Chapter 8 Final

Chapter 8 Multiple-Choice Questions 1. easy a

Which of the following is not one of the three main reasons why the auditor should properly  plan engagements? engagements? a. To enable proper on-the-job training of employees.  b. To enable the auditor auditor to obtain sufficient appropriate appropriate evidence. c. To avoid avoid misund misunders erstan tandin dings gs with with the client client.. d. To help help kee keep p audi auditt cost costss rea reaso sona nabl ble. e.

2. easy a

Avoiding misunderstandings with the client is important for:

a.  b. c. d. 3. easy

Good client relations Yes  No Yes  No

Facilitating high-quality work at a reasonable cost Yes  No  No Yes

A measur measuree of how willing willing the audito auditorr is to accep acceptt that that the financi financial al state statemen ments ts may be materially misstated after the audit is completed and an unqualified opinion has been issued is the: a. inherent risk.  b. acceptable audit risk. c. statistical ri risk. d. financial ri risk.

 b

4. easy d

A measure of the auditor’s assessment of the likelihood that there are material misstatements misstatements in an account before considering the effectiveness of the client’s internal control is called: a. control risk.  b. acceptable audit risk. c. statistical ri risk. d. inherent risk.

5. Easy

When inherent risk is high, there will need to be: d a.  b. c. d.

6. easy a

More evidence accumulated by the auditor   Yes  No  No Yes

The auditor is likely to to accumulate mo more ev evidence wh when the audit is for a company:

a.  b. c. d. 7. easy d

A lower assessment of audit risk Yes  No Yes  No

Which has large amounts of debt Yes  No Yes  No

Which is to be sold in the near future Yes  No  No Yes

Which of the following is not typically included in initial audit planning? a. Client acceptance/continuation decisions. b. Determination of the purpose of the audit. c. Obta Obtain in an an unde unders rsta tand ndin ing g with with the the cli clien ent. t.

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d.

Perfor Perform m analy analytic tical al proce procedur dures es as subs substan tantiv tivee tests tests..

8. easy  b

Initial au audit planning in involves fo four matters. Wh Which of th the fo following is not one of th these? a. Develop an overall audit strategy. b. Request that bank bank balances be confirmed. confirmed. c. Schedu Schedule le enga engage gemen mentt staff staff and audit audit specia specialis lists. ts. d. Identi Identify fy the client client’s ’s reason reason for the audit. audit.

9. easy  b

Most auditors assess inherent risk as high for related parties and related-party transactions  because: a. of the unique classification classification of related-party related-party transactions transactions required required on the balance sheet. sheet.  b. of the lack of independence independence between between the parties. c. of the unique unique classifi classificati cation on of relate related-par d-party ty transact transactions ions require required d on the income income statemen statement. t. d. it is requ require ired d by genera generally lly accep accepted ted accou accounti nting ng princi principle ples. s.

10. easy a

Which of the following is not correct regarding the communications between successor and  predecessor auditors? auditors? a. The burden of initiating the communication rests with the predecessor auditor.  b. The burden of initiating initiating the communication communication rests rests with the successor successor auditor. c. The predec predecessor essor audito auditorr must must receive receive their their former former client client’s ’s permissi permission on prior prior to divulg divulging ing information to the successor auditor  d. The predec predecessor essor audito auditorr may choose choose to provide provide a limit limited ed response response to to a success successor or auditor. auditor.

11. easy a

A successor auditor may perform which of the following for a new audit client?

a.  b. c. d.

Speak to local attorneys, banks and other businesses regarding the company’s reputation Yes No Yes No

Speak to the predecessor auditors about disagreements they had with management Yes No No Yes

12. medium  b

Which of the following is not a potential effect of an auditor’s decision that a lower acceptable audit risk is appropriate? a. More evidence is accumulated.  b. Less evidence is accumulated. c. Specia Speciall care care is requ require ired d in assig assignin ning g experi experienc enced ed staff staff.. d. Review Review of audit audit docume documentati ntation on is perfo performed rmed by personnel personnel not not assigned assigned to to the engage engagement. ment.

13. medium a

It is easier and more common to implement increased evidence accumulation for inherent risk  than for acceptable audit risk because: a. inherent risk can usually be isolated to specific accounts.  b. inherent risk applies applies to the entire entire audit. c. accept acceptabl ablee audit audit risk risk and samp sample le sizes sizes are are set stat statist istica ically lly.. d. acce accept ptab able le audi auditt risk risk does does not not impa impact ct on the amou amount nt of evid eviden ence ce which which must must be accumulated.

