CPA AUD text a4 apr12

CPA Audit HOCK international books are licensed only for individual use and may not be lent, copied, sold or otherwise distributed without permission directly from HOCK international If you did not download this book directly from HOCK international, it is not a genuine HOCK book Using genuine HOCK books assures that you have complete, accurate and up-to-date materials Books from unauthorized sources are likely outdated and will not include access to our online study materials or access to HOCK teachers Hard copy books purchased from HOCK international or from an authorized training center should have an individually numbered orange hologram with the HOCK globe logo on a color cover If your book does not have a color cover or does not have this hologram, it is not a genuine HOCK book Ninth Edition CPA Preparatory Program Audit Brian Hock, CMA, CIA HOCK international, LLC P.O Box 204 Oxford, Ohio 45056 (866) 807-HOCK or (866) 807-4625 (281) 652-5768 www.hockinternational.com cma@hockinternational.com Published April 2012 Acknowledgements Material from Uniform CPA Examination, Selected Questions and Unofficial Answers, Copyright © 1990-2011 by the American Institute of Certified Public Accountants, Inc., is reprinted and/or adapted with permission Acknowledgement is due to the Institute of Certified Management Accountants for permission to use questions and problems from past CMA Exams The questions and unofficial answers are copyrighted by the Certified Institute of Management Accountants and have been used here with their permission © 2012 HOCK international, LLC No part of this work may be used, transmitted, reproduced or sold in any form or by any means without prior written permission from HOCK international, LLC ISBN: 978-1-934494-77-6 Thanks The author would like to thank the following people for their assistance in the production of this material:      Kevin Hock for his work in the formatting and layout of the material, Lynn Roden, CMA for her assistance in the technical elements of the material, All of the staff of HOCK Training and HOCK international for their patience in the multiple revisions of the material, The students of HOCK Training in all of our classrooms and the students of HOCK international in our Distance Learning Program who have made suggestions, comments and recommendations for the material, Most importantly, to our families and spouses, for their patience in the long hours and travel that have gone into these materials Editorial Notes Throughout these materials, we have chosen particular language, spellings, structures and grammar in order to be consistent and comprehensible for all readers HOCK study materials are used by candidates from countries throughout the world, and for many, English is a second language We are aware that our choices may not always adhere to “formal” standards, but our efforts are focused on making the study process easy for all of our candidates Nonetheless, we continue to welcome your meaningful corrections and ideas for creating better materials This material is designed exclusively to assist people in their exam preparation No information in the material should be construed as authoritative business, accounting or consulting advice Appropriate professionals should be consulted for such advice and consulting   CPA Audit Table of Contents Table of Contents Introduction to External Auditing Generally Accepted Auditing Standards (GAAS) The General Standards The Fieldwork Standards The Reporting Standards 4 Quality Control Standards Documentation and Communication of Quality Control Policies and Procedures The Elements of Quality Control Planning the Engagement 11 Supervision 18 Understanding the Entity and Its Environment 19 Documentation of the Understanding Obtained Risk Assessment Procedures 20 21 Audit Risk and Materiality 22 Audit Risk Materiality Assessing Misstatements Materiality Levels in the Audit Components of Audit Risk Assessing the Components of Audit Risk 22 22 22 23 23 24 Substantive Tests Prior to the Balance Sheet Date – Interim Work 26 Communication with those Charged with Governance 27 Internal Control 28 Limitations of Internal Controls Influences of Internal Controls 29 29 Components of Internal Control 30 Considering Internal Controls in Planning the Audit 37 Assessing the Level of Control Risk 39 Evidence to Support the Assessed Level of Control Risk 41 Documenting Internal Controls 42 Communication of Internal Control Matters 43 Control Deficiencies 43 Objectives of Internal Controls 46 General Internal Control Questionnaires 47 Control Environment Accounting System Universal Procedures © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 47 49 50 i Table of Contents CPA Audit Documents and Individuals in Internal Control 50 Purchases, Payables and Cash Disbursements Cycle Sales, Receivables and Cash Receipts Cycle Inventory and Production Cycle Personnel and Payroll Cycle Property, Plant and Equipment Cycle 50 51 51 52 52 Transaction Cycle Internal Control Questionnaires 53 Revenues and Receivables Cash Receipts Purchases and Accounts Payable Payroll Cash Disbursements Inventory and Cost of Sales Property and Equipment Stockholders’ Equity and Capital Accounts 53 54 55 56 57 58 59 60 Audit Evidence and Sources of Audit Evidence 64 Evidential Matter 64 Sufficiency of Evidence Appropriateness of Evidence Constraints of Evidence 64 65 65 The Audit Assertions 67 Internal Audit Function 69 Management Representation Letter 72 Form of the Management Representation Letter 73 Analytics 76 Using the Work of a Specialist 78 Inquiry of Client’s Lawyer 79 Related Parties 83 Audit Documentation (The Working Papers) 86 Audit Programs 88 Considerations in Planning the Audit Program Types of Audit Evidence Standardized Audit Procedures 88 88 89 Cash 92 Accounts Receivables and Sales 94 Inventory 97 Fixed Assets 101 Investments 102 Accounts Payable, Purchases and Other Liabilities 105 ii © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Table of Contents Payroll 106 Long-term Liabilities 108 Stockholders’ Equity 109 Accounting Estimates 111 The Auditor’s Responsibility to Detect Fraud 112 Procedures Related to Fraud 113 Illegal Acts by Clients 115 Sampling Fundamentals 117 Sampling Risk Types of Sampling Determining Sample Size Attribute (Control) Sampling Variables Sampling Classical Sample Selection Methods Sampling Methodology 117 120 121 122 124 125 126 Auditing EDP Systems 133 Electronic Data Processing (EDP) Systems Data Processing in an EDP System Development and Implementation of an EDP System Client Documentation 133 134 134 135 The Effect of an EDP System on an Audit 137 Considerations in Internal Control Accounting Controls in an EDP System EDP and Evidential Matter 137 138 138 General Controls 140 Organization and Operation Controls Systems Development and Documentation Controls Hardware and Systems Software Controls Access Controls Data and Procedural Controls Physical Safeguards 140 141 142 142 143 144 Application Controls 145 Input Controls Processing Controls Output Controls 145 146 146 Information Technology’s Impact on Internal Controls 148 General Auditing Procedures 153 Generalized Audit Software (GAS) 155 Auditing Special Systems 157 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited iii Table of Contents On-Line, Real-Time Systems Mini and Microcomputer Systems Service Bureaus Time-Sharing Systems CPA Audit 157 157 158 158 The Audit Report 159 The Reporting Standards 159 Conformity with US GAAP Consistency of GAAP Application Adequacy of