perishable tools should be stored in a locked storeroom under control of a reliable employee.
6. Manufacturing equipment should be kept in an area protected by burglar alarms and fire alarms and kept locked
when not in use.
7. Marketable securities should be stored in a safety deposit vault.
16) Explain what is meant by independent checks on performance and give five specific examples.
F: Independent checks on performance are internal control activities designed for the continuous internal verification of
other controls. Examples of independent checks include:
< Preparation of the monthly bank reconciliation by an individual with no responsibility for recording transactions or
handling cash.
< Re-computing inventory extensions for a listing of inventory by someone who did not originally do the extensions.
< The preparation of the sales journal by one person and the accounts receivable master file by a different person,
and a reconciliation of the control account to the master file.
< The counting of inventory by two different count teams.
< The existence of an effective internal audit staff.
17) Describe the four phases performed by the auditor when obtaining an understanding of internal control and
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assessing control risk.
F: As illustrated by Figure 10-3, there are four phases in the process of understanding internal control and assessing con
trol risk. In the first phase the auditor obtains an understanding of internal controls. Next the auditor must make a pre
liminary assessment control risk (phase 2) and perform tests of controls in every audit as part of their integrated audits
(phase 3). The auditor uses the results of tests of controls for both the audit report on internal control over financial re
porting and to assess control risk and to ultimately decide planned detection risk and substantive tests for the audit of
nancial statements, which is phase 4.
18) What are management’s responsibilities for documenting internal control over financial reporting in a public
company? How would the lack of documentation affect an auditor’s report on internal control over financial re
porting by PCAOB standard 2?
F: Section 404 of the Sarbanes-Oxley Act requires management to document its processes for assessing the effectiveness
of the company’s internal control over financial reporting. Management must document the design of controls, including
all five control components and also the results of its testing and evaluation. The types of information gathered by man
agement to assess and document internal control effectiveness can take many forms, including policy manuals, flow-
charts, narratives, documents, questionnaires and other forms that are in either paper or electronic formats. PCAOB
Standard 2 requires the auditor to evaluate the client’s documentation when auditing internal control over financial re-
porting. The lack of management documentation of internal control over financial reporting may prevent the auditor
from concluding that the controls are adequately designed or operating effectively. When documentation is inadequate,
the auditor may decide to withdraw from the engagement or to issue a disclaimer of opinion on internal control over fi
nancial reporting.
19) What two aspects of internal control must the auditor assess when performing procedures to obtain an un
derstanding of internal control?
F: When obtaining an understanding of internal control, the auditor must assess two aspects about those controls. First,
the auditor must gather evidence about the design of internal controls. Second, the auditor must gather evidence about
whether those controls have been placed in operation.
20) What is a walkthrough of internal control? What is the PCAOB standard 2 requirement related to auditor
walkthroughs of internal control in an integrated audit?
F: In a walkthrough of internal control, the auditor selects one or a few documents for the initiation of a transaction
type and traces them through the entire accounting process. At each stage of processing, the auditor makes inquiries
and observes current activities, in addition to examining completed documentation for the transaction or transactions
selected. Thus, the auditor combines observation, documentation, and inquiry to conduct a walkthrough of internal con
trol. PCAOB Standard 2 requires the auditor to perform at least one walkthrough for each major class of transactions.
21) Describe what is meant by a key control and a control deficiency.
F: A key control is a control that is expected to have the greatest effect on meeting the transaction-related audit objec-
tives. A control deficiency represents a deficiency in the design or operation of controls that does not permit company
personnel to prevent or detect misstatements on a timely basis. A design deficiency exists if a necessary control is miss
ing or not properly designed. An operation deficiency exists if a well designed control does not operate as designed or
when the person performing the control is insufficiently qualified or authorized.
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22) Distinguish a significant deficiency in internal control form a material weakness in internal control. How
would the presence of one significant deficiency affect the auditor’s report on internal control required by
PCAOB standard 2? How would the presence of one material weakness affect an auditor’s report on internal con
trol required by PCAOB standard 2?
F: A significant deficiency exists if one or more control deficiencies exist that, more than remotely, adversely affect a com
pany’s ability to initiate, authorize, record, process, or report external financial statements reliably. A material weakness
exists if a significant deficiency, by itself, or in combination with other significant deficiencies, results in a more than re
mote likelihood that internal control will not prevent or detect material financial statement misstatements. The presence
of one significant deficiency that is not deemed to be a material weakness may not affect the auditor’s report. In that in
stance, the auditor’s report on internal control over financial reporting would contain an unqualified opinion. However, if
the deficiency is deemed to be a material weakness, the auditor must express an adverse opinion on the effectiveness of
internal control over financial reporting.
23) Frank James, a highly competent employee of Brinkwater Sales Corporation, had been responsible for ac-
counting-related matters for two decades. His devotion to the firm and his duties always been exceptional, and
over the years, he had been given increased responsibility. Both president of Brinkwater and the partner of an
independent CPA firm in charge of the audit were shocked and dismayed to discover that James had embezzled
more than $500,000 over a 10-year period by not recording billings in the sales journal and subsequently divert
ing the cash receipts. What major factors permitted the defalcation to take place?
F: The most important internal control deficiency which permitted the defalcation to occur was the failure to adequately
segregate the accounting responsibility of recording billings in the sales journal from the custodial responsibility of re-
ceiving the cash. Regardless of how trustworthy James appeared, no employee should be given the combined duties of
custody of assets and accounting for those assets.
24) Jeanne Maier, CPA, believes that it is appropriate to obtain an understanding of intaernal control about half
way through the audit, after she is familiar with the client’s operations and the way the system actually works.
Sha has found through experience taht filling out internal control questionnaires and flowcharts early in the en
gagement is not beneficial because the system rarely functions the way it is supposed to. Later in engagement,
the auditor can prepare flowcharts and questionnaires with relative ease because of the knowledge already ob
tained on the audit. Evaluate her approach.
F: Maier is correct in her belief that internal controls frequently do not function in the manner they are supposed to. How
ever, regardless of this, her approach ignores the value of beginning the understanding of internal control by preparing
or reviewing a rough flowchart. Obtaining an early understanding of the client’s internal control will provide Maier with a
basis for a decision about the audit procedures and sample sizes based on assessed control risk. By not obtaining an un
derstanding of internal control until later in the engagement, Maier risks performing either too much or too little work, or
emphasizing the wrong areas during her audit.
25) Distinguish the auditor’s responsibility for testing control in an audit of a public company from the responsi
bility to test controls in an audit of a nonpublic company.
F: The extent of controls tested by auditors to express an opinion on internal controls for a public company is significantly
greater than that tested solely to express an opinion on the financial statements. To express an opinion on internal con
trols for a public company, the auditor obtains an understanding of and performs tests of controls for all significant ac
count balances, classes of transactions, and disclosures and related assertions in the financial statements. In contrast,
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the extent of controls tested by an auditor of a nonpublic company is dependent on the auditor’s assessment of control
risk. Whenever the auditor assesses control risk below maximum, the auditor must perform tests of controls to support
that control risk assessment. The auditor will not perform tests of controls when the auditor assesses control risk at maxi
mum, either because of inadequate controls or because it is inefficient to test those controls. When control risk is as-
sessed below the maximum, the auditor designs and performs a combination of tests of controls and substantive proce
dures. Thus, for a nonpublic company, the tests of controls vary based on the auditor’s assessment of control risk.
26) How does the sufficiency of evidence differ between procedures to obtain an understanding of internal con
trol and tests of controls?
F: There is a significant overlap between tests of controls and procedures to obtain an understanding of internal control.
Both include inquiry, documentation, and observation. There are two primary differences in the application of these com
mon procedures. First, in obtaining an understanding of internal control, the procedures to obtain an understanding are
applied to all controls identified during that phase. Tests of controls, on the other hand, are applied only when the as-
sessed control risk has not been satisfied by the procedures to obtain an understanding. Second, procedures to obtain
an understanding are performed only on one or a few transactions or, in the case of observations, at a single point in
time. Tests of controls are performed on larger samples of transactions (perhaps 20 to 100), and often observations are
made at more than one point in time.
27) During the prior-year audits of McKimmon Inc., a public company, the auditor did tests of controls for all rel
evant financial statement assertions. Some of the related controls are manual while others are automated. De
scribe the extent the auditor can rely on tests of controls performed in prior years.
F: PCAOB Standard 2 requires a public company auditor to test controls each year for all relevant assertions for signifi
cant accounts and transactions. However, if evidence was obtained in the prior year’s audit that indicates that a key con
trol was operating effectively, and the auditor determines that the control is still in place, the extent of the tests of that
control may be reduced somewhat in the current year.
28) What are two opinions that must be included in the auditor’s report on internal control over financial re-
porting required by PCAOB standard 2?
F: PCAOB Standard 2 requires that the auditor’s report on internal control include two auditor opinions:
1. The auditor’s opinion on whether management’s assessment of the effectiveness of internal control over financial
reporting as of the end of the fiscal period is fairly stated, in all material respects. In practice it is unlikely for the au
ditor to issue anything other than an unqualified report on this opinion. If the auditor concludes that management
has not identified and reported all significant deficiencies and material weaknesses, it will be in management’s best
interests to revise its report to conform to the auditor’s conclusions.
2. The auditor’s opinion on whether the company maintained, in all material respects, effective internal control over
nancial reporting as of the specified date. There is likely to be more variety in these reports.
29) What two conditions must be present for the auditor to issue an unqualified opinion on internal control over
financial reporting? What type of condition will cause the auditor to issue a qualified or disclaimer of opinion on
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internal control over financial reporting?
F: The auditor may issue an unqualified opinion on internal control over financial reporting when two conditions are
present:
there are no identified material weaknesses; and