14. (SOX) medium d

If an auditor is requested to perform nonaudit services for a public company audit client, who is responsible for agreeing to those services with the audit firm? a. The client’s management.  b. The client’s chief chief executive officer. officer. c. The The clie client nt’s ’s chi chief ef fin finan anci cial al off offic icer er.. d. The The clie client nt’s ’s audi auditt comm commit itte tee. e.

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15. medium  b

Which of the following statements is true regarding communications between predecessor and successor auditors? a. The burden of initiating initiating the communication communication rests rests with the predecessor. predecessor.  b. The predecessor’s predecessor’s response can be limited limited to stating stating that no information information will be provided. c. The prede predecesso cessorr should should commun communicat icatee with with the successor successor only if the the client client is is public. public. d. There There must must be communi communicati cation on between between the the predec predecessor essor and succes successor sor if the succe successor ssor is is to accept the engagement.

16. medium  b

Investigating new clients with a focus on assessing the auditor’s potential relationship with that new client is a critical element in determining: a. inherent risk.  b. acceptable audit risk. c. statistical ri risk. d. financial ri risk.

17. medium  b

The purpose of an engagement letter is to: a. docu docume ment nt the the CPA CPA firm firm’s ’s resp respon onsi sibi bili lity ty to extern external al user userss of the audi audite ted d fina financ ncia iall statements.  b. document the terms terms of the engagement engagement in writing writing to minimize misunderstandings. misunderstandings. c. notif notify y the audit audit staff staff of an upcomi upcoming ng engage engagemen mentt so that perso personne nnell schedul scheduling ing can can be facilitated. d. emphasize emphasize manageme management’s nt’s responsibi responsibility lity for approving approving the audit audit progra program. m.

18. medium a

One means of informing the client that the auditor is not responsible for the discovery of all acts of fraud is the: a. engagement letter.  b. representation letter. letter. c. resp respo onsib nsibil iliity let letter. ter. d. client letter.

19. medium d

Which of of the following normally signs th the engagement le letter fo for an au audit of a public company? ny? a. Corporate treasurer. b. Chief financial officer. c. Chai Chairm rman an of the the boa board rd of dire direct ctor ors. s. d. Audit committee.

20. medium a

Which of of the following normally signs th the engagement le letter fo for an au audit of a private co company? a. Management. b. Board of directors representative. c. Audi Auditt comm commit itte teee rep repre rese sent ntat ativ ive. e. d. Corp Corpo orate rate trea treasu surrer. er.

21. medium d

An understanding of a client’s business and industry and knowledge about operations are essential essential for performing performing an adequate adequate audit. For a new client, most of this informati information on is obtained: a. from from the the pre prede dece cess ssor or aud audit itor or..  b. from the Securities Securities and Exchange Exchange Commission. c. from from the perma ermane nent nt file ile. d. at the the cli clien ent’ t’ss pre premi mise ses. s.

22. medium c

The least effective me method of of identifying related pa parties fo for a pu public company would be a(n): a. inquiry of management. b. review of SEC filings. c. distri distribut bution ion of of the enga engage gemen mentt letter letter to to all stoc stockho kholde lders. rs. d. examinati examination on of stockholde stockholders’ rs’ listi listings ngs to to identify identify principal principal stockhold stockholders. ers.

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23. medium c

An official record of meetings of the board of directors and stockholders is included in the corporate: a. bylaws.  b. charter. c. minutes. d. license.

24. medium c

Which of the following is not likely to be a related party? a. Affiliated companies. b. A major stockholder of the company. c. A war wareh ehou ouse se employ ployee ee.. d. The The chie chieff exe execu cuti tive ve off offic icer er..

25. medium c

Which of of the following is most likely to oc occur at at the beginning of of an initial audit engageme ement? a. Prepare a rough dr draft of the financial statements and of the auditor’s report. b. Study and evaluate the system of internal administrative control. c. Determ Determine ine the clien client’s t’s reaso reason n for for an audit. audit. d. Consul Consultt with and and review review the work work of the predec predecess essor or auditor auditor prior prior to discus discussin sing g the engagement with the client management.

26. medium  b

An auditor should examine minutes of the board of directors’ meetings: a. through the date of the financial statements. b. through the date of of the audit report. report. c. only only at the the beg begin inni ning ng of the the audi audit. t. d. on a test basis.

