Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS ___ Page [34 REVIEW QUESTIONS L, Given that an audit in accordance with generally accepted auditing standards is influenced by the possibility of material errors and fraud, the auditor should conduct the audit with an attitude of a, professional responsiveness. b. conservative advocacy. ¢. objective judgment. > professional skepticism. With respect to errors and fraud, which of the following should be a part of an auditor’s planning in an audit engagement? a. Planning to search for errors or fraud that would have a material or immaterial effect on the financial statements b. Planning to discover errors or fraud that are either material or immaterial c. Planning to discover errors or fraud that are material Planning to consider factors affecting the risk of material misstatements both at the financial statement and the account balance level , The risk that the auditor may unknowingly fail to appropriately modify the unqualified opinion on financial statements that are materially misstated is referred to as audit risk. b, detection risk. c. information risk. d. business risk, The risk that financial statements are likely to be misstated materially without regard to the effectiveness of internal control is which type of risk? Inherent risk b. Audit riskPLANNING AND : AUDIT F MISSTATEMENTS 1 Chapter 1: AT ONO a Re CONSIDE i 5, The type of transacti : they involve managemen 4) estimation transactions. nonroutine transactions. routine transactions. — related-party transactions. ‘ons that ordinarily have a high inherent risk tng judgment or assumptions are referred tg a u ae op 6. Inherent risk is defined as the susceptibility of an account balance Or dy of transactions to error that could be material assuming that there were related internal controls. Of the following conditions, which one does ny increase inherent risk? . a. The client has entered into numerous related party (ansactions dugg the year under audit. € ; o@ Internal control over shipping, billing, and recording of sales revenueis weak. ¢, The client has lost a major customer accounting for approximately 30% of annual revenue. d. The board of directors approved a substantial bonus for the presidex and chief executive officer, and also approved an attractive stock optia plan for themselves. 7. Which of the following descriptions best describes inherent risk? a, Auditors fail to discover a material misstatement in the course of the audit and do not modify their audit opinion. 24%}. jLuLk b. A company's internal control fails to identify a material misstatemet! onatimely fashion. tented wh, £. Auditing procedures fail to find a material misstatement. 4 The possibility that a material misstatement will occur in any giv account before considering internal control. \ 8. The risk that a material misstatement in an assertion will not be preven detected on a timely basis by internal control is as detection risk, c. inherent risk d. audit riskChapter 1: AUDIT PLANNING CONSIDER PATEME ATIONOF MISSTATEMENTS Page [36 9. The risk that the aud he it will fail to uncover a material, misstatement is eliminate dl Lantt he Uviningtid a. ifa client has strong internal controls. X. | b. ifaclient follows generally accepted accounting principles (GAAP), ¥ c. when the auditor has complied with the generally accepted auditing standards (GAAS), @© under no circumstances. Audit tisk components consist of inherent, control and detection risks. Which of them is (are) the dependent variable(s)? a. Inherent risk b, Control risk @ Detection risk d. Inherent and control risks The probability that an auditor's procedures leading to the conclusion that a material erroydoes not exist in an account balance when, in fact, such error does exist is referred to as a. prevention risk. b. inherent risk. ¢. control risk. detection risk. Which of the following is the best definition of detection risk? a, The auditor will compute audit materiality incorrectly. BH) The auditor will fail to detect material misstatements that exist. ¢. The auditor will apply more audit procedures than are required in the circumstances. d. The auditor will modify the audit opinion on financial statements that are materially Which of the follo a. Detection risk — oO Business —Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS 14. 