there have been no restrictions on the scope of the auditor’s work.
A scope limitation is the condition that would cause the auditor to express a qualified opinion or a disclaimer of opinion
internal control over financial reporting. This type of opinion is issued when the auditor is unable to determine if there
are material weaknesses, due to a restriction on the scope of the audit of internal control over financial reporting or
other circumstances where the auditor is unable to obtain sufficient evidence.
30) Describe the concept of an integrated audit of the financial statements and internal control required by
PCAOB standard 2.
F: PCAOB Standard 2 requires that the audit of the financial statements and the audit of internal control over financial re
porting be integrated. In an integrated audit, the auditor must consider the results of audit procedures performed to is
sue the audit report on the financial statements when issuing the audit report on internal control. For example, if the au
ditor identifies a material misstatement in the financial statements that was not initially identified by the company’s inter
nal controls, the auditor should consider this as at least a significant deficiency, if not a material weakness for purposes
of reporting on internal control. In such circumstances, the auditor’s report on the financial statements may be unquali
fied as long as management corrected the misstatement before issuing the financial statements. In contrast, however,
the auditor’s report on internal control must include an adverse opinion if the auditor concludes it is a material weakness.
The Audit Process-Fraud Auditing
1) Define fraudulent financial reporting and give two examples that illustrate fraudulent financial reporting.
: Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to
deceive users. Two examples of fraudulent financial reporting are accelerating the timing of recording sales revenue to
increased reported sales and earnings, and recording expenses as fixed assets to increase earnings.
2) Define misappropriation of assets and give two examples of misappropriation of assets.
: Misappropriation of assets is fraud that involves theft of an entity’s assets. Two examples are an accounts payable clerk
issuing payments to a fictitious company controlled by the clerk, and a sales clerk failing to record a sale and pocketing
the cash receipts.
3) Distinguish fraudulent financial reporting from misappropriation of assets.
: Fraudulent financial reporting is an intentional misstatement or omission of amounts or disclosures with the intent to
deceive users, while misappropriation of assets is fraud that involves theft of an entity’s assets. Frauds involving financial
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reporting are usually larger than frauds involving misappropriation of assets, usually involve top management, and do
not directly involve theft of company assets.
4) What are the three conditions of fraud often referred to as “the fraud triangle?”
: The three conditions of fraud referred to as the “fraud triangle” are (1) Incentives/Pressures; (2) Opportunities; and (3)
Attitudes/Rationalization. Incentives/Pressures are incentives of management or other employees to commit fraud. Op
portunities are circumstances that allow management or employees to commit fraud. Attitudes/Rationalization are indi
cations that an attitude, character, or set of ethical values exist that allow management or employees to commit a dis-
honest act or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a
dishonest act.
5) Give examples of risk factors for fraudulent financial reporting for each of the three fraud conditions: in-
centives/pressures, opportunities, and attitudes/rationalization.
: The following are example of risk factors for fraudulent financial reporting for each of the three fraud conditions:
< Incentives/Pressures – The company is under pressure to meet debt covenants or obtain additional financing.
< Opportunities – Ineffective oversight of financial reporting by the board of directors allows management to exercise
discretion over reporting.
< Attitudes/Rationalization – Management is overly aggressive. For example, the company may issue aggressive earn
ings forecasts, or make extensive acquisitions using company stock.
6) Give examples of risk factors for misappropriation of assets for each of the three fraud conditions: incen
tives/pressures, opportunities, and attitudes/rationalization.
: The following are example of risk factors for misappropriation of assets for each of the three fraud conditions:
< Incentives/Pressures – The individual is unable to meet personal financial obligations.
< Opportunities – There is insufficient segregation of duties that allows the individual to handle cash receipts and re
lated accounting records.
< Attitudes/Rationalization – Management has disregarded the inadequate separation of duties that allows the poten
tial theft of cash receipts.
7) What sources are used by the auditor to gather information to assess fraud risks?
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: Auditors use several sources to gather information about fraud risks, including:
< Information obtained from communications among audit team members about their knowledge of the company
and its industry, including how and where the company 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 for fraudulent financial reporting and misappropriations of assets.
< Analytical procedures results 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 or control risks.
8) What should the audit team consider in its planning discussion about fraud risks?
: SAS 99 requires the audit team to conduct discussions to share insights from more experienced audit team members
and to “brainstorm” ideas that address the following:
1. How and where they believe the entity’s financial statements might be susceptible to material misstatement due to
fraud. This should include consideration of known external and internal factors affecting the entity that might
< create an incentive or pressure for management to commit fraud.
< provide the opportunity for fraud to be perpetrated.
< indicate a culture or environment that enables management to rationalize fraudulent acts.
1. How management could perpetrate and conceal fraudulent financial reporting.