Disclosure Expression of Opinion 159 159 160 161 Types of Opinions 162 Unqualified Opinion Unqualified Opinion, Standard Report Unqualified Opinion, Additional Language Qualified Opinion Adverse Opinion Disclaimer of Opinion 162 163 165 170 173 173 Reports on Comparative Financial Statements 175 Changing Opinion from One Period to the Next Current Auditor Did Not Audit the Prior Period 175 176 The Dating of the Audit Report (AU 530, Amended by SAS 103) 178 Subsequent Events (AU 560) 178 Discovering Facts After the Report Is Issued (AU 561) 179 Consideration of Omitted Procedures (AU 390) 181 Association with the Financial Statements (AU 504) 182 When Audited and Unaudited Statements Are Presented in Comparative Form 183 Going Concern Assessment (AU 341) 184 Other Information in Audited Financial Statements (AU 550) 186 Required Supplementary Information (AU 558) 187 Segment Information (AU 435) 187 Other Types of Reports 188 Additional Info with Basic Financial Info in Auditor-Submitted Documents (AU 551) 188 Special Purpose Reports (AU 623) 190 Financial Statements in Conformity with OCBOA 190 Reports on Specified Elements, Items or Accounts of a Financial Statement 191 Report on Compliance 192 Financial Presentations to Comply With Contractual Agreements or Regulatory Provisions193 Incomplete Information in Accordance with US GAAP or OCBOA 194 Complete Presentation not in Conformity with GAAP or OCBOA 195 iv © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited Statements on Standards for Consulting Services (SSCS) CPA Audit Question 191: Which of the following services may a CPA perform in carrying out a consulting service engagement for a client? I Review of the client-prepared business plan II Preparation of information for obtaining financing a) I only b) II only c) Both I and II d) Neither I nor II (CPA Adapted) Question 192: Under the Statements on Standards for Consulting Services, which of the following statements best reflects a CPA’s responsibility when undertaking a consulting services engagement? The CPA must: a) Not seek to modify any agreement made with the client b) Not perform any attest services for the client c) Inform the client of significant reservations concerning the benefits of the engagement d) Obtain a written understanding with the client concerning the time for completion of the engagement (CPA Adapted) 252 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Responsibilities in Specialty Practices Responsibilities in Specialty Practices Personal Financial Planning Services The Personal Financial Planning Executive Committee of the AICPA approves these statements of responsibilities in Personal Financial Planning Personal financial planning engagements are those in which the member develops strategies and recommendations to help clients define and achieve personal financial goals They may be very general or specific to a certain goal Personal financial planning engagement activities include the following items: • Defining the engagement objectives, • Planning specific procedures, • Developing a basis for recommendations, • Communicating recommendations to the client, and • Identifying action tasks for planning decisions The engagement may also include: • Assisting the client to take action on planning decisions, • Monitoring progress in achieving goals, and • Updating recommendations and revising planning decisions The compilation of personal financial statements, projecting future taxes, preparing tax returns and other tax compliance work or advice is not included in the scope of personal financial planning For these types of jobs, the member should follow the Rules relating to integrity and objectivity, professional competence, due professional care, planning and supervision, sufficient, relevant data, confidential client information, contingent fees and referral fees In addition, the AICPA has developed standards to address the following specific issues: • The functions and responsibilities regarding the ongoing monitoring and updating of an engagement • Development of the basis for a recommendation to the client • Cooperation with other advisors • The functions and responsibilities related to the implementation of the engagement’s recommendations AICPA Assurance Services for E-Commerce Privacy Issues WebTrustSM informs potential customers that a CPA has evaluated a website’s business practices and controls to confirm that they conform to WebTrustSM principles In a SysTrustSM engagement, the CPA firm issues a report that evaluates whether management has maintained effective controls to ensure that its systems function reliably within a specified time frame It uses four essential principals as benchmarks: availability, security, integrity and maintainability © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 253 Responsibilities in Specialty Practices CPA Audit Tax Services The AICPA provides specific standards for the performance of tax services These guidelines, called “Statements of Standards on Tax Services” (SSTS), help to define the responsibility that the member has towards the client and the IRS These guidelines are important because many CPAs sign the tax returns that they prepare for their clients This signature is evidence of involvement by a CPA even though the tax return remains the responsibility of the taxpayer Therefore the roles and responsibilities between the taxpayer and the CPA need to be defined There are eight statements: SSTS – Tax return positions: This statement defines the CPA’s responsibilities when interpreting the tax law for a client to decide how to report a business activity for tax purposes (called a tax “position”) The main points for the CPA are: • Tax positions on a tax return should be realistic (the CPA has good faith belief that the IRS would agree to the proposed tax treatment – the possibility of agreement is between 33% to 50%) and non-frivolous • A frivolous tax position is an interpretation of a business activity that is clearly not in agreement with the tax law The CPA may not advocate taking frivolous tax positions, not even with disclosure to the IRS • A CPA may prepare and sign a tax return with a tax position that is judged non-frivolous as long as it is disclosed to the IRS by the taxpayer • A CPA may use multiple sources of information to determine whether a tax position is realistic There is no limitation on the sources of information so long as client confidentiality is maintained Examples include published articles, tax treaties, official government publications and interpretations, and other tax returns from the same or a different taxpayer • SSTS No allows the taking of positions that not have at least a 33% chance (realistic possibility) of being agreed by the IRS as long as they are non-frivolous and are disclosed • A tax position should not be taken just because the chances of getting audited by the IRS is limited The position should stand on its merit regardless of the chances of audit • A tax position should not be overstated as a negotiating tactic with the IRS The correct supported value should always be used • The CPA should inform the taxpayer regarding the penalties and other consequences that could occur if the IRS does not accept a tax position SSTS – Answers to questions on returns This statement defines the CPA’s responsibilities when trying to understand the taxable activity of the client Before signing off on the tax return the CPA must make a reasonable effort to obtain information from the taxpayer to answer all questions about the tax