7-21 (Objectives 7-3, 7-4) : Chapter 7 & 8

Chapter 7 & 8
7-21 (Objectives 7-3, 7-4) The following questions concern persuasiveness of evidence.
Choose the best response.
a. Which of the following types of documentary evidence should the auditor consider
to be the most reliable?
(1) A sales invoice issued by the client and supported by a delivery receipt from an
outside trucker
(2) Confirmation of an account payable balance mailed by and returned directly to
the auditor
(3) A check, issued by the company and bearing the payee’s endorsement, that is
included with the bank statements mailed directly to the auditor
(4) An audit schedule prepared by the client’s controller and reviewed by the client’s treasurer
b. Audit evidence can come in different forms with different degrees of persuasiveness.
Which of the following is the least persuasive type of evidence?
(1) Vendor’s invoice
(2) Bank statement obtained from the client
(3) Computations made by the auditor
(4) Prenumbered sales invoices
c. Which of the following presumptions is correct about the reliability of audit evidence?
(1) Information obtained indirectly from outside sources is the most reliable audit evidence.
(2) To be reliable, audit evidence should be convincing rather than merely persuasive.
(3) Reliability of audit evidence refers to the amount of corroborative evidence obtained.
(4) Effective internal control provides more assurance about the reliability of audit
evidence.
7-22 (Objectives 7-5, 7-6) The following questions concern the use of analytical procedures
during an audit. Select the best response.
a. For all audits of financial statements made in accordance with auditing standards, the
use of analytical procedures is required to some extent
In the Planning Stage As a Substantive Test In the Completion Stage
(1) Yes No Yes
(2) No Yes No
(3) No Yes Yes
(4) Yes No No
b. Which of the following situations has the best chance of being detected when a CPA
compares 2016 revenues and expenses with the prior year and investigates all changes
exceeding a fixed percent?
(1) An increase in property tax rates has not been recognized in the company’s 2016 accrual.
(2) The cashier began lapping accounts receivable in 2016.
(3) Because of worsening economic conditions, the 2016 provision for uncollectible accounts
was inadequate.
(4) The company changed its capitalization policy for small tools in 2016.
c. Which of the following would not be considered to be an analytical procedure?
(1) Estimating payroll expense by multiplying the number of employees by the average
hourly wage rate and the total hours worked.
(2) Projecting the error rate by comparing the results of a statistical sample with the
actual population characteristics.
(3) Computing accounts receivable turnover by dividing credit sales by the average net
receivables.
(4) Developing the expected current year sales based on the sales trend of the prior five years.
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7-24 (Objectives 7-3, 7-5, 7-7) The following questions concern audit evidence and audit
documentation. Choose the best response.
a. According to PCAOB audit standards, audit documentation must be retained for
(1) one year.
(2) three years.
(3) five years.
(4) seven years.
b. Which of the following types of audit evidence is generally the most reliable?
(1) A bank statement
(2) A bank confirmation
(3) Analytical procedures
(4) Inquiries made of the audit committee
c. An auditor most likely would apply analytical procedures in the overall review stage of an
audit to
(1) identify unusual or unexpected balances that were not previously identified.
(2) obtain an understanding of high-risk areas.
(3) evaluate the design and implementation of internal control.
(4) identify related party transactions that may not have been previously identified.
7-26 (Objective 7-4) The following are examples of audit procedures:

1. Calculate the ratio of sales commission expense to sales as a test of sales commissions.
2. Review the accounts receivable with the credit manager to evaluate their collectibility.
3. Compare a duplicate sales invoice with the sales journal for customer name and amount.
4. Obtain a written statement from a bank stating that the client has $15,671 on deposit and
liabilities of $500,000 on a demand note.
5. Add the sales journal entries to determine whether they were correctly totaled.
6. Count a sample of inventory items and record the amount in the audit files.
7. Obtain a letter from the client’s attorney addressed to the CPA firm stating that the attorney
is not aware of any existing lawsuits.
8. Extend the cost of inventory times the quantity on an inventory listing to test whether it is
accurate.
9. Obtain a letter from an insurance company to the CPA firm stating the amount of the fire
insurance coverage on buildings and equipment.
10. Examine an insurance policy stating the amount of the fire insurance coverage on
buildings and equipment.
11. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of
gross margin relative to the preceding year.
12. Obtain information about internal control by requesting the client to fill out a
questionnaire.
13. Trace the total in the cash disbursements journal to the general ledger.
14. Watch employees count inventory to determine whether company procedures are being
followed.
15. Examine a piece of equipment to make sure that a major acquisition was actually received
and is in operation.
16. Examine corporate minutes to determine the authorization of the issue of bonds.
17. Obtain a letter from management stating that there are no unrecorded liabilities.
18. Review the total of repairs and maintenance for each month to determine whether any
month’s total was unusually large.
Classify each of the preceding items according to the eight types of audit evidence:
(1) physical examination, (2) confirmation, (3) inspection,
(4) analytical procedures, (5) inquiries of the client, (6) recalculation,
(7) reperformance, and (8) observation.
Answer
( 1; 4); ( 2; 5); (3: 3); ( 4; 2); ( 5: 6); (6; 1); (7: 2); (8: 6); (9: 2); (10:3); ( 11: 4); (12: 5); (13:
7); (14: 8); (15:1); (16:3); (17:5); (18:4)
7-29 (Objective 7-4) The following audit procedures were performed in the audit of
inventory
to satisfy specific balance-related audit objectives as discussed in Chapter 6. The audit
procedures assume that the auditor has obtained the inventory count sheets that list the
client’s inventory. The general balance-related audit objectives from Chapter 6 are also
included.
Audit Procedures
1. Select a sample of inventory items in the factory warehouse and trace each item to the
inventory count sheets to determine if it has been included and if the quantity and description
are correct.
2. Trace selected quantities from the inventory list to the physical inventory to make sure that
it exists and the quantities are the same.
3. Compare the quantities on hand and unit prices on this year’s inventory count sheets with
those in the preceding year as a test for large differences.
4. Test the extension of unit prices times quantity on the inventory list for a sample of
inventory items, test foot the list, and compare the total to the general ledger.
5. Send letters directly to third parties who hold the client’s inventory, and request that they
respond directly to the auditors.
6. Examine sales invoices and contracts with customers to determine whether any goods are
out on consignment with customers. Similarly, examine vendors’ invoices and contracts with
vendors to determine whether any goods on the inventory listing are owned by vendors.
7. Question operating personnel about the possibility of obsolete or slow-moving inventory.
General Balance-Related Audit Objectives
Existence Cutoff
Completeness Detail tie-in
Accuracy Realizable value
Classification Rights and obligations
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general balance-related audit objective or objectives satisfied by each audit
procedure
Answer
1. Select a sample of inventory items in the factory warehouse and trace each item to the
inventory count sheets to determine if it has been included and if the quantity and description
are correct
a) Physical examination
b) Completeness and accuracy
2. Trace selected quantities from the inventory list to the physical inventory to make sure that
it exists and the quantities are the same.
a) Physical examination
b) Existence and Accuracy
3. Compare the quantities on hand and unit prices on this year’s inventory count sheets with
those in the preceding year as a test for large differences.
a) Analytical procedures
b) Accuracy
4. Test the extension of unit prices times quantity on the inventory list for a sample of
inventory items, test foot the list, and compare the total to the general ledger.
a) Recalculation
b) detail Tie-in
5. Send letters directly to third parties who hold the client’s inventory, and request that they
respond directly to the auditors.
Confirmation
Existence, completeness and accuracy
7-32 (Objectives 7-4, 7-5) Analytical procedures consist of evaluations of financial