2. How assets of the entity could be misappropriated.
3. How the auditor might respond to the susceptibility of material misstatements due to fraud.
9) Auditors are required to make inquiries of individuals in the company when gathering information to asses
fraud risk. Identify those with whom the auditor must make inquiries.
: Auditors must inquire whether management has knowledge of any fraud or suspected fraud within the company. SAS
99 also requires auditors to inquire of the audit committee about its views of the risks of fraud and whether the audit
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committee has knowledge of any fraud or suspected fraud. If the entity has an internal audit function, the auditor should
inquire about internal audit’s views of fraud risks and whether they have performed any procedures to identify or detect
fraud during the year. SAS 99 further requires the auditor to make inquiries of others within the entity whose duties lie
outside the normal financial reporting lines of responsibility about the existence or suspicion of fraud.
10) Describe the purpose of corporate codes of conduct and identify three examples of items addressed in a
typical code of conduct.
: The corporate code of conduct establishes the “tone at the top” of the importance of honesty and integrity and can
also provide more specific guidance about permitted and prohibited behavior. Example of items typically addressed in a
code of conduct include expectations of general employee conduct, restrictions on conflicts of interest, and limitations
on relationships with clients and suppliers.
11) Discuss the importance of the control environment, or “setting the tone at the top,” in establishing a culture
of honesty and integrity in a company.
: Management and the board of directors are responsible for setting the “tone at the top” for ethical behavior in the com
pany. It is important for management to behave with honesty and integrity because this reinforces the importance of
these values to employees throughout the organization.
12) Distinguish management’s responsibility from the audit committee’s responsibility for designing and imple
menting antifraud programs and controls within a company.
: Management has primary responsibility to design and implement antifraud programs and controls to prevent, deter,
and detect fraud. The audit committee has primary responsibility to oversee the organization’s financial reporting and in
ternal control processes and to provide oversight of management’s fraud risk assessment process and antifraud pro-
grams and controls.
13) What are the three categories of auditor responses to fraud risks?
: The three auditor responses to fraud are: (1) change the overall conduct of the audit to respond to identified fraud risks;
(2) design and perform audit procedures to address identified risks; and (3) perform procedures to address the risk of
management override of controls.
14) What three auditor actions are required to address the potential for management override of controls?
: Auditors are required to take three actions to address potential management override of controls: (1) examine journal
entries and other adjustments for evidence of possible misstatements due to fraud; (2) review accounting estimates for
biases; and (3) evaluate the business rationale for significant unusual transactions.
15) Describe the three main techniques used to manipulate revenue.
: Three main techniques use to manipulate revenue include: (1) recording of fictitious revenue; (2) premature revenue
recognition including techniques such as bill-and-hold sales and channel stuffing; and (3) manipulation of adjustments to
revenue such as sales returns and allowance and other contra accounts.
16) You go through the drive-through window of a fast food restaurant and notice a sign that reads “your meal is
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free if we fail to give you a receipt.” Why would the restaurant post this sign?
: Cash register receipts are particularly susceptible to theft. The notice “your meal is free if we fail to give you a receipt” is
designed to ensure that every customer is given a receipt and all sales are entered into the register, establish account-
ability for the sale.
17) Name the three categories of inquiry and describe the purpose of each when used by an auditor to obtain
additional information about a suspected fraud.
: The three types of inquiry are informational, assessment, and interrogative. Auditors use informational inquiry to obtain
information about facts and details that the auditor does not have. For example, if the auditor suspects financial state-
ment fraud involving improper revenue recognition, the auditor may inquire of management as to revenue recognition
policies. The auditor uses assessment inquiry to corroborate or contradict prior information. In the previous example,
the auditor may attempt to corroborate the information obtained from management by making assessment inquiries of
individuals in accounts receivable and shipping. Interrogative inquiry is used to determine if the interviewee is being de
ceptive or purposefully omitting disclosure of key knowledge of facts, events, or circumstances. For example, a senior
member of the audit team might make interrogative inquiries of management or other personnel about key elements of
the fraud where earlier responses were contradictory or evasive.
18) Identify three verbal and three nonverbal cues that may be observed when making inquiries of an individual
who is being deceitful.
: When making inquiries of a deceitful individual, three examples of verbal cues are frequent rephrasing of the question,
filler terms such as “well” or “to tell the truth,” and forgetfulness or acknowledgements of nervousness. Three examples
of nonverbal cues by the individual are creating physical barriers by blocking their mouth, leaning away from the auditor,
and signs of stress such as sweating or fidgeting.
19) You have identified a suspected fraud involving the company’s controller. What must you do in response to
this discovery? How might this discovery affect your report on internal control when auditing a public company?
: When the auditor suspects that fraud may be present, SAS 99 requires the auditor to obtain additional evidence to de
termine whether material fraud has occurred. SAS 99 also requires the auditor to consider the implications for other as
pects of the audit. When the auditor determines that fraud may be present, SAS 99 requires the auditor to discuss the
matter and audit approach for further investigation with an appropriate level of management that is at least one level
above those involved, and with senior management and the audit committee, even if the matter might be considered in
consequential. For public company auditors, the discovery of fraud of any magnitude by senior management is at least a
significant deficiency and may be a material weakness in internal control over financial reporting. This includes fraud by
senior management that results in even immaterial misstatements. If the public company auditor decides the fraud is a
material weakness, the auditor’s report on internal control over financial reporting will contain an adverse opinion.
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The Audit Process-The Impact of Information Technology
1) Explain how client internal controls can be improved through the proper installation of IT.
ÿ: The proper installation of IT can lead to internal control enhancements by replacing manually-performed controls with
computer-performed controls. IT-based accounting systems have the ability to handle tremendous volumes of complex
business transactions cost effectively. Computer-performed controls can reduce the potential for human error by replac
ing manual controls with programmed controls that apply checks and balances to each transaction processed. The sys
tematic nature of IT offers greater potential to reduce the risk of material misstatements resulting from random, human
errors in processing.
The use of IT based accounting systems also offers the potential for improved management decisions by providing more
and higher quality information on a more timely basis than traditional manual systems. IT-based systems are usually ad
ministered effectively because the complexity requires effective organization, procedures, and documentation. That in
turn enhances internal control.
2) Identify risks for accounting systems that rely heavily on IT functions.
ÿ: When entities rely heavily on IT systems to process financial information, there are new risks specific to IT environ-
ments that must be considered. Key risks include the following:
< Reliance on the functioning capabilities of hardware and software. The risk of system crashes due to hardware or soft
ware failures must be evaluated when entities rely on IT to produce financial statement information.
< Visibility of audit trail. The use of IT often converts the traditional paper trail to an electronic audit trail, eliminating
source documents and paper-based journals and records.
< Reduced human involvement. The replacement of traditional manual processes with computer-performed processes
reduces opportunities for employees to recognize misstatements resulting from transactions that might have appeared
unusual to experienced employees.
< Systematic versus random errors. Due to the uniformity of processing performed by IT based systems, errors in com
puter software can result in incorrect processing for all transactions processed. This increases the risk of many signifi-
cant misstatements.
< Unauthorized access. The centralized storage of key records and files in electronic form increases the potential for
unauthorized on-line access from remote locations.
< Loss of data. The centralized storage of data in electronic form increases the risk of data loss in the event the data
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file is altered or destroyed.
< Reduced segregation of duties. The installation of IT-based accounting systems centralizes many of the traditionally
segregated manual tasks into one IT function.
< Lack of traditional authorization. IT-based systems can be programmed to initiate certain types of transactions auto
matically without obtaining traditional manual approvals.
< Need for IT experience. As companies rely to a greater extent on IT-based systems, the need for personnel trained in
IT systems increases in order to install, maintain, and use systems.
3) Define what is meant by an audit trail and explain how it can be affected by client’s integration of IT.
ÿ: The audit trail represents the accumulation of source documents and records maintained by the client to serve as sup
port for the transactions occurring during the accounting period. The integration of IT can change the audit trail by con
verting many of the traditionally paper-based source documents and records into electronic files that cannot be visually
observed. Because many of the transactions are entered directly into the computer as they occur, some of the docu-
ments and records are even eliminated.
4) Distinguish between random error resulting from manual processing and systematic error resulting from IT
processing and give an example of each category of error.
ÿ: Random error represents errors that occur in an inconsistent pattern. Manual accounting systems are especially prone
to random errors that result from honest mistakes that occur as employees perform day-to-day tasks. When those mis
takes do not consistently occur while performing a particular task, errors are distributed randomly into the accounting
records. An example of a random error is when an employee accidentally pulls the wrong unit price off the approved
price list when preparing a sales invoice for a particular customer.
Systematic error represents errors that occur consistently across all similar transactions. Because IT-based systems per
form tasks uniformly for all transactions submitted, any mistake in software programming results in the occurrence of
the same error for every transaction processed by the system. An example of a systematic error occurs when a program
that is supposed to post sales amounts to the accounts receivable subsidiary records actually posts the sales amount
twice to customers’ accounts.
5) Identify the traditionally segregated duties in noncomplex IT systems and explain how increases in the
complexity of the IT function affect that separation.
ÿ: In most traditional accounting systems, the duties related to authorization of transactions, recordkeeping of transac
tions, and custody of assets are segregated across three or more individuals. As accounting systems make greater use of
IT, many of the traditional manually performed tasks are now performed by the computer. As a result, some of the tradi
tionally segregated duties, particularly authorization and recordkeeping, fall under the responsibility of IT personnel. To
compensate for the collapsing of duties under the IT function, key IT tasks related to programming, operation of hard-
ware and software, and data control are segregated. Separation of those IT functions restricts an IT employee’s ability to
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inappropriately access software and data files in order to misappropriate assets.
6) Distinguish between general controls and application controls and give two examples of each.
ÿ: General controls relate to all aspects of the IT function. They have a global impact on all software applications. Exam-
ples of general controls include controls related to the administration of the IT function; software acquisition and mainte
nance; physical and on-line security over access to hardware, software, and related backup; back-up planning in the event
of unexpected emergencies; and hardware controls. Application controls apply to the processing of individual transac-
tions. An example of an application control is a programmed control that verifies that all time cards submitted are for
valid employee id numbers included in the employee master file.
7) Identify the typical duties within an IT function and describe how those duties should be segregated among
IT personnel.
ÿ: The typical duties often segregated within an IT function include systems development, computer operations, and data
control. Systems development involves the acquisition or programming of application software. Systems development
personnel work with test copies of programs and data files to develop new or improved application software programs.
Computer operations personnel are responsible for executing live production jobs in accordance with a job schedule and
for monitoring consoles for messages about computer efficiency and malfunctions. Data control personnel are responsi
ble for data input and output control. They often independently verify the quality of input and the reasonableness of out
put. By separating these functions, no one IT employee can make changes to application software or underlying master
files and then operate computer equipment to use those changed programs or data files to process transactions.
8) Explain how the effectiveness of general controls affects the auditor’s tests of automated application con
trols, including the auditor’s ability to rely on tests done in prior audits.
ÿ: If general controls are ineffective, there is a potential for material misstatement in each computer-based accounting
application, regardless of the quality of application controls. If, for example, the systems development process is not
properly controlled, there is a greater risk that unauthorized and untested modifications to accounting applications soft
ware have occurred. If general controls are strong, there is a greater likelihood of placing greater reliance on application
controls. Stronger general controls should lead to greater likelihood that underlying applications operate effectively and
data files contain accurate, authorized, and complete information.
9) Explain the relationship between application controls and transaction-related audit objectives.
ÿ: Application controls apply to the processing of specific individual transactions within a transaction cycle, such as a
computer performed credit approval process for sales on account. Due to the nature of these types of controls, applica
tion controls generally link directly to one or more specific transaction objectives. For example, the credit approval appli
cation control directly links to the existence objective for sales. Auditors typically identify both manual and computer-per
formed application controls for each transaction-related objective using a control risk matrix similar to the one discussed
in Chapter 10.
10) Explain what is meant by auditing around the computer and describe what must be present for this ap-
proach to be effective when auditing clients who use IT to process accounting information.
ÿ: “Auditing around the computer” represents an audit approach whereby the auditor does not use computer controls to
reduce control risk. Instead, the auditor uses non-IT controls to support a reduced control risk assessment. In these situ
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ations, the use of IT does not significantly impact the audit trail. Typically, the auditor obtains an understanding of inter
nal control and performs tests of controls, substantive tests of transactions, and account balance verification pro
cedures in the same manner as if the accounting system was entirely manual. The auditor is still responsible for gaining
an understanding of general and application computer controls because such knowledge is useful in identifying risks that
may affect the financial statements.
11) Explain what is meant by the test data approach. What are the major difficulties with using this approach?
Define parallel simulation with audit software and provide an example of how it can be used to test a client’s
payroll system.
ÿ: The test data approach involves processing the auditor’s test data using the client’s computer system and the client’s
application software program to determine whether the computer-performed controls correctly process the test data.
Because the auditor designs the test data, the auditor is able to identify which test items should be accepted or rejected
by the computer. When using this approach the auditor should assess the following:
< How effectively does the test data represent all relevant conditions that the auditor wants to test?
< How certain is the auditor that the application programs being tested by the auditor’s test data are the same pro-
grams as those used by the client throughout the year to process actual transactions?
< How certain is the auditor that test data is effectively eliminated from the client’s records once testing is completed?
Parallel simulation with audit software involves the auditor’s use of an auditor-controlled software program to perform
parallel operations to the client’s software by using the same data files. Because the auditor’s software is designed to par
allel an operation performed by the client’s software, this strategy is referred to as parallel simulation testing. Parallel
simulation could be used in the audit of payroll by writing a program that calculates the accrued vacation pay liability for
each employee using information contained in the employee master file. The total liability calculated by the auditor’s soft
ware program would then be compared to the client’s calculation to determine if the liability for accrued vacation pay is
fairly stated at year-end.
12) Describe risks that are associated with purchasing software to be installed on microcomputer hard drives.
What precautions can clients take to reduce those risks?
ÿ: Often companies that purchase and install vendor developed software applications on computer hard drives rely on IT
consultants to assist in the installation and maintenance of that software because those companies do not have dedi-
cated IT personnel. Also, assignment of responsibility may reside with user departments. Companies can reduce these
risks related to not having IT personnel by performing sufficient reference and background checks about software ven
dor and IT consultant reputations. In addition, companies can load software programs onto hard drives in a format that
does not permit changes by client personnel, particularly non-IT user department personnel who may have primary re
sponsibility for the system. Companies should also consider segregating key duties related to access to master files and
responsibilities for processing transactions.
13) Compare the risks associated with network systems to those associated with centralized IT functions.
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ÿ: Because many companies that operate in a network environment decentralize their network servers across the organi
zation, there is an increased risk for a lack of security and lack of overall management of the network operations. The de
centralization may lead to a lack of standardized equipment and procedures. In many instances responsibility for pur-
chasing equipment and software, maintenance, administration, and physical security, often resides with key user groups
rather than with a centralized IT function. Also, network-related software often lacks the security features, including seg
regation of duties, typically available in traditionally centralized environments because of the ready access to software
and data by multiple users.
14) How does the use of a database management system affect risks?
ÿ: In database management systems, many applications share the same data files. This increases risks in some cases
given that multiple users, including individuals outside accounting, access and update data files. Without proper data-
base administration and access controls, risks of unauthorized, inaccurate, and incomplete data files increase. The cen
tralization of data also increases the need to properly back-up data information on a regular basis.
15) An audit client is in the process of creating an online web-based sales ordering system for customers to pur
chase products using personal credit cards for payment. Identify three risks related to an online sales system
that management should consider. For each risk, identify an internal control that could be implemented to re
duce that risk.
ÿ: An online sales ordering system poses many potential risks for an audit client. Risks that may exist include:
1. Customer data is susceptible to interception by unauthorized third parties.