return When deciding what a reasonable effort is, the CPA should consider the importance of the information for the tax return and the difficulty to obtain it 254 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Responsibilities in Specialty Practices SSTS – Procedural aspects of preparing tax returns for clients This statement defines the CPA’s administrative and review responsibilities when finalizing the tax return for submission to the IRS The CPA: • Should make a reasonable effort to determine whether the taxpayer maintains adequate supporting documentation, as defined by tax law, to support an expense deduction • May rely, in good faith and without verification, on the information that the taxpayer provides regarding their taxable activity if he has a reasonable basis for this reliance • Should not ignore situations that appear incorrect or incomplete In such cases the CPA should make a reasonable effort to resolve such situations through inquiry and gathering further information from other sources • May refer to the tax return of another taxpayer to research and resolve open questions as long as client confidentiality is maintained SSTS – Use of estimates This statement defines the CPA’s responsibilities when using the tax payer’s estimates for the tax return The CPA must make a good faith reasonable effort to validate the estimates used by taxpayers in their tax returns However the CPA may use the taxpayers estimates if: • the CPA determines that the estimate is reasonable • it is not practical to obtain precise information • the use of the estimate is allowed by professional or legal requirements • the estimate does not create the impression of more accuracy than actually exists The use of estimates does not have to be disclosed to the IRS except when it is necessary to avoid misleading the IRS regarding the reliability of the estimated amounts Examples of situations where disclosure is appropriate include when a lawsuit is pending and the outcome is not finalized or when the taxpayer is sick and unavailable at the filing deadline SSTS – Departure from a tax position that was reviewed already by the tax authorities This statement defines the CPA’s responsibilities when proposing a tax treatment of an activity that has already been reviewed by the tax authorities (IRS, tax courts, etc) In this case the CPA may propose a treatment that is different versus the tax authorities previous decisions as long as the tax authorities did not require the usage of their interpretation as part of a specific settlement decision related to the taxpayer In addition, the CPA’s alternative treatment must respect SSTS #1 requirements regarding tax positions A treatment that conflicts with previous tax authority decisions could be possible, for example, when: • new information becomes available that supports the taxpayer • the tax authorities have made decisions for a different taxpayer that are relevant to support the tax position • laws have changed in the current period that support the taxpayers interpretation © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 255 Responsibilities in Specialty Practices CPA Audit SSTS – Knowledge of errors in a tax return This statement defines the CPA’s responsibilities when he becomes aware of an error in a taxpayers tax return In such cases the CPA is not obligated to report errors to the IRS without the taxpayer’s agreement except when required by law However the CPA must: • Inform the taxpayer immediately and recommend a solution to correct the error The recommendation can be made in oral or written format • Consider discontinuing working with a taxpayer who does not agree to disclose known errors to the IRS SSTS – Knowledge of errors and administrative proceedings with the tax authorities This statement defines the CPA’s responsibilities when he is representing the taxpayer in official proceedings with tax authorities and he becomes aware of an error in the tax return In such cases the CPA is not obligated to report errors to the IRS without the taxpayer’s agreement except when required by law However the CPA must: • Inform the taxpayer immediately and recommend a solution to correct the error The recommendation can be made in oral or written format • Consider special procedures when the CPA is working for a legal counsel that is representing the taxpayer • Consider discontinuing working with a taxpayer who does not agree to disclose known errors to the IRS SSTS – Form and content of tax advice to taxpayers This statement defines the CPA’s responsibilities when communicating tax advice to the taxpayer The CPA: • Must use good professional judgment to provide advice to the taxpayer that fulfills their needs • Should assume that the taxpayer will use the advice • Should provide their advice in writing when the advice relates to material issues A written response is not, however, a requirement since there is no standard format for tax advice required by SSTS • Is not obliged to inform the taxpayer about changes to the tax law that affect previous advice given to the taxpayer unless the CPA has a special contractual obligation in this regard Question 193: A CPA owes a duty to: a) Provide for a successor CPA in the event death or disability prevents completion of an audit b) Advise a client of errors contained in a previously filed tax return c) Disclose client fraud to third parties d) Perform an audit according to GAAP so that fraud will be uncovered (CPA Adapted) 256 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Disciplinary Systems Question 194: While preparing a client’s individual federal tax return, the CPA noticed that there was an error in the previous year’s tax return that was prepared by another CPA The CPA has which of the following responsibilities to this client? a) Inform the client and recommend corrective action b) Inform the client and the previous CPA in writing, and leave it to their discretion whether a correction should be made c) Discuss the matter verbally with the former CPA and suggest that corrective action be taken for the client d) Notify the IRS if the error could be considered fraudulent or could involve other taxpayers (CPA Adapted) Question 195: According to the profession’s ethical standards, a CPA preparing a client’s tax return may rely on unsupported information furnished by the client, without examining underlying information, unless the information: a) Is derived from a pass-through entity b) Appears to be incomplete on its face c) Concerns dividends received d) Lists charitable contributions (CPA Adapted) Disciplinary Systems There are a number of different bodies that may be in a position to discipline a member They are listed below with a description of their scope of jurisdiction Note that the organizations are both professional as well as governmental Discipline by Professional Organizations 1) State CPA Societies Membership in each state society is governed by the society itself Membership is not required in order to practice as a CPA 2) American Institute of CPAs Membership in the AICPA requires having passed the CPA exam and possessing a valid and unrevoked CPA license from a state board Membership can be terminated for failure to pay dues, failure to comply with continuing education requirements or the commission of a criminal act Membership can be suspended if a CPA’s license is suspended, revoked or withdrawn as the result of a disciplinary action by a state board The professional ethics executive committee investigates potential disciplinary matters involving members