1. Papen Which of the following types of risk is ire alfected by the ay amount and timing of substantive auditing procedures? a. Inherent risk b. Control risk Detection risk d. Sufficiency risk The understanding between the client Tesponsibilities to be assumed by each i a. representation letter, @ engagement letter. c, d. and the auditor as to the degree oy is normally set forth in a(an) management letter. comfort letter, After an auditor had been engaged to perform the first audit for a nonpublic entity, the client Tequested to change the engageme: of the following situations would there be a reaso1 to comply with the client’s Tequest? The client’s bank Tequired an audit before committing to a loan, but the client subsequently acquired alternative financing. b. The auditor is Prohibited by the client from Corresponding with the client’s legal counsel, Na 7 c, ‘agement refuses to sign the client representation letter. a. The audi it is substantially complete and the auditor determined that an unqualified opinion is warrant ed but there is a disagrcement conceming the audit fee, Which of the following statements is Correct with respect to obtaining at understanding with a client? a. Auditors ate ot required to obtain an understanding with their clients. b. Auditors must obtain an understanding only if an audit is to be 4 conducted, ® Auditors must document their i understanding of the Auditors must obtain an enga; engagement. gcment letter,Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Page [38 18. An engagement letter is best described as: a. A letter from company management to the auditors specifying management's expectations for completion of the audit on a timely basis and the fees. b. A letter from the auditors to company management specifying that management is responsible for the financial statements and the auditors will issue an opinion on the financial statements. eS A letter from the auditors to company management that specifies the responsibilities of both the company and the auditors in completing the audit and the timing for its completion. d. A letter from the Board of Directors’ audit committee to the auditor that indicates that the auditor has been engaged to perform the audit and the fees to be paid. 19, The primary reason why an engagement letter is submitted by audit firms prior to starting the work is that it (a) clarifies the responsibilities of the management and those of the audit firm. b. defines the firm’s policies and procedures regarding new clients. ¢. provides an insurance policy for both the firm and its client. d. communicates the type of opinion that will be rendered on the engagement 20. Which of the following best describes the purpose of an engagement letter? a. The engagement letter relieves the auditor of some responsibility for the exercise of due care. i (G) By clearly defining the nature of the engagement, the engagement letter helps avoid and resolve misunderstandings between the CPA and the client regarding the precise nature of the work to be performed and the type of report to be issued. * The engagement letter conveys to the management the detailed steps to be applied in the audit process. ent letter should be signed by both the client and the CPA ly for independent audits.G AND AUDIT PLANNING AND aa A Chapter 1: TONOF MISSTATE CONSIDERAT 3 Which of the following is not included in an audit engagement letter? jecti g t/ a._ Objectives of the engagement : i @) Representations that the financial statements Prepared accordance with PFRS c. Management's responsibilities / d. "A clear explanation of the services to be performed on the engagemey 21. 22, Which of the following statements would Ieast likely appear in an auditor’ engagement letter? a a. The fees for our services are based on our regular per diem rates, plus travel and other out-of-pocket expenses. / b. During the course of our audit, we may observe opportunities for economy in, or improved controls over, your operations. ¢. Our engagement is subject to the risk that material errors, fraud, and defalcations, if they exist, will not be detected," After performing our preliminary analytical Procedures, we will discuss with you the other procedures we consider nec engagement, ‘essary to complete the 23. Which of the following is not done duri i ' cof planning? “ing the client sclection and