2. The client company’s data, programs, and hardware are susceptible to potential interception or sabotage by exter
nal parties.
3. An unauthorized third party may attempt to transact business with the client company.
These risks can be addressed by the use of firewalls, encryption techniques, and digital signatures. A firewall is a system
of hardware and software that monitors and controls the flow of e-commerce communications by channeling all net-
work connections through a control gateway. A firewall protects data, programs, and other IT resources from external
users accessing the system through networks, such as the Internet. Encryption techniques are based on computer pro-
grams that transform a standard message into a coded (encrypted) form. One key (the public key) is used for encoding
the message and the other key (the private key) is used to decode the message. Encryption techniques protect the secu
rity of electronic communication during the transmission process. Finally, the use of digital signatures can enhance inter
nal controls over the online sales order system by authenticating the validity of customers and other trading partners
who conduct business with the client company.
16) Explain why it is unacceptable for an auditor to assume that an independent computer service center is pro
viding reliable accounting information to an audit client. What can auditor do to test the service center’s inter
nal controls?
ÿ: It is unacceptable for an auditor to assume an independent computer service center is providing reliable accounting in
formation to an audit client because the auditor has no firsthand knowledge as to the adequacy of the service center’s
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controls. If the client’s service center application is involved in processing significant financial data, the auditor must con
sider the need to obtain an understanding of internal control and test the service center’s controls.
The auditor can test the service center’s system by use of the test data and other tests of controls. Or, he or she may re
quest that the service center auditor obtain an understanding and test controls of the service center, which are summa
rized in a special report issued by the service center auditor for use by the customer’s auditor.
The Audit Process-Overall Audit Plan and Audit Program
1) What are the five types of tests auditors use to determine whether financial statements are fairly stated?
Identify which tests are performed to reduce control risk and which tests are performed to reduce planned de
tection risk. Also, identify which tests will be used by a public company auditor when internal control over finan
cial reporting.
%: The five types of tests auditors use to determine whether financial statements are fairly stated include the following:
< Procedures to gain an understanding of internal control
< Tests of controls
< Substantive tests of transactions
< Analytical procedures
< Tests of details of balances
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While procedures to gain an understanding of internal control help the financial statement auditor obtain information to
make an initial assessment of control risk, tests of controls must be performed as support of an assessment of control
risk that is below maximum. The purpose of tests of controls is to obtain evidence regarding the effectiveness of con-
trols, which may allow the auditor to assess control risk below maximum. If controls are found to be effective and func
tioning, the substantive evidence may be reduced. Substantive evidence is obtained to reduce detection risk. Substantive
evidence includes evidence from substantive tests of transactions, analytical procedures, and tests of details of balances.
For audits of internal control over financial reporting, the auditor only performs the first two types of audit tests: proce
dures to obtain an understanding of internal control and tests of controls. Because a public company auditor must issue
a report on internal control over financial reporting, the extent of the auditor’s tests of controls must be sufficient to is
sue an opinion about the operating effectiveness of those controls. That generally requires a significant amount of test
ing of controls over financial reporting.
2) What is the purpose of tests of controls? Identify specific accounts on the financial statements that are a
ffected by performing tests of controls for the acquisition and payment cycle.
%: Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in support
of a reduced assessed control risk. Tests of controls provide the primary basis for a public company auditor’s report on
internal controls over financial reporting. Specific accounts affected by performing tests of controls for the acquisition
and payment cycle include the following: cash, accounts payable, purchases, purchase returns and allowances, purchase
discounts, manufacturing expenses, selling expenses, prepaid insurance, leasehold improvements, and various adminis
trative expenses.
3) Distinguish between a test of control and a substantive test of transactions. Give two examples of each.
%: Tests of controls are audit procedures to test the operating effectiveness of control policies and procedures in sup-
port of a reduced assessed control risk. Examples include:
1. The examination of vendor invoices for indication that they have been clerically tested, compared to a receiving re
port and purchase order, and approved for payment.
2. Examination of employee time cards for approval of overtime hours worked.
3. Examination of journal entries for proper approval.
4. Examination of approvals for the write-off of bad debts.
Substantive tests of transactions are audit procedures testing for monetary misstatements to determine whether the six
transaction-related audit objectives have been satisfied for each class of transactions. Examples are:
1. Recalculation of amounts (quantity times unit selling price) on selected sales invoices and tracing of amounts to
the sales journal.
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2. Examination of vendor invoices in support of amounts recorded in the acquisitions journal for purchases of inven
tories.
3. Recalculation of gross pay for selected entries in the payroll journal.
4. Tracing of selected customer cash receipts to the accounts receivable master file, agreeing customer names and
amounts.
4) State a test of control audit procedure to test the effectiveness of the following control: approved wage
rates are used in calculating employees’ earnings. State a substantive test of transactions audit procedure to
determine whether approved wage rates are actually used in calculating employees’ earnings.
%: A test of control audit procedure to test that approved wage rates are used to calculate employees’ earnings would be
to examine rate authorization forms to determine the existence of authorized signatures.
A substantive test of transactions audit procedure would be to compare a sample of rates actually paid, as indicated in
the earnings record, to authorized pay rates on rate authorization forms.
5) A considerable portion of the tests of controls and substantive tests of transactions are performed simulta
neously as a matter of audit convenience. But the substantive tests of transactions procedures and sample size,
in part, depend on the results of the tests of controls. How can the auditor resolve this apparent inconsistency?
%: The auditor resolves the problem by making assumptions about the results of the tests of controls and performing
both the tests of controls and substantive tests of transactions on the basis of these assumptions. Ordinarily the auditor
assumes an effective system of internal control with few or no exceptions planned. If the results of the tests of controls
are as good as or better than the assumptions that were originally made, the auditor can be satisfied with the substan
tive tests of transactions, unless the substantive tests of transactions themselves indicate the existence of misstate-
ments. If the tests of controls results were not as good as the auditor assumed in designing the original tests, expanded
substantive tests must be performed.
6) Evaluate the following statement: “tests of sales and cash receipts transactions are such an essential part
of every audit that i like to perform them as near the end of the audits as possible. By that time i have a fairly
good understanding of the client’s business and its internal controls because confirmations, cutoff tests, and
other procedures have already been completed.”
%: The primary purpose of testing sales and cash receipts transactions is to evaluate the internal controls so that the
scope of the substantive tests of the account balances may be set. If the auditor performs the tests of details of balances
prior to testing internal controls, no benefit will be derived from the tests of controls. The auditor should attempt to un
derstand the client’s business and internal controls as early as practical through the analysis of the accounting system,
tests of controls, and substantive tests of transactions.
7) Explain how the calculation and comparison to previous years of the gross margin percentage and the ratio
of accounts receivable to sales are related to the confirmation of accounts receivable and other tests of the ac
curacy of accounts receivable.
%: When the results of analytical procedures are different from the auditor’s expectations and thereby indicate that there
may be a misstatement in the balance in accounts receivable or sales, the auditor should extend the tests to determine
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why the ratios are different from expectations. Confirmation of accounts receivable and cutoff tests for sales are two
procedures that can be used to do this. On the other hand, if the ratios are approximately what the auditor expects, the
other tests can be reduced. This means that the auditor can satisfy the evidence requirements in different ways and that
analytical procedures and confirmation are complementary when the results of the tests are both good.
8) Distinguish between substantive tests of transactions and tests of details of balances. Give one example of
each for the acquisition and payment cycle.
%: Substantive tests of transactions are performed to verify the accuracy of a client’s accounting system. This is accom
plished by determining whether individual transactions are correctly recorded and summarized in the journals, master
files, and general ledger. Substantive tests of transactions are also concerned with classes of transactions, such as pay
roll, acquisitions, or cash receipts. Tracing amounts from a file of vouchers to the acquisitions journal is an example of a
substantive test of transactions for the acquisition and payment cycle. Tests of details of balances verify the ending bal
ance in an individual account (such as inventory, accounts receivable, or depreciation expense) on the financial state-
ments. An example of a test of details of balances for the acquisition and payment cycle is to physically examine a sam
ple of the client’s fixed assets.
9) The auditor Ferguson’s Inc. identified two internal controls in the sales and collection receipts cycle for test
ing. In the first control, the computer verifies that a planned sale on account will not exceed the customer’s
credit limit entered in the accounts receivable master file. In the second control, the accounts receivable clerk
matches bills of ladding, sales invoices, and customer orders before recording in the sales journal. Describe how
the presence of general controls over software programs and master file changes affects the extent of audit
testing of each of these two internal controls.
%: 1. Control #1 — Computer verification of the customer’s credit limit. The presence of strong general controls over soft
ware programs and master file changes can significantly reduce the auditor’s testing of automated controls such as con
trol #1. Once it is determined that control #1 is functioning properly, the auditor can focus subsequent tests on assessing
whether any changes have occurred that would limit the effectiveness of the control. Such tests might include determin
ing whether any changes have occurred to the program and whether these changes were properly authorized and tested
prior to implementation. These are all tests of general controls over software programs and master file changes.
1. Control #2 – The accounts receivable clerk matches bills of lading, sales invoices, and customer orders before recording
in the sales journal. This control is not an automated control, but is rather a manual control performed by an em-
ployee. General controls over software programs and master file changes would have little effect on the auditor’s
testing of control #2. If the auditor identifies control #2 as a key control in the sales and collection cycle, he or she
would most likely examine a sample of the underlying documents for the accounts receivable clerk’s initials and
reperform the comparisons.
10) Assume that the client’s internal controls over the recording and classifying of fixed asset additions are con
sidered deficient because the individual responsible for recording new aquisitions has inadequate technical
training and limited experience in accounting. How will this situation affect the evidence you should accumulate
in auditing fixed assets as compared with another audit in which the controls are excellent? Be as specific as
possible.
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%: The audit of fixed asset additions normally involves the examination of invoices in support of the additions and possi
bly the physical examination of the additions. These procedures are normally performed on a test basis with a concentra
tion on the more significant additions. If the individual responsible for recording new acquisitions is known to have inade
quate training and limited experience in accounting, the sample size for the audit procedures should be expanded to in
clude a larger sample of the additions for the year. In addition, inquiry as to what additions were made during the year
may be made by the auditor of plant managers, the controller, or other operating personnel. The auditor should then
search the financial records to determine that these additions were recorded as fixed assets.
Care should also be taken when the repairs and maintenance expense account is analyzed since lack of training may
cause some depreciable assets to be expensed at the time of acquisition.
11) For each of the eight types of evidence discussed in chapter 7, identify whether it is applicable for risk as-
sessment procedures, tests of controls, substantive tests of transactions, analytical procedures, adn tests of de
tails of balances.
%: The following shows which types of evidence are applicable for the five types of tests.
TYPE OF EVIDENCE TYPES OF TESTS
Physical examination Tests of details of balances