27. medium a

The first standard of field work, which states that the work is to be adequately planned and that assistants, if any, are to be properly supervised, recognizes that: a. early appointment of the auditor is advantageous to the auditor and the client.  b. acceptance of an audit audit engagement after after the close of the client’s fiscal fiscal year is generally not  permissible. c. appoin appointme tment nt of the auditor auditor subse subseque quent nt to the physic physical al count count of inventor inventories ies requi requires res a disclaimer of opinion. d. performa performance nce of substanti substantial al parts parts of of the examinati examination on is necessary necessary at interi interim m dates. dates.

28. medium d

The corporate minutes are the official record of the meetings of the board of directors and stockholders. The minutes typically typically include authorizations authorizations related to:

a.  b. c. d.

The CPA’s use of outside specialists Yes  No Yes  No

Management compensation Yes  No  No Yes

29. medi medium um c

An engagement letter sent to an audit client usually would not include a(n): a. ref refere erence nce to the audit uditor or’’s respon sponsi sibi billity for the dete detect ctio ion n of errors rors or irr irregul egular arit itie ies. s. b. estimation of the time to be spent on the audit work by audit staff and management. c. statement statement that manageme management nt advisory advisory services services would would be be made made availab available le upon upon request request.. d. reference reference to manage management ment’s ’s respons responsibili ibility ty for for the the financ financial ial statements statements..

30. medium c

Which of the following is correct with respect to to a company’s co corporate charter? a. The corpor corporate ate charte charterr is grante granted d by the federal federal govern government ment and and is requir required ed to recog recognize nize the the corporation as a separate entity.  b. The corporate charter charter includes the the rules and procedures procedures used to operate operate a corporation. c. The The corp corpor orat atee char charte terr incl includ udes es the the exac exactt name name of the the corp corpor orat atio ion, n, the the date date of  incorporation, and the types of business the corporation is authorized to conduct.

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d. 31. Medium d

The corp corpora orate te chart charter er must must be annu annuall ally y review reviewed ed by the the PCAO PCAOB. B.

Corporate bylaws include:

a.  b. c. d.

The types and amounts of capital stock   the corporation is authorized to issue Yes  No Yes  No

The rules and procedures used to operate the corporation Yes  No  No Yes

32. medium  b

In what order should the following steps occur? A. Assess client business risk  B. Understand the client’s business and industry C. Perform preliminary analytical procedures D. Assess acceptable audit risk  a. D, B, C, A.  b. B, A, D, C. c. B, D, A, C. d. D, C, B, A.

33. medium  b

Which of the following statements is not correct with respect to analytical procedures? a. Auditing st standards em emphasize th the ne need fo for au auditors to to de develop an and us use exp expeectations. b. Analytical procedures procedures must be performed performed throughout the the audit. c. Analytical Analytical procedure proceduress may be perfo performed rmed at any any time time during during the the audit. audit. d. Analy Analytic tical al procedu procedures res use compari comparison sonss and relati relations onship hipss to assess assess whethe whetherr accoun accountt  balances appear reasonable. reasonable.

34. medium d

The most widely used profitability ratio is the: a. quick ratio. b. profit margin. c. return on assets. d. earnings pe per sh share.

35. challenging  b

The purpos purposee of the requi require remen mentt in SAS SAS No. 84 of having having commun communica icatio tion n betwee between n the  predecessor and successor successor auditor is to: a. allow the predecessor predecessor to disclose information which which would otherwise otherwise be confidential. confidential.  b. help the successor auditor to evaluate evaluate whether to accept the engagement. engagement. c. help help the the clien clientt by faci facilit litati ating ng the the chan change ge of of audit auditors ors.. d. ensure ensure the prede predecess cessor or collect collectss all unpaid unpaid fees fees prior prior to a change change in auditor. auditor.

36. challenging

The predecessor auditor is required to respond to the request of the successor auditor for  information, but the response can be limited to stating that no information will be provided when: a. the predecessor auditor has poor relations with the successor auditor.  b. the client is dissatisfied with with the predecessor’s predecessor’s work. c. there there are actual actual or potent potential ial legal legal probl problems ems betwe between en the client client and and the predecess predecessor. or. d. the pred predece ecesso ssorr believ believes es that that the the client client lack lackss integr integrity ity..

c

37. challenging d

Which of of the following is correct wi with respect to to the use of of analytical pr procedures? a. Analytical Analytical procedure proceduress may be be used used in evalua evaluating ting balances balances in in the testing testing phase phase as long long as the auditor also uses them in assessing the going concern assumption.  b. Analytical procedures procedures must be used throughout the audit. audit. c. Analytical Analytical proced procedures ures used used in the testing testing phase phase of the the audit audit are primar primarily ily used used to direct direct an auditor’s attention so that the auditor’s understanding of the business is improved. d. Analytical Analytical proce procedure duress are perfor performed med by study studying ing plausibl plausiblee relatio relationship nshipss between between financi financial al

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and nonfinancial data. 38. challenging c

Which of the following ratios is best used to assess a company’s ability to meet its long-term debt obligations? a. Quick ratio.  b. Return on common common equity. c. Debt to equity. d. Current ratio.