retention Obtain an understanding of internal Controls @ Obtain and review financial information ©. Consider the need for special skills 4. Ensure that the firm has suffi f icient engagement on a timely manner Tesource. ‘ S tO complete the 24. Professional skepticism (a,) neither assumes that the m ‘anagement ig qi, ~~ honesty, is dishonesy hor of b aSsumes that management is iter gi, “nduestioned honesty. Nest op of ©. either assumes that management is honest or 4: Unquestioned . None of the given choices is a correct Staten ishones. ‘ntChapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS 240 Page |40 25. Which of the following is not required by PSA No. 6. "Consideration of Fraud in a Financial Statement Audit"? a. Conduct a continuing assessment of the risks of material misstatement due to fraud throughout the audit. b. Conduct a discussion by the audit team of the risks of material _ misstatement due to fraud. ¢) Conduct the audit with professional skepticism, which includes an attitude that assumes balances are incorrect until verified by the auditor. d. Conduct inquiries of the audit committee as to their views about the risks of fraud and their knowledge of any fraud or suspected fraud. 26. The primary difference between financial statement errors and fraud is that a. errors are intentional misstatements by management, while fraud involves unintentional mistakes or omissions. O. errors are unintentional mistakes or omissions, while fraud involves intentional misstatements. c. there is no difference as errors and fraud have the same meaning. d. errors are more likely to provide an indication that an illegal act may have occurred. incentive systems based on operating income. improved control systems. c. substantial increases in sales. d. frequent changes in suppliers. 27. The risk of fraudulent financial reporting increases in the presence of @ b, 28. Which of the following is least likely included in an auditor's inquiry of management while obtaining information to identify the risks of material location? i b. Does it have knowled; ' misstatement due to fraud? ( Are financial | seporting ‘operations controlled by and limited to one * f fraud or suspect fraud? mitigate fraud risks? mmittee the nature of the company's NI | Asset | Liab after NI Asset | Liab. te z closing clos B Cc D E LF | fe | [ H Ta 1 Fa [4 aChapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Page |52 /CASE 2 - PROPOSED ADJUSTING ENTRIES San Juan Corporation, a manufacturer of high-quality computers is under your audit for the first time, relative procedures were performed by the auditor and revealed the following transactions that affect the books and balances of San Juan at the end of business year 2020 before any adjustments and closing entries are prepared. a. A three-year insurance policy to cover future casualty was purchased last year when the business was opened for P120,000. The amount was debited to insurance expense when paid. b. On December 31, 2020, a count was made on the company’s warehouse of its inventory and revealed that an item of high-speed computer was counted twice, the inventory cost is P11. 10,000, The company uses perpetual inventory system. c. Upon inspection of the book, a commission for P185,000 was recorded as expense in 2020, further investigation reveals that commission is paid in September 14, 2020 when the full amount of credit sales made in 2019 was collected from the customer. d. Your inquiry indicates that in previous year, San Juan provides 1% of credit sales as uncollectible. At the beginning of 2020, the management revised its estimate of uncollectible accounts by decreasing to’0.75%. Sales on account for 2019 and 2020 were P7,400,000 and 8,000,000, respectively. e. San Juan purchased an anti-static computer tools at the beginning of 2018 with estimated useful life of 10 years and depreciated using straight line method. Salvage value of machine is deemed immaterial. The cost of P500,000 was charge to repairs expense when bought and no adjustment is made for thisT PLANNING AND > ter 1: AUDIT PLANNI Cee CONSIDERATIONOF MISSTATEME Pay ce. debit to retained carnings of P80,000, d. credit to insurance expense of P40,000, ¢, eredit to prepaid insurance of P80,000. 2. The proposed adjusting journal entry in item B should include a: a. credit to purchases of P1 10,000. b. debit to inventory of P110,000. c. debit to retained carnings of P1 10,000. d. no proposed adjusting journal entry. 