Confirmation Tests of details of balances

Documentation All except analytical procedures

Observation Procedures to obtain an understanding of internal control and tests of controls

All five types
Inquiries of the client
Tests of controls, substantive tests of transactions, and tests of details of balances
Reperformance
Analytical procedures
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Analytical procedures
12) Rank the following types of tests from moct costly to least costly: analytical procedures, tests of details of
balances, risk assessment procedures, tests of controls, and substantive tests of transactions.
%: Going from most to least costly, the types of tests are:
< Tests of details of balances
< Substantive tests of transactions
< Tests of controls
< Procedures to obtain an understanding of internal controls
< Analytical procedures
13) In figure 13-3, explain the difference among C3, C2, and C1. Explain the circumstances under which it will be
a good decision to obtain audit assurance from substantive tests at point C1. Do the same for points C2, and C3.
%: C represents the auditor’s assessment of the effectiveness of internal control. C3 represents the idea that the auditor
chooses not to perform any tests of controls. Since no tests of controls are performed, no assurance can be obtained
from controls and all assurance must come from substantive testing. This would not represent the audit of a public
company’s financial statements.Tests of controls at the C1 level would provide minimum control risk. This would require
more testing of the controls than would be required at either C2 or C3. Testing controls at the C1 level allows the auditor
to obtain assurance from the controls, thereby allowing for a reduction in the amount of substantive testing which must
be performed to meet the level of acceptable audit assurance. C1 reflects the level of testing of controls necessary for the
audit of internal controls over financial reporting required by PCAOB Standard 2.
It would be a good decision to obtain assurance from tests of controls at point C1 if the cost of substantive testing is con
siderably greater than tests of controls. However, if the cost of testing controls is high, it may be a good decision to ob
tain assurance at point C3.
At point C2, the auditor performs some tests of controls and is able to reduce control risk below maximum. Point C2
would be appropriate if it is cost beneficial for the auditor to obtain assurance at a level between the two extremes men
tioned above (C1 and C3).
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14) Table 13-3 illustrates variations in the emphasis on different types of audit tests. What are the benefits to
the auditor of identifying the best mix of tests?
%: By identifying the best mix of tests the auditor can accumulate sufficient competent evidence at minimum cost. The
auditor can thereby meet the standards of the profession and still be cost effective and competitive.
15) State the four-step approach to designing tests of controls and substantive tests of transactions.
%: The four-step approach to designing tests of controls and substantive tests of transactions is as follows:
1. Apply the transaction-related audit objectives to the class of transactions being tested.
2. Identify specific control policies and procedures that should reduce control risk for each transaction-related audit
objective.
3. Develop appropriate tests of controls for each key control.
4. Design appropriate substantive tests of transactions considering deficiencies in internal control and expected re
sults from 3 above.
16) Expalin the relationship between the methodology for designing tests of controls and substantive tests of
transactions in figure 13-4 to the methodology for designing tests of details of balances in figure 13-6.
%: The approach to designing tests of controls and substantive tests of transactions (Figure 13-4) emphasizes satisfying
the transaction-related audit objectives developed in Chapters 6 and 10. Recall that these objectives focus on the proper
functioning of the accounting system.
The methodology of designing tests of details of balances (Figure 13-6) emphasizes satisfying the balance-related audit
objectives developed in Chapter 6. The primary focus of these objectives is on the fair presentation of account balances
in the financial statements.
17) Why is it desirable to design tests of details of balances before performing tests of controls and substantive
tests of transactions? State the assumptions that the auditor must make in doing that. What does the auditor
do if the assumptions are wrong?
%: It is desirable to design tests of details of balances before performing tests of controls and substantive tests of trans
actions to enable the auditor to determine if the overall planned evidence is the most efficient and effective in the cir-
cumstances. In order to do this, the auditor must make assumptions about the results of the tests of controls and sub
stantive tests of transactions. Ordinarily the auditor will assume no significant misstatements or control problems in
tests of controls and substantive tests of transactions unless there is reason to believe otherwise. If the auditor deter-
mines that the tests of controls and substantive tests of transactions results are different from those expected, the
amount of testing of details of balances must be altered.
18) Explain the relationship of tolerable misstatement, inherent risk, and control risk to planned tests of details
of balances.
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%: If tolerable misstatement is low, and inherent risk and control risk are high, planned tests of details of balances which
the auditor must perform will be high. An increase in tolerable misstatement or a reduction of either inherent risk or con
trol risk will lead to a reduction in the planned tests of details of balances.
19) List the nine balance-related audit objectives in the verification of the ending balance in inventory and pro
vide one useful audit procedure for each of the objectives.
%: The nine balance-related audit objectives and related procedures are as follows:
GENERAL BAL-
ANCE-RELATED
AUDIT OBJEC-
TIVE