39. challenging  b

Which of the following statements is not correct? a. Analy Analytic tical al procedu procedures res used used in the planning planning phase phase of the audit audit are primari primarily ly directe directed d at understanding the client’s business and directing the auditor’s attention to areas that may contain possible misstatements.  b. Analytical procedures procedures used in the completion phase are primarily primarily aimed at assessing assessing going concern concern and secondarily secondarily aimed at directing directing the auditor’s auditor’s attention attention to areas areas that may contain possible misstatements. c. Analy Analytic tical al proce procedur dures es must must be used in the plann planning ing and and complet completion ion phase phasess of the audit, audit, and are optional in the testing phase. d. Analytical Analytical proce procedures dures used used in the the complet completion ion phase phase are prima primarily rily aimed aimed at at directin directing g the auditor’s attention to areas that may contain possible misstatements and secondarily aimed at assessing going concern.

40. medium a

Which of the following would not likely be classified as a related-party transaction? a. An advance of one week’s salary to an employee. b. Sales of merchandise between affiliated companies. c. Loans Loans or credit credit sales sales to the principal principal owner owner of the client client compa company. ny. d. Exchanges Exchanges of equipm equipment ent between between two two compa companies nies owned owned by the same same person. person.

41. challenging d

Which of of the following would not be found in in the corporate ch charter? a. The kinds and amount of capital stock authorized zed. b. The date of incorporation. c. The types types of busine business ss activit activity y that that the the corpora corporation tion is allowe allowed d to conduct. conduct. d. The rule ruless and and proced procedure uress adopte adopted d by the the stock stockhol holder ders. s.

42. challenging a

Which of of the following would not usually be included in in th the mi minutes of the bo board of di directors? a. The du duties an and po powers of of th the co corporate of officers. b. Declaration of dividends. c. Auth Author oriz izat atio ion n of of lon longg-te term rm loan loans. s. d. Appr Approv oval al of exec execut utiv ivee bonu bonuse ses. s.

43. challenging d

When ar are au auditors li likely to encounter ju judgment pr problems in the use of of analytical pr procedures? a. When Whenev ever er the the audi audito torr plac places es reli relian ance ce on mana manage geme ment nt’s ’s expl explan anat atio ions ns for for unus unusua uall fluctuations in account balances without first developing independent expectations.  b. Whenever the auditor allows unaudited balances to unduly influence his/her expectations of current balances. c. Whenever Whenever the the auditor auditor fails fails to to consider consider the patter pattern n reflect reflected ed by severa severall unusual unusual fluctua fluctuations tions when trying to explain what caused them. d. The audito auditorr is likely likely to encounter encounter judgme judgment nt problem problemss in each each of the above above insta instances. nces.

44. challenging a

The major concern wh when using nonfinancial data in analytical procedures is is the: a. accuracy of the nonfinancial data. b. source of the nonfinancial data. c. type type of nonf nonfin inan anci cial al data data.. d. presen presence ce of of multi multiple ple source sourcess of nonf nonfina inanci ncial al data. data.

45.

An au auditor se searching fo for re related pa party tr transactions sh should ob obtain an an un understanding of of ea each

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chal challe leng ngin ing g  b

subs subsid idia iary ry’s ’s rela relati tion onsh ship ip to the the tot total al enti entity ty beca becaus use: e: a. the business structure structure may be deliberately deliberately designed designed to obscure related related party transactions. transactions.  b. this may reveal whether transactions would have taken place if the parties had been unrelated. c. tran transa sact ctio ions ns may may have have been been cons consum umma mate ted d on term termss equi equiva vale lent nt to arm’ arm’ss-le leng ngth th transactions. d. this this may permi permitt the the audi auditt of inter interco comp mpan any y acco accoun untt bala balanc nces es to be perfo perform rmed ed as of  concurrent dates.