3. The proposed adjusting journal entry in item C should include a: a. credit to retained earnings of P185,000. b. debit to commissions expense of P185,000, “xc. debit to retained carnings of P185,000. d. no proposed adjusting journal entry The proposed adjusting journal entry in item D should include a; 2 a. debit to retained earnings of P60,000. * ZH db. credit to allowance for doubtful accounts of P60,000, é c. debit to doubtful account expense of P60,000. d. no proposed adjusting journal entry 5. The proposed adjusting journal entry in item E should include a: a. debit to retained carnings of P200,000, credit to accumulated depreciation of P150,000. ©. debit to depreciation expense of P100,000. ¥ 4. no proposed adjusting journal entry : «ned atti 6. After adjustment in items A to E, the restated amount of retained o™ the end of 2020 shall: a. increase by 295,000. increase by 490,000, increase by P600,000, decrease by 650,000. increase by P710,000, a epea a (dam) Chapter 1: AUDIT PLANNING Axi A) . CONSIDERATIONOF MISSTATEMENTS Page |54 CASE 3 - EFFECTS OF ERROR ON NET INCOME The Statement of Comprehensive Income of ‘Mandaluyong Company for the years ended December 2018, 2019, and 2020 indicate the following net income: 2018 — P320,000 2019 — P402,000 2020 — P367,000 An examination of the accounting records for these years indicates that several errors were made in arriving at the net income amounts reported. The following errors were discovered: a, Sale of merchandise on account amounting to P 100,000 was not recorded at the end of 2020. pL6S 1 fener b. Goods costing P24,000 were in transit from a supplier on December 31, 2018. The goods were appropriately included in the ending inventory but the corresponding purchase was not recorded until it is received the following year. c. Accrued salaries were consistently omitted from the records. The amounts omitted were: 2018- P35,000 . 2019 — P47,000 2020- 29,000 d. The merchandise inventory at December 31, 2019 was overstated by P40,000 as the result of errors made in the footings and éxtensions on the inventory sheets. e. Unexpired insurance of P22,000 applicable to 2019 was expensed in 2018. f. Interest receivable of P12,500 was not recorded on December 31, 2020. ey 15%, g. On January 2, 2018, a piece of equipment costing P250,000was sold for P120,00Q4At the date of sale, the equipment had an accumulated depreciation of 100,000. The cash received was recorded as income in 2018, In addition, depreciation was recorded for this equipment in 2018 at the rate of 10% of v8 974 on (22603) — wai 2 cost.4 Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Pay Compute the following as a result of your audit: 1. How much is the adjusted net income in 2018? a. P218,000 b. P184,000 —c. P164,000 EPisem 2. How much is the adjusted net income in 2019? a. P321,000 5 P352,000 c. P388,000 d P4024 3. How much is the adjusted net income in 2020? a. P457,600 b. P487,500 CG od. P582 549 g ss CASE 4 You discovered the follo trors in connection with your examinat financial statement of any Corporation: ination 12 Jon] 204 A. Patek ei Peep of merchandise on account on December 28, 2019 amouniy was not recorded until it was paid in January 5, 2 AP PovoiMerchandlse was i i enn properly included in the ending i vapor) 2014 CoS Rrduntectig °° SONS inventory in 201s, GR Worn > Sale of merchandise on account on December 31,2019 amounting io Pl? Co Wan was not recorded until it was collected in January 15, 2020, The merchasi was not included in its 2019 ending inventory. Cye¢ x fa dpe \2)>!}70 —c. On December 31,2020, footings and extensions on their inventory balst (oer go,va WAS overstated by P40,000. Iv, 4G 0h . 44nc following Were extracted from the financial statement of; i, Corporation: 4 Net income 400,000 320,000 Working capital 360,000 520,000 nal Fas of year 400,000 720,000 Me eteme dO) BARE. 2 Sy A fav 19 cs) 6 leo 1 Ct ae (4) - 4Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Page |56 Based on the result of your analytical procedure and your audit, determine the following: 1, Net income in 2019? @ P440,000 b. P400,000 cc. P280,000 d.P240,000 e. no answer BR Working capital, end-of 2019? a. P480,000 Q) P400,000 —_c. P360,000 d. P240,000 . no answer 3. Retained carnings, end of 2019? - y a. P240,000 b. P280,000 cc. P440,000 .