SPECIFIC OBJECTIVE AUDIT PROCEDURE
Detail tie-in Inventory on the inventory summary agrees Check extensions of price times quantity on a sample basis, foot
with the physical count, the extensions are the detailed inventory summary, and trace the balance to the
correct, and the total is correctly added and general ledger and financial statements.
agrees with the general ledger.
Existence Inventory as stated in financial statements ac- Trace inventory from final inventory summary to actual inven-
tually exists. tory and physically count selected items.
Completeness Existing inventory items have been counted Select items from the physical inventory and trace to the client’s
and included in the financial statements. final summary to make sure that all items are included.
Accuracy Inventory items included in the financial Perform price tests of inventory by examining supporting ven-
statements are stated at the correct amounts. dors’ invoices for selected inventory items and reverify price
times quantity.
Classification Inventory as included in the financial state- Compare the classification of inventory into raw materials, work
ments is properly classified. in process, and finished goods by comparing the description on
physical inventory count tags with the client’s final inventory list
ing.
Cutoff Inventory cutoff is properly recorded at the Trace selected receiving reports several days before and after
balance sheet date. the balance sheet date to determine whether inventory pur-
chases are recorded in the proper period and related physical

inventory counts are included or excluded from inventory.
Realizable value Inventory on the financial statements ex- Inquire of factory employees and management regarding obso
cludes unusable items. lescence of inventory, and examine storeroom for evidence of
damaged or obsolete inventory.
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GENERAL BAL-
ANCE-RELATED AU-
DIT OBJECTIVE