You not need to know this in depth © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 257 Disciplinary Systems CPA Audit Discipline by Governmental Organizations 1) State Boards of Accountancy These are the bodies that actually give CPA licenses, and it is the state board that is in a position to revoke a license Each state has its own requirements for the obtaining and maintaining of a license 2) Securities and Exchange Commission (SEC) Rule 102(e) authorizes the SEC to suspend or prevent any professional from practicing before the commission any professional that: • Lacks the required qualifications to represent others, • Lacks in character or integrity, or has engaged in unethical or improper behavior, • Has willfully violated, or aided in the violation of, and provision of the Federal Securities laws, its rules or regulations Please note that the SEC does not revoke a person’s CPA license Rather, the SEC simply does not allow that person to function as the certifying auditor for documents submitted to the SEC 3) Public Company Accounting Oversight Board (PCAOB) The PCAOB was established as part of the Sarbanes-Oxley legislation to oversee aspects of the public accounting profession Its mandate is to regulate public accounting firms that perform audits of companies that are registered on public stock exchanges Private companies are not within its scope Specific requirements of the PCAOB that impact public accountants include: • Registration requirement for a CPA to perform audits of public companies • This registration with the PCAOB must be updated annually • Developing audit standards that the public accounting firm must respect • Enforcing the audit requirement and, when necessary, penalizing the CPA for lack of compliance • Performing inspections of public accounting firms and, when necessary, conducting disciplinary proceedings against firms that not follow PCAOB guidelines 4) Internal Revenue Service (IRS) The IRS may assess fines and even bar an accountant from practicing before the IRS based upon issues regarding competency or non-compliance with tax laws and regulations 258 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Answers to Questions Answers to Questions d – Critical review is one of the main elements of due professional care c – Of these choices, only c has to with the quality control system that a firm needs to have d – Asking about disagreements with management should be done This will alert the new auditor to potential problems with management and if they are serious enough, may prevent the auditor from accepting the engagement The other choices are all things the auditor should already know d – The thing that needs to be agreed upon with the client is the timing of the inventory count The other items, although important, are not discussed and agreed upon with the client b – When considering materiality for planning purposes, the auditor considers the smallest amount that is material to one of the financial statements b – Annualized, interim financial statements are the best choice of those presented to determine a preliminary assessment of materiality b – By definition, this is detection risk c – As explained in the previous question, it is best if the year-end balance of the item tested at interim can be predicted or rolled forward a – Both of these items should be communicated to the audit committee 10 b – If there are changes in significant accounting policies, this should be communicated to the audit committee The other choices not need to be communicated to the audit committee 11 d – Because an internal control system cannot be 100% perfect and because the costs of the system should be less than the benefits derived from the system, this leads to the concept that internal controls can only provide reasonable (not absolute) assurance 12 b – Both timekeeping and preparation of payroll journal entries should take place outside of the payroll department As long as a person performing those two functions had no payroll department function, that person could both timekeeping and prepare journal entries without violating segregation of functional responsibilities 13 d – If the same person is recording cash receipts and also reconciling the bank account, that person could post a cash receipt to a customer’s account, divert the cash from the bank deposit, and cover it up by reporting an outstanding deposit or a reconciling item on the bank reconciliation 14 c – The accounts receivable manager’s writing off delinquent accounts is a violation of segregation of duties, because it combines under one person the functions of authorizing a transaction and recording the transaction 15 b – Monitoring is an activity overseen and/or performed at the management level for the purpose of assessing the operation and effectiveness of existing internal controls A reconciliation performed at the departmental level does not provide information for monitoring the internal control system 16 c – When there is one person who dominates management (and is also a shareholder) and the decisionmaking process, this will most likely influence the control environment of the company 17 a – The auditor is able to both the testing of the system and the gaining of the understanding of the system at the same time 18 d – When the auditor actually tests the controls to see if they are working as designed, this means that the auditor has concluded that if the tests are working the amount of tests performed during the audit may be reduced 19 b – By definition, these are the main ways that assessing control risk can be done 20 d – If the auditor wants to reduce the level of control risk, he or she needs to make certain that there will actually be information that would enable doing that before beginning any tests of the internal controls 21 a – The more assurance that is provided by the audit tests, the lower the detection risk Similarly, if the tests not provide much assurance, detection risk will be high 22 c – If the acceptable level of detection risk decreases, this means that the auditor is willing to accept more risk that the audit conclusion will be wrong In this case, the auditor will be able to move some of the testing from after year end to the interim date 23 b – If control risk is increased and the auditor wants to keep the same overall level of audit risk, he or she will need to decrease detection risk The auditor is unable to decrease inherent risk, because inherent risk is something that is uncontrollable © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 259 Answers to Questions CPA Audit 24 d – In respect to the initiation and execution of equipment transactions, the auditor should look for the review of requests and the solicitation of competitive bids The other three choices are all good controls, but just not controls of the initiation of an equipment transaction 25 c – The report on reportable conditions should be limited in the scope of its distribution 26 c – By definition, reportable conditions are significant deficiencies in the design or operation of internal controls 27 d – If management has changed, a previously communicated reportable condition should again be reported to new management If management is the same management group and they understand the reportable condition and accept the risks associated with it, the reportable condition does not need to be reported each year 28 c – If the payroll supervisor also authorizes pay rate changes, the auditor will be very concerned because the payroll supervisor is in charge of authorization