46. challenging a

The first standard of fieldwork requires, in part, that audit work be properly planned. Proper   planning as intended intended by the first standard of fieldwork fieldwork would occur occur when the auditor: auditor: a. physically ob observes th the mo movement of of se securities al already co counted to to gu guard ag against th the substitution of such securities for others that are not actually on hand.  b. uses negative accounts receivable receivable confirmations confirmations instead of positive confirmations confirmations because because the latter require mailing of second requests and review of subsequent cash collections. c. compares compares all all cash cash as of a parti particula cularr date to to avoid avoid perform performing ing time-co time-consumi nsuming ng cash cash cutoff  cutoff   procedures. d. elimin eliminate atess the possibil possibility ity of counti counting ng invento inventory ry items items more more than once once by arrang arranging ing to make extensive test counts.

47. challenging d

Early appointment of the independent auditor will enable: a. a more thorough examination to be performed. b. a proper study and evaluation of internal control to be performed. c. suffic sufficien ientt compet competent ent eviden evidentia tiall matter matter to to be obta obtaine ined. d. d. a more more effici efficient ent examin examinati ation on to be planne planned. d.

48. medium a

Whenever an auditor compares client data to client-prepared budgets, there are two special concerns. Indicate if the two items below are concerns.

a.  b. c. d.

Assessing whether the budgets were realistic plans A concern Not a concern concern A concern Not a concern

Client data may have been altered to conform to the budget A concern Not a concern concern Not a concern A concern

49. challenging  b

An auditor who accepts an audit engagement and does not possess the industry expertise of the  business entity should: a. engage financial experts familiar familiar with the nature nature of the business business entity.  b. obtain a knowledge knowledge of matters that that relate to the nature of the entity’s business. business. c. refer refer a substantia substantiall portion portion of the audit audit to another another CPA CPA who will act act as the the principa principall auditor. auditor. d. first first inform inform manageme management nt that that an an unqualif unqualified ied opini opinion on cannot cannot be issued. issued.

50. medium  b

Which is a liquidity activity ratio? a. Profit margin b. Inventory turnover  c. Return on assets d. Times interest earned

51.

Which is usually included in an engagement letter?

medium d

a.  b. c.

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Estimate of hours required to complete audit Yes  No Yes

Dollar estimate of fees to be billed to the client Yes  No  No

d. 52. medium a

A reference to GAAP Yes No Yes No

A reference to GAAS Yes  No  No Yes

Which is usually included in an engagement letter?

a.  b. c. d 54. medium

Yes

Which is usually included in an engagement letter?

a.  b. c. d. 53. medium c

No

The financial statements are the responsibility of the company’s management Yes  No Yes  No

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

When may the auditor refer to a specialist in the audit report?

c Only if the specialist’s report results in a modification of the audit opinion a. Yes  b.  No c. Yes d  No

Only if the specialist assisted in the audit of an account material to the financial statements Yes  No  No Yes

55. medium

Which is usually included in the engagement letter?

 b

The projected projected type of opinion on the financials statement to be audited a. Yes  b.  No c. Yes d  No

56. medium  b

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

Which is usually included in the engagement letter? List of audit procedures to be used in inventory observation a. Yes  b.  No c. Yes d  No

Essay Questions  Arens/Elder/Beasley  Arens/Elder/Beasley

The auditors’ assessment of Audit Risk   Yes  No  No Yes

57. easy

Discuss the factors an auditor should consider before accepting a company as an audit client. Answer: The auditor auditor should should investig investigate ate and consider the prospecti prospective ve client’s client’s standing in the  business community, community, financial stability, management’s integrity, and relations with its  bankers, attorneys, and previous CPA firm. The auditor should also determine whether he or she possesses the required competence and independence to do the audit.

58. easy

Discuss the primary purpose of an audit engagement letter. Is an engagement letter required? Answer: The purpose of an audit engagement letter is to establish a clear understanding between the auditor and the client regarding the terms of the engagement. An engagement is required for   both public and private private company audits. audits.

59. easy

Define the term “related party” and discuss why an auditor should identify the client’s related  parties early in the audit. Answer: A related party is an affiliated company, principal owner of the client company, or any other party with which the client deals where one of the parties can influence the management or operating policies of the other. Auditors need to be aware of who the client’s related parties are early in the audit to enable the auditor to identify related-party transactions, especially those that have not been disclosed.