SPECIFIC OBJECTIVE AUDIT PROCEDURE
Rights and obliga- Inventory items in the financial state- Review contracts with suppliers and customers for the possibility
tions ments are owned by the client. of the inclusion of consigned or other non-owned inventory.
Presentation and Inventory and related accounts in the Examine financial statements for proper presentation and disclo
disclosure inventory and warehousing cycle are sure including proper description of pledged inventory and inclu
properly presented and disclosed. sion of significant sales and purchase commitments.
20) Why do auditors often consider it desirable to perform audit tests throughout the year rather than wait un
til year-end? List several examples of evidence that can be accumulated before year-end.
%: Auditors frequently consider it desirable to perform audit tests throughout the year rather than waiting until year-end
because of the CPA firm’s difficulty of scheduling personnel. Due to the uneven distribution of the year-end dates of their
clients, there is a shortage of personnel during certain periods of the year and excess available time at other periods. The
procedures that are performed at a date prior to year-end are often dependent upon adequate internal controls and
when the client will have the information available. Additionally, public company auditors must begin their testing of con
trols earlier in the year to ensure they are able to test a sufficient sample of controls for operating effectiveness. Some
controls may only be performed monthly or quarterly. Thus, the public company auditor must begin testing early in the
year so that there is a sufficient number of months or quarters to test.
Procedures that may be performed prior to the end of the year are:
1. Update fixed asset schedules.
2. Examine new loan agreements and other legal records.
3. Vouch certain transactions.
4. Analyze changes in the client’s accounting systems.
5. Review minutes of board of directors’ meetings.
6. If the client has strong internal control, the following procedures may be performed with minor review and updat
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ing at year-end:
(a) Observation of physical inventories;
(b) Confirmation of accounts receivable balances;
(c) Confirmation and reconciliation of accounts payable balances.
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Completing The Audit
1) Distinguish between a contingent liability and an actual liability and give three examples of each.
Ñ: A contingent liability is a potential future obligation to an outside party for an unknown amount resulting from activi
ties that have already taken place. Some examples would be:
< Pending litigation
< Income tax disputes
< Product warranties
< Notes receivable discounted
< Guarantees of obligations of others
< Unused balances of outstanding letters of credit
An actual liability is a real future obligation to an outside party for a known amount from activities that have already
taken place. Some examples would be:
< Notes payable
< Accounts payable
< Accrued interest payable
< Income taxes payable
< Payroll withholding liabilities
< Accrued salaries and wages
2) In the audit of the James Mobley Company, you are concerned about the possibility of contingent liabilities resulting
from income tax disputes. Discuss the procedures you could use for an extensive investigation in this area.
Ñ: If you are concerned about the possibility of contingent liabilities for income tax disputes, there are various proce-
dures you could use for an intensive investigation in that area. One good approach would be an analysis of income tax
expense. Unusual or nonrecurring amounts should be investigated further to determine if they represent situations of
potential tax liability. Another helpful procedure for uncovering potential tax liabilities is to review the general correspon
dence file for communication with attorneys or internal revenue agents. This might give an indication that the potential
for a liability exists even though no actual litigation has begun. Finally, an examination of internal revenue agent reports
from prior years may provide the most obvious indication of disputed tax matters.
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3) Explain why an auditor is interested in a client’s future commitments to purchase raw materials at affixed price.
Ñ: The auditor would be interested in a client’s future commitments to purchase raw materials at a fixed price so that this
information could be disclosed in the financial statements. The commitment may be of interest to an investor as it is
compared to the future price movements of the material. A future commitment to purchase raw materials at a fixed
price may result in the client paying more or less than the market price at a future time.
4) Explain why the analysis of legal expense is an essential part of every audit.
Ñ: The analysis of legal expense is an essential part of every audit engagement because it may give an indication of con
tingent liabilities which may become actual liabilities in the future and require disclosure in the current financial state-
ments. Since any single contingency could be material, it is important to verify all legal transactions, even if the amounts
are small. After the analysis of legal expense is completed, the attorneys to whom payment was made should be consid
ered for letters of confirmation for contingencies (attorney letters).
5) During the audit of the Merrill Manufacturing Company, Ralph Pyson, CPA, has become aware of four lawsuits
against the client though discussions with the client, reading corporate minutes, and reviewing correspondence files.
How should Pyson determine the materiality of the lawsuits and the proper disclosure in the financial statements?
Ñ: Pyson should determine the materiality of the lawsuits by requesting from Merrill’s attorneys an assessment of the le
gal situations and the probable liabilities involved. In addition, Pyson may have his own attorney assess the situations.
Proper disclosure in the financial statements will depend on the attorneys’ evaluations of the probable liabilities involved.
If the evaluations indicate highly probable, material amounts, disclosure will be necessary in the form of a footnote, as
suming the amount of the probable material loss cannot be reasonably estimated. If the client refuses to make adequate
disclosure of the contingencies, a qualified or adverse opinion may be necessary.
6) Distinguish between an asserted and unasserted claim. Explain why a client’s attorney may not reveal an unasserted
claim.
Ñ: An asserted claim is an existing legal action that has been taken against the client, whereas an unasserted claim repre
sents a potential legal action. The client’s attorney may not reveal an unasserted claim for fear that the disclosure of this
information may precipitate a lawsuit that would be damaging to the client, and that would otherwise not be filed.
7) Describe the action that an auditor should take if an attorney refuses to provide information that is within the attor
ney’s jurisdiction and may directly affect the fair presentation of the financial statements.
Ñ: If an attorney refuses to provide the auditor with information about material existing lawsuits or likely material
unasserted claims, the audit opinion would have to be modified to reflect the lack of available evidence. This is required
by SAS 12 (AU 337), and has the effect of requiring management to give its attorneys permission to provide contingent li
ability information to auditors and to encourage attorneys to cooperate with auditors in obtaining information about con
tingencies.
8) Distinguish between the two general types of subsequent events and explain how they differ. Give two examples of
each type.
Ñ: The first type of subsequent event is one that has a direct effect on the financial statements and requires adjustment.
Examples of this type of subsequent event are as follows:
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< Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due to the deteriorating
financial condition
< Settlement of a litigation for an amount different from the amount recorded on the books
< Disposal of equipment not being used in operations at a price below the current book value
< Sale of investments at a price below recorded cost
< Sale of raw material as scrap in the period subsequent to the balance sheet date
The second type of subsequent event is one that has no direct effect on the financial statements but for which disclosure
is advisable. Examples include the following:
< Decline in the market value of securities held for temporary investment or resale
< Issuance of bonds or equity securities
< Decline in the market value of inventory as a consequence of government action barring further sale of a product
< Uninsured loss of inventories as a result of fire
9) In obtaining letters from attorneys, Bill Malano’s aim is to receive the letters as early as possible after the balance
sheet date. This provides him with a signed letter from every attorney in time to properly investigate any exceptions. It
also eliminates the problem of a lot unresolved loose ends near the end of the audit. Evaluate Malano’s approach.
Ñ: Malano’s approach does not take into consideration the need to obtain letters from attorneys as near the end of field
work as possible. If the letters are received near the balance sheet date, the period from the balance sheet to the end of
the auditor’s field work will not be included in the attorneys’ letters. His procedure would not obtain the most current in
formation regarding contingent liabilities, and would not provide adequate information for disclosure of pertinent subse
quent events.
10) What major considerations should the auditor take into account in determining how extensive the review of subse
quent events should be?
Ñ: The major considerations the auditor should take into account in determining how extensive the subsequent events
review should be are:
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< The company’s financial strength and stability of earnings
< The effectiveness of the company’s internal controls
< The number and significance of the adjustments made by the auditor
< The length of time between the balance sheet date and the completion of the audit
< Changes in key personnel
Auditors of public companies should be aware that PCAOB Standard 2 requires them to also inquire about changes in in
ternal control over financial reporting occurring subsequent to the end of the fiscal period that might significantly affect
internal control over financial reporting.
11) Identify five audit procedures normally done as a part of the review for subsequent events
Ñ: Audit procedures normally performed as a part of the review for subsequent events are:
< Cutoff and valuation tests of various balances and related transactions; e.g., sales cutoff tests
< Inquire of management
< Correspond with attorneys
< Review internal statements prepared subsequent to the balance sheet date
< Review records prepared subsequent to the balance sheet date
< Examine minutes of meetings of board of directors and stockholders subsequent to the balance sheet date
< Obtain a letter of representation
12) Distinguish between subsequent events occurring between the balance sheet date and the date of the auditor’s re
port, and subsequent discovery of facts existing at the date of the auditor’s report. Give two examples of each and ex-
plain the appropriate action by the auditor in each instance.
Ñ: Subsequent events occurring between the balance sheet date and the date of the auditor’s report are those transac
tions and events which might affect the financial statements being audited (either adjustment, disclosure, or both). Ex
amples of these types of events would be:
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< Declaration of bankruptcy by a customer with an outstanding accounts receivable balance due because of a deterio
rating financial condition
< Settlement of a litigation for an amount different from the amount recorded on the books
< Disposal of equipment not being used in operations at a price below the current book value
< Sale of investments at a price below recorded cost
< Sale of raw material as scrap in the period subsequent to the balance sheet date
< Decline in the market value of securities held for temporary investment or resale
< Issuance of bonds or equity securities
< Decline in the market value of inventory as a consequence of government action barring further sale of a product
< Uninsured loss of inventories as a result of fire
If these events and transactions have a material effect on the financial statements, they may require adjustment of the
current period financial statements or disclosure. Auditors of public companies should also be alert for subsequent
changes in internal control over financial reporting.
The subsequent discovery of facts existing at the date of the auditor’s report occurs when the auditor becomes aware
that some information included in the financial statements was materially misleading after the audited financial state-
ments have been issued. Some examples of such facts would be:
< Subsequent discovery of the inclusion of fraudulent sales
< Subsequent discovery of the failure to write-off obsolete inventory
< Omission of an essential footnote
In such cases when the auditor discovers the statements to be misleading, he or she should request the client to issue a
revised set of financial statements as soon as possible containing a new audit report and an explanation of the reasons
for the revisions to the financial statements.
13) Miles Lawson, CPA, believes that the final summarization is the easiest part of the audit if careful planning is follow
throughout the audit. He makes sure that each segment of the audit is completed, he is finished with the audit. He be-
lieves this may cause each part of the audit to take a little longer, but he makes up for it by not having to do the final sum
marization. Evaluate Lawson’s approach.
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Ñ: The weakness in Lawson’s approach is the danger of discovering an inadequacy in one audit area which could affect
other areas of the audit. For example, if misstatements were discovered as part of the tests of controls for sales, the ini
tial plans for the tests of details of balances for accounts receivable may have been insufficient and should have been re
vised. Similarly, the audit of fixed assets is related to the contracts and notes payable whenever fixed assets are used as
collateral.
Another difficulty with Lawson’s approach is that there is no combining of the misstatements in different audit areas to
determine if the combined misstatements are material. If the combined misstatements are considered material, it may
be necessary to expand the testing in certain areas or require adjusting entries to some balances.
14) Compare and contrast the accumulation of audit evidence and the evaluation of the adequacy of the disclosures in
the financial statements. Give two examples in which adequate disclosure could depend heavily on the accumulation of
evidence and two others in which audit evidence does not normally significantly affect the adequacy of the disclosure.
Ñ: The accumulation of audit evidence is crucial to the auditor in determining whether the financial statements are stated
in accordance with generally accepted accounting principles, applied on a basis consistent with the preceding year. The
evaluation of the adequacy of the disclosures in financial statements is made to determine that the account balances on
the trial balance are properly aggregated and disclosed on the financial statements.
Examples where adequate disclosure could depend heavily upon the accumulation of evidence are:
< The disclosure of declines in inventory values below cost
< The segregation of current from noncurrent receivables
< The segregation of trade accounts receivable from amounts due from affiliates
< The disclosure of contingent liabilities that the auditor has not been informed of by the client
Examples where audit evidence does not normally significantly affect the adequacy of the disclosure are:
< Deciding whether a disposal of equipment should be recorded as an extraordinary item
< The disclosure of an acquisition as a pooling of interests or a purchase
< The disclosure of contingencies that the auditor was informed of by the client
15) Distinguish between a client letter of representation and a management letter and state the primary purpose of
each. List some items that might be included in each letter.
Ñ: A letter of representation is a written communication from the client to the auditor which formalizes statements that
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the client has made about matters pertinent to the audit. SAS 85 (AU 333) suggests four categories of items that should
be included in the letter. Below are those four items with examples in each category follow (refer students to SAS 85―
333―for a comprehensive list):
1. Financial statements
< Management’s acknowledgment of its responsibility for the fair presentation in the financial statements of financial
position, results of operations, and cash flows in conformity with generally accepted accounting principles
< Management’s belief that the financial statements are fairly presented in conformity with generally accepted ac-
counting principles
1. Completeness of information
< Availability of all financial records and related data
< Completeness and availability of all minutes or meetings of stockholders, directors, and committees of directors
< Absence of unrecorded transactions
1. Recognition, measurement, and disclosure
< Management’s belief that the effects of any uncorrected financial statement misstatements are immaterial to the
nancial statements
< Information concerning fraud involving (1) management, (2) employees who have significant roles in internal con
trol, or (3) others where the fraud could have a material effect on the financial statements
< Information concerning related party transactions and amounts receivable from or payable to related parties
< Unasserted claims or assessments that the entity’s lawyer has advised are probable of assertion and must be dis
closed in accordance with Financial Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies
< Satisfactory title to assets, liens or encumbrances on assets, and assets pledged as collateral
< Compliance with aspects of contractual agreements that may affect the financial statements
1. Subsequent events
< Bankruptcy of a major customer with an outstanding account receivable at the balance sheet date
75 of 79 1/6/2017 10:03 AM
< A merger or acquisition after the balance sheet date
For audits of public companies, PCAOB Standard 2 requires the auditor to obtain specific representations from manage
ment about internal control over financial reporting. Some of those representations are noted below:
5. Internal controls
< Management’s acknowledgement of its responsibility for establishing and maintaining effective internal controls
over financial reporting.
< Management’s conclusion about the effectiveness of internal control over financial reporting as of the end of the
cal period.
< Disclosure to the auditor of all deficiencies in the design or operation of internal control over financial reporting
identified as part of management’s assessment, including separate disclosure of significant deficiencies and material
weaknesses.
< Management’s knowledge of any material fraud or other fraud involving senior management or other employees
who have a significant role in the company’s internal control over financial reporting.
Auditors of public companies may obtain a combined representation letter for both the audit of the financial statements
and the audit of internal control over financial reporting.
A management letter is a letter directed to the client to inform management of certain recommendations about the busi
ness which the CPA believes would be beneficial to the client.
Items that might be included in a management letter are:
< Recommendation to switch inventory valuation methods
< Recommendation to install a formal security system
< Recommendation to prepare more timely bank reconciliations
< Recommendation to segregate duties
< Recommendation to have certain types of transactions authorized by specific individuals
76 of 79 1/6/2017 10:03 AM
16) Explain what is meant by information accompanying basic financial statements. Provide two examples of such infor
mation. What levels of assurance may the CPA offer for this information?
Ñ: Information accompanying basic financial statements is any and all information prepared for management or outside
users included with the basic financial statements. Examples include detailed comparative statements supporting control
totals in the basic statements, supplementary information required by the SEC, statistical data such as ratios and trends,
and specific comments on the changes that have taken place in the financial statements.
The auditor can provide one of two levels of assurance for information accompanying basic financial statements. The au
ditor may issue a positive opinion indicating a high level of assurance, or a disclaimer indicating no assurance.
17) What is meant by reading other financial information in annual reports? Give an example of the type of information
the auditor is examining.
Ñ: SAS 8 (AU 550) requires the auditor to read information in annual reports containing audited financial statements
for consistency with the financial statements and the auditor’s report. Types of information the auditor examines include
statements about financial condition in the president’s letter and displays and summaries of statistical financial informa
tion.
18) Distinguish between regular audit documentation review and independent review and state the purpose of each.
Give two examples of potential findings in each of these two types of review.
Ñ: A regular audit documentation review is the one that is done by someone who is knowledgeable about the client and
the unique circumstances in the audit. The purposes of this review are to:
< Evaluate the performance of inexperienced personnel
< To make sure that the audit meets the CPA firm’s standard of performance
< To counteract the bias that frequently enters into the auditor’s judgment.
Examples of important potential findings in a regular audit documentation review are:
< Incorrect computations
< Inadequate scope
< Lack of proper documentation for audit decisions
An independent review is one done by a completely independent person who has no experience on the engagement. The
purpose is to have a competent professional from within the firm who has not been biased by the ongoing relationship
77 of 79 1/6/2017 10:03 AM
between the regular auditors and the client perform an independent review. Examples of important potential findings in
an independent review are:
< A number of small adjustments waived that should have been accumulated into an adjusting journal entry due to
materiality
< Too narrow and too biased of a scope in an audit area
< Inadequate disclosure of contingencies
19) Describe matters that the auditor must communicate to audit committees of public companies.
24-19 Ñ: In addition to the SAS 61 required audit committee communications, the Sarbanes-Oxley Act expands these
communications requirements by also requiring public company auditors to timely report the following items to the au
dit committee:
< All critical accounting policies and practices to be used.
< All alternative treatments of financial information within generally accepted accounting principles that have been
discussed with management, ramifications of the use of such alternative disclosures and treatments, and the treatment
preferred by the auditor.
< Other material written communications between the auditor and management, such as any management letter or
schedule of unadjusted differences.
As the audit of the public company is completed, the auditor should determine that the audit committee is informed
about the initial selection of and changes in significant accounting policies or their application during the current audit
period. When changes have occurred, the auditor should inform the committee of the reasons for the change. The audi
tor should also communicate information about methods used to account for significant unusual transactions and the
effect of significant accounting policies in controversial or emerging areas.
Disclaimer:
This is not my pure work, I just copy paste from the source that I barely remember. Feel free to put your comment below
if you think you are the author of this material. I am gladly to put link in this post for the original source. Thank you.
78 of 79 1/6/2017 10:03 AM
This entry was posted in Auditing on October 28, 2012 [https://iandb07.wordpress.com/2012/10/28/auditing-questions-