and record keeping 29 a – By having a bank lockbox system, the money from customers is never received by the company This gives employees no chance to steal any customer payments 30 b – After a voucher is paid, the check signer should mark the voucher as paid to prevent it from being paid a second time 31 d – In the sales process, somebody other than the sales person should be responsible for the writing off of bad debts If the sales person is able to write off the bad debt, he or she could simply make a sale, collect the cash, say that it was a credit sale and then in a few weeks say that the debt is uncollectible and write it off 32 b – When an employee is bonded it means that the company is insured against any loss from theft by that person Therefore, the person knows that if they steal money the insurance company will come looking for them to recover the stolen money 33 d – Only items that have actually been purchased should be accepted for delivery 34 c – This type of misclassification is most likely to be discovered from a comparison between actual and budgeted amounts If a fixed asset is expensed, the maintenance account will have an unusually high balance, which will come out in the variance analysis 35 a – The personnel department should usually approve changes in pay rates 36 b – The three main functions of internal controls are to ensure that authorization, recording and custody of assets are maintained properly In this question, they have listed the first two in the question (using the term executed in place of authorization), so the answer needs to be custody 37 d – The person who signs the checks should also mail them to prevent an additional person from having access to a signed check 38 c – The other three choices are all good controls, but are too specific to the question The question has to with overall company activities The choice with budgets and variances will enable management to supervise company activities 39 b – If the test is to determine if any checks have been used improperly, the population that needs to be checked is all of the checks that have been written 40 c – Anything that comes from outside the client is better than anything from the client Thus, the bank statement is better than any of the other listed choices The bank statement would be even better, though, if it was obtained directly from the bank rather than from the client 41 c – If the internal control system is working within the company, then the information from their accounting system will be more competent It will still need to be verified, but it will require less supporting evidence to reach a conclusion 42 b – The most valid evidence is that which is obtained directly by the auditor, in this case through observation 43 a – Because valuation is subject to interpretation and estimation, this is the assertion that will be tested by recomputation 44 a – When assessing competence we are concerned with the quality of the work that is done by the internal auditor This is checked by reviewing their work papers 45 c – Whenever the internal auditors are used, the external auditor will place only limited reliance on the work that is done by the internal auditor Under no circumstances will the external auditor allow the internal auditor to make decisions regarding risk or conclusions 46 c – The existence of fixed assets is the choice that has the least amount of subjectivity in it A fixed asset either exists, or it does not There are no categories in between Therefore, this is the area in which the external auditor will most likely use the work of the internal auditor 260 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Answers to Questions 47 c – One of the purposes of the management representation letter is to reduce the risk of their being a misunderstanding of the responsibilities of the two parties This is accomplished through an inclusion in the letter a section about these responsibilities 48 b – The signatures on the management rep letter need to cover the time period from the beginning of the first year presented to the date on the letter itself 49 a – In respect to the minutes of the board meetings, one example not being available is material, because a lot may have been discussed at that one meeting that is relevant to the audit as a whole 50 b – This is not an analytical procedure, but rather sampling because it does not compare the relationship between two different items 51 c – The square footage of selling space is very good financial information for n analytical procedure From this we can estimate sales by using ratios from last year, industry averages or other items The remaining choices would be difficult to compare to some sort of financial value 52 d – In this situation, what has changed for the company is that everything related to receivables has doubled in size This will best be explained by the opening of another store 53 c – In this question we need to recognize that it is about the results of operations, which is a fairly general item that is being evaluated Choice c is the only more general item among the choices as the other three choices relate to a very specific element of the company’s operations 54 a – The specialist should generally be referred to only if the referral will explain a particular item within the report If the findings of the specialist are the reason behind the going concern opinion, then the auditor will probably refer to the specialist in the report 55 b – The lawyer’s response to the letter sent by the auditor is simply corroborative evidence for the other work of the auditor The auditor should not rely solely on the information provided by the lawyer 56 c – One of the procedures that the auditor needs to perform is to discuss with management its policies for the evaluation of and accounting for litigation and claims The other choices are not things that the auditor would The lawyer is not going to make an assessment about the going concern issue and the lawyer is not the party to confirm that all litigation has been disclosed 57 b – The problem for the auditor with this response is how much is less? Is it $1 less or $1 million less than the amount being claimed by the other party 58 c – The first thing that an auditor must with a related party transaction is to understand why it took place It is possible that the related party transaction (if it is a no interest loan) indicates a going concern issue 59 d – The disclosure of related party transactions is the most important thing for the auditor This is because there is nothing wrong with a related party transaction, as long as it is properly disclosed 60 c – If the company claims that related party transactions are carried out as if they are at an arm’s length when this statement is not able to be proven, the auditor will modify an unqualified opinion This statement may be proven if there are similar transactions under similar terms carried out with non-related parties 61 d – What is in the management representation letter will probably not greatly affect the content of the working papers since the management rep letter is simply a confirmation of what management has told the auditor during the audit Therefore, there should be nothing in this letter that the auditor is not already aware of 62 a – The working papers are the support for the conclusions that are drawn by the auditor This support needs to be documented in case the auditor ever needs to defend the conclusion that they drew 63 a – The auditor will be most concerned with anything that is classified