information made by a study of plausible relationships among both financial and nonfinancial
data. They range from simple comparisons to the use of complex models involving many
relationships and elements of data. They involve comparisons of recorded amounts, or ratios
developed from recorded amounts, to expectations developed by the auditors.
a. Describe the broad purposes of analytical procedures.
b. When are analytical procedures required during an audit? Explain why auditors use
analytical procedures extensively in all parts of the audit.
c. Describe the factors that influence the extent to which an auditor will use the results
of analytical procedures to reduce detailed tests in meeting audit objectives.*
Answer:
a) The board purpose of analytical procedures is to assist auditor determining the scope,
timing and nature of the audit.
b) Analytical procedure is fundamental in the audit process. It allows the auditor to evaluate
the financial information based on available data, which might be financial and non-financial.
c) Independence of the evidences (where they come from), effectiveness of internal control,
and auditor’s knowledge of the matter being audited .
8-25 (Objectives 8-1, 8-3, 8-4) The following questions concern the planning of the
engagement. Select the best response.
a. Which of the following will most likely indicate the existence of related parties?
(1) Writing down obsolete inventory prior to year end
(2) Failing to correct deficiencies in the client’s internal control
(3) An unexplained increase in gross margin
(4) Borrowing money at a rate significantly below the market rate
b. Which of the following is least likely to be included in the auditor’s engagement letter?
(1) Details about the preliminary audit strategy
(2) Overview of the objectives of the engagement
(3) Statement that management is responsible for the financial statements
(4) Description of the level of assurance obtained when conducting the audit
c. Analytical procedures used in planning an audit should focus on identifying
(1) material weaknesses in internal control.
(2) the predictability of financial data from individual transactions.
(3) the various assertions that are embodied in the financial statements.
(4) areas that may represent specific risks relevant to the audit.
8-26 (Objective 8-2) The following questions pertain to client acceptance. Choose the best
response.
a. When approached to perform an audit for the first time, the CPA should make inquiries
of the predecessor auditor. This is a necessary procedure because the predecessor
may be able to provide the successor with information that will assist the successor in
determining whether
(1) the predecessor’s work should be used.
(2) the company follows the policy of rotating its auditors.
(3) in the predecessor’s opinion, internal control of the company has been satisfactory.
(4) the engagement should be accepted.
b. A successor would most likely make specific inquiries of the predecessor auditor regarding
(1) specialized accounting principles of the client’s industry.
(2) the competency of the client’s internal audit staff.
(3) the uncertainty inherent in applying sampling procedures.
(4) disagreements with management as to auditing procedures.
c. Which of the following circumstances would most likely pose the greatest risk in accepting
a new audit engagement?
(1) Staff will need to be rescheduled to cover this new client.
(2) There will be a client-imposed scope limitation.
(3) The firm will have to hire a specialist in one audit area.
(4) The client’s financial reporting system has been in place for 10 years.
(3) The firm will have to hire a specialist in one audit area.
(4) The client’s financial reporting system has been in place for 10 years.
8-28 (Objectives 8-1, 8-2, 8-6) The following questions deal with client acceptance, audit
planning, and materiality. Choose the best response.
a. Which of the following procedures would a CPA least likely perform during the planning
stage of the audit?
(1) Determine the timing of testing
(2) Take a tour of the client’s facilities
(3) Perform inquiries of outside legal counsel regarding pending litigation
(4) Determine the effect of information technology on the audit
b. A successor auditor’s inquiries of the predecessor auditor should include questions
regarding
(1) the number of engagement personnel the predecessor assigned to the engagement.
(2) the assessment of the objectivity of the client’s internal audit function.
(3) communications to management and those charged with governance regarding
significant deficiencies in internal control.
(4) the response rate for confirmations of accounts receivable.
c. In which of the following circumstances would an auditor of an issuer be least likely to
reevaluate established materiality levels?
(1) The materiality level was established based on preliminary financial statement
amounts that differ significantly from actual amounts.
(2) The client disposed of a major portion of the client’s business.
(3) The client released third-quarter results before the SEC-prescribed deadline.
(4) Significant new contractual arrangements draw attention to a particular aspect of a
client’s business that is separately disclosed in the financial statements.
8-30 (Objective 8-3) In your audit of Canyon Outdoor Provision Company’s financial
statements,
the following transactions came to your attention:
1. Canyon Outdoor’s operating lease for its main store is with York Properties, which
is a real estate investment firm owned by Travis Smedes. Mr. Smedes is a member of
Canyon Outdoor’s board of directors.
2. One of Canyon Outdoor’s main suppliers for kayaks is Hessel Boating Company. Canyon
Outdoor has purchased kayaks and canoes from Hessel for the last 25 years under
a long-term contract arrangement.
3. Short-term financing lines of credit are provided by Cameron Bank and Trust.
Suzanne Strayhorn is the lending officer assigned to the Canyon Outdoor account.
Suzanne is the wife of the largest investor of Canyon Outdoor.
4. Hillsborough Travel partners with Canyon Outdoor to provide hiking and rafting
adventure vacations. The owner of Hillsborough Travel lives in the same neighborhood