\P440,000 e. no answer 4. Net income in 2020? a. P400,000 b. P280,000 @P240, 000 d.P440,000 e. no answer 5. Working capital, end of 2020? a. P640,000 b. P520,000 (3. P480,000 d.P360,000 ¢. no answer 6. Retained earnings, end of 2020? a. P840,000 P680,000 —c. P720,000 d. P560,000 e. no answer CASE 5 You are auditing the financial statement of Pasig Company for the first time. You have discovered that the merchandise inventory at the end of each year was understated by P50,000 and P100,000 in 2019 and 2020, respectively. In addition, in inspecting the record of the company, you discovered that some items had been improperly recorded and that certain year-end adjustments had been overlooked in 2019 and 2020. These omission and other errors for each year ‘were summarized as follows: 12/31/2020 12/31/2019 Accrued Salaries 436,800. a 106,500 129,600, 153,900, 192,000,! i i { Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Advances from Customers (Collections from customers had been recorded as sales but should have been recognized as advances from customers because goods were not shipped until the following year) 280,500 Machinery (Capital expenditures had been reeerds as repairs but should have been & oe charged to Machinery; the depreciation rate is 10% per year, but depreciation in the year of expenditure is to be recognized at 5%.) 261,000 My ay Based on the above data and the r a. increased by P15,000 b. decreased by P22,000 2. What is the total effect of the errors on the 2020 net income? c. decreased by P132,500 d. increased by P242,550 increased by P210,050 decreased by P205,550 esult of your audit, provide the follovi 1. What is the total effect of the errors on the 2019 net income? decreased by P32,500 increased by P11,500 3. What is the total effect of the errors on the balance of the company'st earnings at December 31, 20207 a. increased by P15,000 b. decreased by P22,000 c. decreased by P32,500 d. increased by P11,500 » ‘1 ital at 4. What is the total effect of the errors on the company’s working capit! December 31, 2020? a, decreased by P150,550 b. decreased by P202,000 c. decreased by P20. @ decreased by P30AF: Macinrn} Gay ~ : Hye ~ a : Be icet IN A Benes Chapter 1: AUDIT PLANNIN on ain epee AEN M5 Page [58 5. TI necessary adjusting journal entry for the error in recording capital expenditures on Machinery as of December 31, 2020 would include a: a debit to machinery of P543,000 Cost b. acredit to retained earnings of P323,250 ¢. a debit to depreciation expense of P13,050 d. accredit to accumulated depreciation of P41,250 ASE 6 Yong a CPA was engaged by Makati Inc. in 2020 to examine its books and records and to proposed any corrections if necessary. During the audit process, Yong noted the following on her working paper: a) Makati Inc. had failed to record sales commissions payable of P10,800 and P3,300 at the end of 2019 and 2020, respectively. bd) Makati Inc, also failed to recognize supplies on hand of P2,550 and P5,160 at the end of 2019 and 2020, respectively. c) Improvements in machinery and equipment of P32,400 had been debited to expense account at the end of April 2017. Improvements made are estimated to have 12-year life, The company’s policy is to compute depreciation to the nearest month using straight line method, d A physical count of inventory was made at the end of 2018 and 2019, by the audit procedures performed the following were noted: Date Per book Per audit (count) 12/31/2018 P725,900 P735,500 12/31/2019 623,450 637,700 ¢) Merchandise inventories at the end of 2019 and 2020 did not include merchandise that was in transit from Trust Co, and to which the company had title, This shipment of P6,300 and P8,700 were recorded as purchases in January 2020 and 2021, respectively,1: AUDIT PLANNING AND Chan DERATIONOF MISSTATEMENTS coNSsID f) Dividends have been declared on December 20 in 2 been entered in the books until payment was made, The retained earnings account the audit. Date 2018 Jan 1 Dec 31 2019 Jan 10 Mar 6 Dec 31 2020 Jan 10 Dec 31 RETAINED EARNINGS Items Debit Balance P- Net income = Dividends paid 46,500 Issued shares - excess of par - Net income - Dividends paid 46,500 Net loss 17,200 Based on the foregoing answer the following: 1. The 2018 corrected net income is: a, P90,900 b. P71,700 c. P121,500 2. The 2019 adjusted net income is: @ 55,700 b. P59,700 c. P66,000 3. The 2020 adjusted net loss is: a, P12,740 ()P24,040 —o, 32,340 Pay 018 and 2019 bu, appeared as shown below on the date Yong Credit Bat P— — Pigsy 120,000 3159 - 268 63,000 331,50 62,000 3935 - sii - x80 pi2690 d. P54,300 d. P46,040 4, The adjusted balance of retained carnings as of December 31, Guns 0 a. P99,060 @)P291,160 — c. P136,060 d, P142,)MH meme win mR Win ert piezo Und. fw In @w) lee (nr cea 40) 9) fyweation — Qa Bm as ewan (ae) (25) So 4% a Chapter 1: AUDIT PLANNING AND CONSIDERATIONOF MISSTATEMENTS Page |60 aban f = (¥ IGo AASET rp) 1 as pp Taguig Company's December=3+—year-end—finmeiat=sttemen-comasred The — following errors: oe December 31,2019 December 31,2020 Ending inventory P100,000 understated » P90,000 overstated Depreciation expense 20,000 understated , An insurance premium of P75,000 was prepaid in 2019 covering the years 2019, 2020, and 2021. The same was charged to expense in full in 2019. In addition, on December 31, 2020, a fully depreciated machinery was sold for P160,000,cash, but the sale was not recorded until 2021. No correftions have been made Say of the errors. Ignore income tax considerations. CAR 160,600 / Gain Nsale {om Based on the above and the result of your audit, answer the following: : 1. What is the total effect of the errors on the 2019 net income? G. Understated by P130,000 c. Overstated by P70,000 b. Understated by P155,000 d. No effect 2. Whatis the total effect of the errors on the 2020 net income? @ Overstated by P55,000 ¢. Overstated by P215,000 b. Overstated by P30,000 d. Understated by P45,000 3. What is the total effect of the errors on the company’s working capital at December 31, 20197 a. Understated by P95,000 c. Overstated by P90,000 b. Understated by P70,000 @ Understated by P150,000 4. What is the total effect of the errors on the balance of the company’s retained carnings at December 31, 20197 a. Understated by P75,000 ¢. Overstated by P110,000 b. Understated by P50,000 @ Understated by P130,000: T PLANNING AND Chapter 1: AUDIT P a CONSIDERATIONOF MISSTATEMENTS r, 5. What is the total effect of the errors on the company’s Workin, December 31,2020? Bee. a. Overstated by P65,000 c. Understated by P160q Q Understated by P9S,000 d. No effect 4 CASE 8 You have been asked by a client to review the records of Pateros Com, : manufacturer of precision tools and machines. Your client is interesteq a the business, and arrangements have been made for YOU to review the aenng records. 4 Your audit procedures disclosed the following exceptions in which yw communicated with management and will provide adjustments; Note 1: Pateros commenced business on April 1, 2018, and has been reporting on2é year ending March 31. The company has never been audited, but the az statements prepared by the bookkeeper reflect the following income beforeds and before deducting income taxes: Year Ended Income March 31 Before Taxes 2018 P 143,200 / 2019 222,800 » 2020 207,160 , Note 2; ow Arelatively small number of machines have been shipped on con Me transactions have been recorded as ordinary sales and billed as su or 31 of cach year, machines billed and in the hands of consignees amo P 13,000 / us i Noe 2020 118! 1 the co Sales price was determined by adding 30% to cost. Assum' machines are sold the fol lowing year, = = PRUE: a}nilvore Ritainid Gonminin 2,590 » tenonting ausLANNING AND : AUDIT P MISSTATEMENTS P a Chapter 1 y RATIONOF CONSIDE ; Note 6: : Commissions on sales have been entered when paid. Commissions p,.. March 31 of cach year were: me 2018 P 2,800 2019 1,600 2020 2,240 Determine the following: 1. Correct income before income tax for the year ended March 31, 2018? a. P112,621 b. P118,942 6) P126,418 d. P132,673 2. Correct income before income tax for the year ended March 31, 2019? 229,841 b. 231,621 c. P233,942 d. P241,744 3, Correct income before income tax for the year ended March 31, 2020? a, P140,680 b. P150,790 c. P170,880 @ 180,390 4. The proposed adjusting entry (entries) for the 2020 audit assuming dete? were closed, will include a: on. Ct ck) a. net debit to retained earnings of P12,644 2,690 net debit to retained carnings of P36,511 4, ot ©. net credit to retained earnings of P22,127 = d. net credit to retained carnings of P27,842 & Lee £ ay