as an asset without some justification or audit evidence to support it This is the debit that management believes will benefit future operations The auditor will have to find corroborating evidence for management’s claim 64 d – Analytical procedures will be useful in detecting strange journal entries Because of the strangeness of the journal entries, the relationships that are looked at through analytical procedures will not be what was expected This will cause further investigation by the auditor and lead to the discovery of these journal entries 65 c – In testing existence the auditor is testing that what is recorded in the financial statements actually exists Therefore, they will start with the accounting records and then find the supporting evidence to prove that the item that has been recorded actually exists 66 d – If the person filling out the bank confirmation is not aware of all of the relationships between the client and the bank, the usefulness of the confirmation is reduced The other three choices should simply not occur within the bank itself © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 261 Answers to Questions CPA Audit 67 c – When a receivable confirmation is not received, the first step is to ask the client to contact the customer to ask that the confirmation be returned 68 a – In order to discover lapping, the auditor needs to compare the date on which the check was received and the date that the clients receivable was credited 69 c – Confirmations of receivables not test completeness because it is unlikely that the customer will disagree if the amount is less than they feel they owe 70 d – By checking the numerical shipping documents and the associated invoices, the auditor is testing to make certain that everything that has been shipped has been included This is testing completeness 71 b – By tracing the test counts (what was counted) to the list of what is included in the inventory count, the auditor is testing completeness If the work was done the other way (from the inventory list to the test counts) it would be testing existence 72 c – This is the opposite of question 11 In order to test that everything exists the auditor needs to trace from the inventory list to the test counts 73 b – Rights and obligations is testing that everything that the client says that they own is actually something that they own This will be tested by checking to see if any of the inventory has been pledged as collateral or is subject to a lien Either of these would indicate that the company does not have complete ownership rights in the inventory 74 d – By analyzing the amounts in the expense account, the only thing that the auditor can test is that any purchases of fixed assets have not been expensed 75 b – Usually the accumulated depreciation account has a credit balance If the debits are the result of retirements during the year, the auditor will most likely be satisfied (of course, assuming that there were actually retirements 76 d – If the auditor is unable to confirm the contents of a safe deposit box at year end, the bank should be asked to seal the box until it may be opened in the presence of the auditor 77 b – By determining if the investments are held in the name of the client, the auditor is testing rights and obligations 78 b – If we are testing that everything that the company was billed for was received, the population needs to be everything that the company was billed for 79 d – If there is a low risk for payroll, the audit procedures may be limited to analytical procedures and the recalculation of the payroll amounts This recalculation is more likely to uncover any errors or other items of importance than any of the other three listed tests 80 d – The restriction on retained earnings is an issue that is related to disclosure Thus, this is testing the assertion of presentation and disclosure 81 d – By definition, the auditor has a responsibility to detect all material misstatements in the financial statements, no matter what the cause of the misstatement 82 d – When documents that should be readily available are not, this will cause the auditor to consider if there is a larger problem (some sort of fraud) behind the unavailability of the documents 83 a – When collusion (two or more people working together to get around a control) is present, it is much more difficult to detect fraud since it is being actively covered up 84 b – Checks made payable to cash are one of the warning signs of illegal acts This does not mean that an illegal act has occurred, but it may be an indication 85 a – The nature of the act needs to be understood so that the auditor may assess the impact on the financial statements Of course, every illegal act is significant, but the client needs to make sure that the risk to the financial statements is understood and addressed 86 c - This is when the auditor concludes that the balance is incorrect because the sample was incorrect, when in reality the balance is correct 87 d – The risk of assessing control risk too high is where the auditor will say the system does not work, when in reality it does This will cause the auditor to more work than is necessary because s/he is not relying on a system that in reality works 88 d – If control risk is assessed too low then the auditor is going to say that controls are working when in fact they are not This is related to the effectiveness of the audit 89 a – Testing internal control procedures is a method where the auditor can conclude that the organization’s control procedures are operating effectively 262 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Answers to Questions 90 b – Internal control procedures are considered to be operating as intended if during a testing procedure a voucher that had been properly voided is replaced by another voucher If a voucher had not been properly voided then the error would be detected 91 b - A deviation in the test of controls does not mean that there is a mistake in the financial statements as there is a chance that either the client or the auditor will detect the error before it reaches the financial statements Thus, deviations from specific internal control procedures at a given rate ordinarily result in misstatements at a lower rate 92 c - Nonstatistical sampling is also an effective method of sampling; it just does not provide the statistical measures provided by statistical sampling 93 b – For attribute sampling the auditor would take into account the relationship between the item to be tested and the objective of the test of controls This is good to look at segregation of duties, i.e., proper supervisor approval 94 b – In this case, the auditor would stratify the cash disbursements population so that the unusual large disbursements are selected 95 d - If the actual deviation plus the allowance for sampling error is less than the tolerable deviation rate, the auditor will most likely accept the control as working to the extent that it was expected to be working 96 a – The auditor should consider the tolerable rate of deviation from the control activity and the likely rate of the deviations The auditor would not consider the allowable risk of assessing control risk too high 97 a - If the auditor selects a sample of every twentieth item then the sample size is 5% If the tolerable misstatement is established at $60,000, then no item should not exceed $3,000 ($60,000 x 5%) Thus, $3,700 exceeds the tolerable level 98 c – The estimated population dollar value is $5,500,000 To calculate: 1) Divide audited value by the number of