60. medium

There are three main reasons why an auditor should properly plan audit engagements. Discuss each of these reasons. Answer: Three reasons why an auditor should properly plan audit engagements are: To enable enable the audito auditorr to obtain obtain suffic sufficien ientt compet competent ent eviden evidence ce for the circumstances. This is essential for minimizing legal liability and maintaining a good  profession reputation. reputation. •

To help help keep keep audit audit costs costs reaso reasonab nable. le. Given Given the compet competit itive ive audit auditing ing environment, keeping costs reasonable helps the firm obtain and retain clients.

•

To avoid misunderstandings with the client. This is important for good client • relations.

61. medium

Discuss the essential activities involved in the initial planning of an audit. Answer: There There are four essential essential activities activities involved involved in the initial initial planning of an audit. audit. These are:

1. Client Client accept acceptanc ancee or contin continuat uation ion.. In the case of a new client, client, the auditor auditor must must

2.

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determine whether the client is one with which (s)he wishes to be associated. In the case case of a contin continuin uing g client client,, an audito auditorr must must determ determine ine whethe whetherr contin continuin uing g the relationship is appropriate and in the firm’s best interest. Determine reason for the audit. The auditor should determine the reason for the audit as soon as practical. The remainder of the planning activities may be impacted by the

3. 4.

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client’s reason for requesting the audit. Obtain an understanding with the client. An understanding with the client should be obtained to avoid misunderstandings. misunderstandings. Auditors are required to obtain an understanding understanding with their clients. This understanding must be written. Develop an overall audit strategy. The strategy should consider the reasons for the audit, including areas where there is greater risk of significant misstatements. misstatements. Setting a strategy helps the auditor determine the resources required for the engagement.

62. medium

Discuss the required communications between predecessor and successor auditors as outlined  by SAS No. 84. Answer: Auditing Auditing standards standards require a successor successor auditor to communica communicate te with the predecess predecessor  or  auditor whenever accepting a client that has been previously audited. The purpose of the comm commun unic icat atio ion n is to help help the the succ succes esso sorr audi audito torr eval evalua uate te whet whethe herr to acce accept pt the the engagement. While the burden of initiating the communication rests on the successor  auditor, the predecessor auditor must respond to the request for information. However,  because of the requirements related to confidentiality, confidentiality, the predecessor must obtain the former client’s permission prior to providing information to the successor.

63. medium

Discuss several reasons why an auditor may not wish to continue a relationship with an existing audit client. Answer: There are a number of reasons an auditor may choose not to continue a relationship with an existing client. Examples include: include: 1. 2. 3. 4. 5.

64. medium

Previous Previous conflic conflicts ts over account accounting ing issues, issues, scope scope of the audit, audit, type type of opinion, opinion, or  fees. Managemen Managementt integri integrity ty may may be deemed deemed to be insuff insufficie icient. nt. Lega Legall acti action on init initia iate ted d by eith either er the audi audito torr or client client rela relate ted d to prior prior audi auditt services. If fees fees remain remain unpaid for for services services perform performed ed more than than one year year prior to to the date date of the current year’s audit report. The The prese presenc ncee of exce excess ssiv ivee risk risk..

Discuss four of the matters that should be specified in an engagement letter. Answer: Matters that should be specified in the engagement letter include: Whether Whether the auditor will perform an audit, audit, a review, review, or a compilati compilation, on, plus any other services such as tax returns or management advisory services. Any restrictions to be imposed on the auditor’s work. Deadlines for completing the audit. Assistance to be provided by the client’s personnel in obtaining records and documents, and schedules to be prepared for the auditor. Agreement on fees. The letter should state that the auditor is not responsible for the discovery of  all acts of fraud. •

• • •

• •

65. medium

What What docume documents nts do audito auditors rs routin routinely ely obtain obtain to aid in their their unders understan tandin ding g of a client client’s ’s governance system? Briefly discuss each each of these documents. Answer: Auditors commonly obtain the client’s corporate charter, bylaws, and minutes of meetings of the board of directors and shareholders. The corporate charter is issued by the state in which the company is incorporated and specifies the exact name of the corporation along with with the date of incorp incorpora oratio tion, n, the kinds kinds and amount amountss of stock stock the corpor corporati ation on is

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authorized to issue, and the types of business that the corporation is authorized to conduct. The bylaw bylawss includ includee the rules rules and proce procedur dures es adopte adopted d by the stockh stockhold olders ers of the corporation. They specify the duties and powers of corporate officers, the method of  voting for directors, and

the frequency of stockholder stockholder meetings. The corporate minutes minutes are the official record record of  the meetings of the board of directors and stockholders. They include summaries of the most important topics discussed and decisions made at the board meetings.