as the CEO of Canyon Outdoor. They are acquaintances, but not close
friends.
5. The board of directors consists of several individuals who own stock in Canyon Outdoor.
At a recent board meeting, the board approved its annual dividend payable to
shareholders effective June 1.
a. Define what constitutes a “related party.”
b. Which of the preceding transactions would most likely be considered a related party
transaction?
c. What financial statement implications, if any, would each of the above transactions
have for Canyon Outdoor?
d. What procedures might auditors consider to help them identify potential related
party transactions for clients like Canyon Outdoor?
Answer:
a) A related party transaction occurs when only one party can impose the terms of a contract.
This party can influence the operations and management of the other party.
b) 1 and 3.
c)
Nature of the relationship(s)
Description of the transaction
The volume of the transaction (amount)
Those information and others should be disclosed whenever related party transaction are
material.
8-32 (Objective 8-4) Your comparison of the gross margin percent for Jones Drugs for the
years 2013 through 2016 indicates a significant decline. This is shown by the following
information:
A discussion with Marilyn Adams, the controller, brings to light two possible explanations.
She informs you that the industry gross profit percent in the retail drug industry declined
fairly steadily for three years, which accounts for part of the decline. A second factor was the
declining percent of the total volume resulting from the pharmacy part of the business. The
pharmacy sales represent the most profitable portion of the business, yet the competition from
discount drugstores prevents it from expanding as fast as the nondrug items such as
magazines, candy, and many other items sold. Adams feels strongly that these two factors are
the cause of the decline. The following additional information is obtained from independent
sources and the client’s records as a means of investigating the controller’s explanations:
a. Evaluate the explanation provided by Adams. Show calculations to support your
conclusions.
b. Which specific aspects of the client’s financial statements require intensive
investigation in this audit?
a) Before we evaluate the explanation provided by Adams, let do some computation first.
Gross margin% for 2016 (drug sales) =( Sales-Cost of goods sold)/sales= (5,126-
3,045)/5,126= 40.60%
Gross Margin ( drug sale 2016)= $ 2,081; gross margin% 2016: 40.60%
For non-drug sale (2016); Gross margin (2016)= $ 2,907; Gross margin%= 32%
The same formula is used for the other years.
Year Gross Margin% (Drug) Gross Margin% (Non drug)
2016 40.60% 32%
2015 42.20% 32%
2014 42.10% 31.90%
2013 42.30% 31.80%
From 2013 to 2016, the gross margin% for drug has significantly lowered, which confirmed
the explanation given by the controller.
b) Gross margin for drugs related product deserve investigation. Several factors may explain
this decline, such as an underestimate of drug inventory, fraud, stealing of inventory, and
underestimate of sale.
8-37 (Objective 8-7) Ling, an audit manager, is planning the audit of Modern Technologies,
Inc. (MT, Inc.), a manufacturer of electronic components. This is the first year that Ling’s
audit firm has performed the audit for MT, Inc. Ling set the preliminary judgment about
materiality for the financial statements as a whole at $66,000 and is now in the process
of setting performance materiality for asset accounts. Asset balances for the current year
(unaudited) and prior year (audited) are listed below, as well as Ling’s initial determination
of performance materiality for each account. Based on preliminary discussions with
management, a tour of the production facility, and background reading about the electronic
components industry, Ling determines that MT, Inc., has strong credit policies, and
most customers pay their full balance on time. Competition in the electronic components
industry is high and inventory can become obsolete quickly due to rapid technology
changes (inventory turnover is a measure that analysts focus on when assessing performance
for electronic component manufacturers). Production equipment is relatively
specialized and additional investment is required when new electronic components are
introduced.
a. What factors should Ling consider in setting performance materiality for the asset
accounts?
b. Explain why Ling set performance materiality for cash at the lowest amount.
c. Explain why Ling set performance materiality for inventory at a lower amount as
compared to accounts receivable, PP&E, and other assets.
d. Explain why Ling set performance materiality for accounts receivable at the highest
amount.
e. Does setting materiality at a lower level result in collecting more or less audit evidence
(as compared to setting materiality at a higher level)?
Answer;
a) Several factors should be considered:
The level of misstatement of certain assets
Under and overstatement
Cost of auditing with respect to materiality
b) There are several reasons why Ling set performance materiality for cast at the lowest
amount. Its easier to audit cash at a lower cost. The level of misstatement is very low
compare to other assets.
c) In this industry, inventory become obsolete very quickly. Inventory is the most important
asset the company have. The level of misstatement is very low.
d) There is a strong credit policy at Modern technology. Most customers pay their full
balance on time, lowering the possibility of material misstatement.
e) There is a reverse relationship between the amount of evidence and the performance
materiality. Its easier to set materiality at a lower level, which will result in collecting more
audit evidence.
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7-21 (Objectives 7-3, 7-4) : Chapter 7 & 8

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Chapter 7 & 8

7-26 (Objective 7-4) The following are examples of audit procedures:

7-32 (Objectives 7-4, 7-5) Analytical procedures consist of evaluations of financial

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