items = $1,100 ($220,000/200) 2) Multiply $1,100 by the population = $5,500,000 ($1,100 x 5,000) 99 d - The estimate of the population dollar value using difference estimation sampling would be $5,700,000 To calculate: 1) Subtract audited value by the number of items and divide by number of items = $100 (($220,000 - $200,000) / 200) 2) Multiply $100 by the population = $500,000 ($100 x 5,000) 3) $500,000 + $5,200,000 = $5,700,000 100 d – The estimate of the population dollar value using ratio estimation would be $5,720,000 To calculate: 1) Divide $220,000 by $200,000 = 1.1 2) Multiply 1.1 by $5,200,000 = $5,720,000 101 b – At a confidence level of 95%, the confidence coefficient = 1.96 P2 = [ (1.96)2 x (35/200) x [1 – (35 / 200)] ] / 200 P2 = 0028 P = 5.3% 102 b – The selection interval is $15,000 ($750,000 / 50) If the first random selection is 4,719, the second item would be 19,719 (15,000 + 4,719) The third would be 34,719 The closest number is 35,482 103 a – Because an error that is actually made may be so destructive and expensive, the company should focus on preventive controls to prevent the mistakes from occurring in the first place 104 c – If there are no paper records produced by the client, the auditor will need to perform audit procedures continuously throughout the year while the records exist 105 d – The auditor should initially focus on general control procedures 106 a – Flowcharts are a useful and efficient place to start to understand the control system 107 c – By actually entering invalid access codes, the auditor may obtain first hand information about the operating effectiveness of the controls 108 c – By inputting test data into the system, the auditor can test whether or not invalid employee numbers are recognized by the computer system 109 d – By definition 110 d – By definition This is the sum of all of the invoice numbers in the batch 111 b – By definition The record count is how many items are in the batch 112 b – In a test data approach, the auditor prepares information and puts them through the client’s system, while it is under the control of the auditor 113 a – By definition 114 b – Proper approval of the time cards is something the auditor cannot test by using test (created) information This test needs to be done using the original cards © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 263 Answers to Questions CPA Audit 115 b – By using test data through the processing system, the auditor can test if there is anything inappropriate being done to the data while it is being processed in the computer 116 d – Because the auditor will never be able to be 100% certain about the financial statements, the auditor provides only reasonable assurance that the financial statements are free from material misstatement 117 b – Internal controls of the company are not referred to in a regular audit 118 c – Whenever another auditor is involved, the auditor will need to evaluate the firm’s professional reputation and independence 119 d – If the auditor hired and supervised the other auditor, it is very unlikely that the auditor would make reference to the other auditor in their report 120 d – As with the earlier question, the auditor needs to be certain about the professional reputation and independence of the other auditor, in any case where there is another auditor 121 a – If there is a remote chance of a loss, this will not affect the opinion in any way The auditor may give an unqualified opinion and will not need to add an additional paragraph 122 c – A change in the useful life of an asset is simply a change in estimate This is not an issue of consistency 123 d – This inclusion of a paragraph about related party transactions does not impact the type of opinion given So, this paragraph may be added to an unqualified opinion It is simply the emphasis of a matter 124 b – When there is another auditor, the standard audit report is modified, but there is not an additional paragraph In the other cases, an additional paragraph is required 125 a – By stating who audited what, the auditor is creating a division of responsibility 126 b – If a financial statement is missing, this is a qualification to the opinion 127 c – Because King was able to gain evidence about the beginning inventory balance through other procedures, it can issue an unqualified opinion that does not have any additional paragraph(s) 128 d – If the client fixes a mistake that led to a qualified opinion in a previous year, the auditor may issue an unqualified opinion on those same financial statements in later years when the mistake is fixed 129 c – One of the things that the predecessor auditor must when reissuing an opinion is to compare the financial statements that they audited with what is being presented as comparative in the current year to make certain that they are the same 130 b – When a dual-date report is given, the responsibility of the auditor up to the second date is limited only to the specific item 131 b – If the auditor discovers that there was an unrecorded contingency, this will cause the auditor to make inquiries as to what this is and also determine if there are other unrecorded items The other choices not give evidence about an event that existed at the balance sheet date 132 b – If management refuses to make an adjustment or restatement of the financial statements, the first step for the auditor is to inform the board of directors of this situation 133 c – If other procedures that were performed compensate for the procedures that were omitted, the auditor most likely will not perform the missed procedures 134 b – The only responsibility for the auditor in the case of preparing financial statements, but not auditing them, is to read the financial statements to make certain that they are free from material misstatement 135 b – Third party agreements for financial support may indicate a going concern issue for a company 136 c – If management is able to sell assets, this will mitigate (offset) the going concern problem This is because the company needs to conserve cash by either increasing cash inflows or decreasing cash outflows 137 a – If cash flows from operating activities are negative, that is not a good sign for the long-term health of the company 138 a – If the issue regarding going concern is eliminated and does not exist in the period following a period when a going concern opinion was issued, the auditor should not repeat the opinion from the previous year in the current audit opinion 139 c – If there is information in the annual report that does not agree with the financial statements, this needs to be disclosed However, this does not impact the opinion on the financial statements themselves Therefore, it is simply disclosed in an additional paragraph like an emphasis of a matter 140 c – The auditor needs to apply limited procedures only to the additional information that is not part of the financial statements 141 c – By definition When the auditor reports on information accompanying the financial statements, the opinion is given in respect to the financial statements taken as a whole 264 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited CPA Audit Answers to Questions 142 c – The opinion given for Other Comprehensive Basis of Accounting does not include an opinion about the appropriateness of the use of the other method 143 b – The cash receipts and disbursements method is a comprehensive basis of accounting, so a contrary statement should not be included 144 c – This is one of the situations in which a special report is given, so