66. medium

What are three factors that have increased the importance of obtaining an understanding of a client’s business and industry? How can an auditor obtain this understanding? Answer: Factors that have increased the importance of obtaining an understanding of a client’s  business and industry include: Advances Advances in informati information on technology technology have increased increased connectiv connectivity ity among among companies, customers, and vendors. Auditors must understand the risks associated with this increased connectivity. Companies have expanded operations to have global reaches, often through  joint ventures and strategic alliances. alliances. Informat Information ion technology technology affects affects internal internal control control processe processes, s, improving improving the quality and timeliness of accounting information. The increased importance of human capital and other intangible assets has increased accounting complexity and the importance of management judgments and estimates. Auditors need a better understanding of the client’s business and industry to  provide additional additional value-added services. services. •

•

•

•

•

The auditor can obtain a sound understanding of the client’s business and industry through severa severall means, means, includ including ing discus discussio sions ns with with previo previous us audito auditors rs and by revie reviewin wing g the  permanent files for the client; conferences with the client’s personnel; studying AICPA industry audit guides, textbooks, technical magazines, and specialized journals; and by  participating in in industry associations associations and training programs.

67. medium

There are three primary reasons for obtaining a thorough understanding of the client’s industry and external environment. What are these reasons? Answer: The three reasons are: Risks associated with specific industries may affect the auditor’s assessment of client  business risk and and acceptable audit risk. risk. Certai Certain n inhere inherent nt risks risks are are typic typicall ally y common common to all client clientss in certai certain n indust industri ries. es. Familiarity with those risks aids the auditor in assessing their relevance to the client. Many Many indust industrie riess have have unique unique accoun accountin ting g requir requireme ements nts that that the audit auditor or must must understand to evaluate whether the client’s financial statements are in accordance GAAP. •

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68. medium

Discuss the four primary purposes of analytical procedures performed during the planning phase of an audit. Answer: The four primary purposes of preliminary analytical procedures are:

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• • • •

69. challenging

to help the auditor understand the client’s industry and business, to help the auditor assess the going concern assumption, to indicate areas of possible misstatements, and to reduce the extent of detailed tests.

Define business risk. List several factors factors that may impact the auditor’s assessment of business risk. Answer: Business risk is the risk that a company will fail to achieve its objectives. Factors that may impact business risk include: General economic conditions, Extent of competition within an industry, Changing regulatory requirements, Competence of management, Ability to maintain sufficient cash flows and secure financing, and Successful implementation of business strategies. • • • • • •

70. challenging

Auditors routinely conduct analytical procedures in the planning, testing, and completion phases of the audit. Identify the primary and secondary secondary purposes of performing analytical analytical procedures in each phase of the audit. Answer: •

•

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71. challenging

Planning – The primary purposes are to understand the client’s business and industry and indicate areas of possible possible misstatemen misstatements. ts. The secondary secondary purposes are to assess assess going concern and reduce the extent of detailed tests. Testing – The primary purpose is to reduce the extent of detailed tests, while the secondary purpose is to indicate areas of possible misstatements. misstatements. Completion –The primary purpose is to indicate areas of possible misstatements, while the secondary purpose is to assess going concern.

Three types of legal documents and records that auditors examine in the planning phase of an audit are the corporate charter and bylaws, corporate minutes of meetings of the board of  directors and stockholders, and contracts. Discuss the audit-relevant information contained in each of these three types of documents that an auditor should be aware of early in the audit. Answer: Corporate charter and bylaws. This includes the amounts of capital stock the corporation is authorized to issue, its par or stated value, preferences and conditions for dividends, and information concerning voting rights of each class of stock. The bylaws specify such things as the fiscal year of the corporation, the frequency of stockholder meetings, the method of voting for directors, and the duties and powers of the corporate officers.  Minutes of meetings. meetings. There are two categories of audit-relevant information contained in the minutes: minutes: authorization authorizationss and discussio discussions ns by the board of directors directors affecting affecting inherent inherent risk. Common authorization authorizationss in the minutes minutes include include compensati compensation on of officers officers,, new contacts and agreements, acquisitions of property, loans, and dividend payments. Contracts. Contracts. The auditor should examine contracts early in the engagement to gain a better   perspective of the organization and to become familiar with potential problem areas. Contracts will also be examined during the tests of individual audit areas.