and-answers/] .
2 thoughts on “Auditing Questions andAnswers”
Carla Williams
July 31, 2015 at 10:08 AM
(2) Deficiencies a. Identify key deficiencies for acquisitions and for cash disbursements. After you decide on the deficien
cies, include each significant deficiency or material weakness in the bottom portion of one of the two matrices.
b. Include a “D” in the matrix in each column for the objective(s) to which each significant deficiency or material weakness
applies.
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March 8, 2016 at 7:23 PM
good post
79 of 79 1/6/2017 10:03 AM

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Auditing Questions andAnswers

&: The unqualiﬁed audit report consists of:

tional paragraphs explaining reasons for the qualiﬁcations.

The information in the scope paragraph includes:

1. The auditor followed generally accepted auditing standards.

1. Change in accounting principle

OPINION EXAMPLE SITUATION

Adverse A highly material departure from GAAP.

Conditions that aﬀect the auditor’s determination of materiality include:

< Potential users of the ﬁnancial statements

The Audit Process-Audit Responsibilities and objectives

CHARACTERISTIC AUDIT STEPS

company’s ratios. Investigate any unusual diﬀerences.

< Investigate whether material transactions occur close to year-end.

GENERAL LEDGER ACCOUNT CYCLE

Sales Sales & Collection

Accounts Payable Acquisition & Payment

Retained Earnings Capital Acquisition & Repayment

Accounts Receivable Sales & Collection

Inventory Inventory & Warehousing

Repairs & Maintenance Acquisition & Payment

RECORDING MISSTATEMENT OBJECTIVE VIOLATED

Fixed asset repair is recorded on the wrong date. Timing

Repair is capitalized as a ﬁxed asset instead of an expense. 

J: The four phases of the audit are:

1. Plan and design an audit approach.

The Audit Process-Audit Evidence

1. Which audit procedures to use.

PHRASE MEANING OF PHRASE

inquiries and conﬁrmations

DETERMINING COMPETENCE COMPETENT EVIDENCE

Independence of provider Conﬁrmation of a bank balance

Auditor’s direct knowledge Physical examination of inventory by the auditor

Degree of objectivity Count of cash on hand by auditor

Timeliness Observe inventory on the last day of the ﬁscal year

TYPES OF AUDIT EVI- EXAMPLES

1. Physical examina- < Count petty cash on hand

< Examine ﬁxed asset additions

1. Conﬁrmation < Conﬁrm accounts receivable balances of a sample of client customers

< Conﬁrm client’s cash balance with bank

TYPES OF AUDIT EVIDENCE EXAMPLES

1. Observation < Observe client employees in the process of counting inventory

@: The four characteristics of the deﬁnition of a conﬁrmation are:

< check request form

< receiving report

< payroll time card

< adjusting journal entry

< vendor’s invoice

< cancelled check

< cancelled note

< validated deposit slip

1. Understanding the client’s industry and business

@: The purposes of audit documentation are as follows:

The purposes of audit documentation are as follows:

@: Audit schedules should include the following:

24) Deﬁne what is meant by a tick mark. What is its purpose?

28) Explain the purposes and beneﬁts of audit documentation software.

The Audit Process-Audit Planning and Analytical Procedures

2) Identify the eight major steps in planning audits.

$: Eight major steps in planning audits are:

1. Accept client and perform initial planning

6) Who is considered “the client” when auditing public companies?

Auditing Questions andAnswers

< Potential users of the ﬁnancial statements

< Investigate whether material transactions occur close to year-end.

Repair is capitalized as a ﬁxed asset instead of an expense.

1. Physical examina- < Count petty cash on hand

< Examine ﬁxed asset additions

1. Conﬁrmation < Conﬁrm accounts receivable balances of a sample of client customers

< Conﬁrm client’s cash balance with bank

1. Observation < Observe client employees in the process of counting inventory

< check request form

< receiving report

< payroll time card

< adjusting journal entry

< vendor’s invoice

< cancelled check

< cancelled note

< validated deposit slip

24) Deﬁne what is meant by a tick mark. What is its purpose?

28) Explain the purposes and beneﬁts of audit documentation software.

2) Identify the eight major steps in planning audits.

6) Who is considered “the client” when auditing public companies?

< Compare client and industry data

< Compare client data with similar prior period data

< Compare client data with client-determined expected results

< Compare client data with auditor-determined expected results

3) Explain why materiality is important but diﬃcult to apply in practice.

1. Materiality is a relative rather than an absolute concept.

2. Bases are needed for evaluating materiality.

3. Qualitative factors aﬀect materiality decisions.

8) Assume a company with the following balance sheet accounts:

Cash $500 Overstatement

Fixed assets $3,000 Overstatement

Long-term loans $1,500 Understatement

PDR = AAR

Where PDR = Planned detection risk

AAR = Acceptable audit risk

IR = Inherent risk

CR = Control risk

13) Explain the causes of an increased or decreased planned detection risk.

< Nature of the client’s business

< Results of previous audits

< Initial vs. repeat engagement

< Related parties

< Non-routine transactions

< Judgment required to correctly record transactions and

< Makeup of the population

< Client’s size

< Distribution of ownership

< Nature and amount of liabilities

< Liquidity position

< Proﬁts (losses) in previous years

< Method of ﬁnancing growth

< Nature of the client’s operations

< Competence of management

< Relationship with current or previous auditors

< Frequency of turnover of key ﬁnancial or internal audit personnel

< Relationship with employees and labor unions

8) State the six transaction-related audit objectives.

1. Recorded transactions exist (existence).

2. Existing transactions are recorded (completeness).

3. Recorded transactions are stated at the correct amounts (accuracy).

4. Transactions are properly classiﬁed (classiﬁcation).

5. Transactions are recorded on the correct dates (timing).

< Integrity and ethical values

< Commitment to competence

< Board of directors or audit committee participation

< Management’s philosophy and operating style

< Organizational structure

< Assignment of authority and responsibility

< Human resource policies and practices

< The control environment

< Risk assessment

< Control activities

< Information and communication

< Adequate separation of duties

< Proper authorization of transactions and activities