this engagement can be accepted 145 b – By definition The assurance given in an underwriter’s letter in respect to unaudited financial statements is negative assurance 146 b – The underwriter’s letter is not part of the registration statement as required by the SEC, so the letter should include a sentence stating this 147 a – Because the engagement was to express an opinion on a description of the controls placed in operation, no opinion regarding their effectiveness should be given 148 c – When incomplete information is presented that was derived from complete financial statements, the comparison in the report is made to the complete financial statements taken as a whole 149 b – In order to assure that the accountant is not held responsible for this report, the report includes a statement that the final responsibility for accounting for the item rests with the client and their management 150 d – When reporting under the GAAP of another country, the auditor needs to be familiar with those GAAP requirements 151 b – This is one of the very few things that an accountant needs to in a compilation 152 d – The accountant must always read the financial statements about which they are expressing any sort of opinion 153 c – In the compilation report the auditor states that he or she does not express an opinion or any other form of assurance on the financial statements 154 a – The accountant does not need to assess internal controls in the performance of a review 155 b – The comparison of financial statements from one year to the next is one of the steps done by the auditor during a review 156 b – In a review, the auditor needs to know and understand how the client accounts for transactions 157 d – Because there is no consideration of internal controls during a review, there is no communication of material weaknesses in a review 158 c – By definition, this is part of the review report 159 d – A review simply identifies if any material modifications need to be made in order for the financial statements to be in conformity with GAAP 160 d – Of these items, only inadequate disclosure requires the modification of a review report on interim information 161 d – Departures from GAAP are disclosed in a separate paragraph to the review report 162 b – As with the previous question, departures from GAAP are disclosed in an additional paragraph to the report 163 a – In the case of many and material departures from GAAP, the auditor should most likely withdraw from the engagement 164 c – In a compilation report it is implied that the auditor is independent The auditor does not need to be independent, but a lack of independence needs to be disclosed Therefore, if there is nothing about independence in the report, it is implied that the auditor is independent 165 d – In this situation, either of the options is an acceptable reporting form 166 b – When more than one level of service is performed, the report should be in the form appropriate for the highest level of service performed 167 d – Because there are disclosures for one year, but not the other, these are not comparative financial statements, and Clark cannot report on them 168 b – If the prescribed form is something other than what the auditor would like to sign, they should reword the form or attach another report 169 c – Agreed-upon procedures reports include a phrase on the limitations of the report 170 c – Either forecast or projections are acceptable for limited use 171 d – A bank negotiating with the company would be an acceptable recipient of a report on a financial projection 172 b – In an examination the accountant needs to evaluate the financial statements and the support underlying the assertions of management © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited 265 Answers to Questions CPA Audit 173 d – A report for pro forma financial information needs to include a reference to the financial statements from which it was taken 174 c – By definition, this is included in the report on internal controls 175 b – In order to accept an engagement to report on internal controls, management must present their assertions to the auditor 176 a – By definition, this is part of the report on compliance with laws and regulations 177 d – The auditor will communicate with the federal inspector only if the client fails to report what needs to be reported 178 b – Under the Single Audit Act, materiality is determined for each grant individually 179 b – By definition, this is part of the report on internal control 180 b – The work papers need to be complete and detailed enough so that there is no need for additional explanation 181 b – The audit is designed to provide reasonable assurance that material misstatements will be detected 182 a – The provision of advisory services does not impair independence, whereas all of the other listed choices will 183 d – If a sibling (brother or sister) works in an internal audit function at the client, the auditor will not be independent 184 d – If the auditor’s bank account at a client is bank is fully insured, that deposit will not cause impairment of independence 185 d – When a partner dies in a firm, the work papers may be made available to the surviving partner(s) In the other cases, the work papers may only be made available with a subpoena or the client’s consent 186 d – The account-client privilege is one that is given by state law Therefore, it can only be claimed in a state in which that privilege exists 187 b – Tax accountants can accept referral fees and commissions However, they should be disclosed to the client (and the question instructs us to assume appropriate disclosure) 188 b – Receiving referral fees is the most likely of these to be a violation of the profession’s ethical standards, but it may not be a violation if everything was disclosed 189 d – In a situation where a CPA works in a firm in which not all partners are CPAs, the CPA can sign his or her name using the CPA designation, but cannot give the impression that all of the partners in the firm are CPAs 190 d – When a client terminates a relationship and demands the return of records, the records must be promptly returned An accountant may retain working papers, but not client records 191 c – Both of these are services that the CPA may perform as part of a consulting engagement 192 c – Whenever the CPA has reservations about the benefits of the engagement to the client, he or she needs to inform the client of these reservations 193 b – The client must be advised of errors that are discovered, so that s/he can take proper action However, the CPA is not under an obligation to disclose the errors to any third party 194 a – As stated in SSTS regarding knowledge of errors in a tax return 195 b – If the CPA knows, or should have known, that he has received false information, he has the responsibility to verify it with the client 266 © 2012 HOCK international, LLC For personal use only by original purchaser Resale prohibited ... different types of auditors are: • Independent auditors are the external auditors that perform financial statement audits • Internal auditors are the individuals who work for and perform audits within... skills employed by the audit firm may be used to perform audit procedures as part of the audit team’s work on the audit If such a professional is part of the audit team, the auditor’s responsibilities... the Engagement CPA Audit The purpose and objective of planning the audit are the same whether the audit is an initial or recurring engagement However, for an initial audit, the auditor may need