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Other Objective Answer Format Questions 72. easy a

When an auditor decides there is higher inherent risk for an account, one potential effect is that more audit evidence will be required for that account. a. True  b. False

73. easy a

As acceptable audit risk is decreased, the likely cost of conducting an audit increases. a. True  b. False

74. easy  b

Before Before accepting a new client, most CPA firms firms investiga investigate te the company to determine determine its accept acceptabi abilit lity. y. Howeve However, r, AICPA AICPA confid confident ential iality ity requir requireme ements nts prohib prohibit it CPA CPA firms firms from from contac contactin ting g certai certain n partie parties—n s—nam amely ely the compan company’ y’ss attorn attorney eyss and banker bankers— s—dur during ing this this investigation. a. True  b. False

75. easy  b

For prospective clients that have previously been audited b y another CPA firm, the predecessor  auditor is required to communicate with the successor auditor. a. True  b. False

76. easy  b

When a successor auditor contacts a company’s previous auditor, the predecessor auditor is required to respond fully and without limit to the request for information. a. True  b. False

77. easy  b

A predecessor auditor who has been contacted by a successor auditor for information about the client client does does not have have to obtain obtain permis permissio sion n from from the former former clien clientt before before provid providing ing any confidential information to the successor auditor because the confidentiality requirement does not extend to former clients. a. True  b. False

78. easy a

Auditors should obtain copies of the client’s articles of incorporation, bylaws, and minutes of  the meetings meetings of the board of direct directors ors to aid in their their under understa standi nding ng of the compan company’ y’ss management and governance structure. a. True  b. False

79. easy a

An auditor must evaluate a specialist’s professional qualifications and understand the objectives of the specialist’s work. a. True  b. False

80. medium  b

To evaluate a specialist’s work the auditor must himself/herself be considered a specialist. a. True  b. False

81. medium a

An engagement letter establishes a clear understanding of the terms of the engagement between the client and the auditor, but it is optional for private companies. a. True  b. False

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82. easy  b

Because of the requirements of Rule 201 of the AICPA’s Code of Professional Conduct which Conduct  which state state that auditors auditors should “undertake “undertake only those professional professional services services that the member member or the member’s firm can reasonably expect to be completed with professional competence,” auditors are not normally permitted to consult with, or rely on the work of, outside specialists during an audit engagement. a. True  b. False

83. medium  b

Acceptable audit risk is a measure of the auditor’s willingness to accept that the financial statements do not contain material misstatements after the audit is completed and a qualified audit report has been issued. a. True  b. False

84. medium  b

If a prospective client has been audited in the past, the successor auditor will typically rely solely on the representations about the client by the predecessor auditor. a. True  b. False

85. medium  b

Two Two major major factor factorss that that affect affect accept acceptabl ablee audit audit risk risk are the likel likely y users users of the the financ financial ial statements and the likelihood of issuing an unqualified audit opinion. a. True  b. False

86. medium  b

A major considerat consideration ion in assigning assigning staff to an audit audit engageme engagement nt is the experience experience levels required for the work, while a less important consideration is maintaining staff continuity on the engagement. a. True  b. False

87. medium  b

Inherent risks typically vary across industries. a. True  b. False

88. medium a

Transactions with related parties must be disclosed in the financial statements if they are deemed to be material. a. True  b. False

89. medium a

All known related parties must be identified and included in the auditor’s permanent files related to the client. a. True  b. False

90. medium  b

Generally, auditors assess inherent risk as moderate for related party transactions because they expect clients to be aware of their scrutiny of such transactions. a. True  b. False

91. medium  b

The corpor corporate ate charte charterr typic typicall ally y establ establish ishes es the compan company’ y’ss fisca fiscall year year and freque frequency ncy of  stockholder meetings. a. True  b. False

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92. medium  b

Ordinarily, the auditor should review and abstract copies of contracts during the later stages of  an audit. a. True  b. False

93. medium a

When a successor auditor requests information from a company’s previous auditor, and there are legal problems or disputes between the client and the predecessor auditor, the predecessor  auditor’s response to the new auditor may be limited to stating that no information will be  provided. a. True  b. False

94. medium  b

One purpose of performing preliminary analytical procedures in the planning phase of an audit is to help the auditor make a preliminary assessment of control risk. a. True  b. False

95. medium  b

Material transactions between the client and the client’s related parties must be disclosed in the auditor’s report. a. True  b. False

96. challenging a

An engagement letter can affect the CPA firm’s legal responsibilities to the client, but does not affect responsibility to external users of audited financial statements. a. True  b. False

97. challenging  b

Two categories categories of audit-rele audit-relevant vant information information found in corporat corporatee charters charters and bylaws bylaws are authorizations and discussions of matters affecting inherent risk. a. True  b. False

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