Test bank auditing and assurance principles ch13 substantive audit testing financing and investing cycle

Chapter 13 Substantive Audit Testing: Financing and Investing Cycle 213 Substantive Audit Testing: Financing and Investing Cycle MULTIPLE CHOICE: Which of the following expressions is least likely to be included in a client's representation letter? a No events have occurred subsequent to the balance sheet date that require adjustment to, or disclosure in, the financial statements b The company has complied with all aspects of contractual agreements that would have a material effect on the financial statements in the event of noncompliance c Management acknowledges responsibility for illegal actions committed by employees d Management has made available all financial statements and related data ANSWER: C When reviewing working papers, an audit supervisor will be primarily concerned with determining whether the a Audit programs have been carried out without deviation b Working papers adequately support the audit findings, conclusions, and reports c Working papers reflect adherence to budget constraints d Auditing department's standard formats and tick marks have been used consistently ANSWER: B A written representation from a client's management which, among other matters, acknowledges responsibility for the fair presentation of financial statements, should normally be signed by the a Chief executive officer and the chief financial officer b Chief financial officer and the chairman of the board of directors c Chairman of the audit committee of the board of directors d Chief executive officer, and the chairman of the board of directors, and the client's lawyer ANSWER: A 214 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle Generally accepted auditing standards require the auditor to apply analytical procedures in both the planning and review stages of the audit The major reason for applying analytical procedures as part of audit review is a To identify abnormalities that warrant audit attention b To assist the auditor in establishing materiality thresholds c To ascertain that the auditor has gathered adequate evidence to resolve suspicions arising during the planning stages of the audit d To provide documentary evidence in the event of future litigation ANSWER: The existence of a related party transaction may be indicated when another entity a Sells real estate to the corporation at a price that is comparable to its appraised value b Absorbs expenses of the corporation c Borrows from the corporation at a rate of interest which equals the current market rate d Lends to the corporation at a rate of interest which equals the current market rate ANSWER: B The main purpose of the auditor/client conference held at the close of audit field work is to a Discuss unresolved matters and audit fee arrangements b Review proposed audit adjustments, internal control weaknesses, and needed disclosures, and agree on the type of audit report to be rendered c Discuss areas of major audit risk and use of client personnel to assist in high risk areas d Arrange for a meeting with outside legal counsel for the purpose of discussing pending litigation ANSWER: C B After discovering that a related party transaction exists, the auditor should be aware that the a Substance of the transaction could be significantly different from its form b Adequacy of disclosure of the transaction is secondary to its legal form Chapter 13 Substantive Audit Testing: Financing and Investing Cycle c d Transaction is assumed to be outside the ordinary course of business Financial statements should recognize the legal form of the transaction rather than its substance ANSWER: B An attorney is responding to an independent auditor as a result of the audit client's letter of inquiry The attorney may appropriately limit the response to a Asserted claims and litigation b Matters to which the attorney has given substantive attention in the form of legal consultation or representation c Asserted, overtly threatened, or pending claims and litigation d Items which have an extremely high probability of being resolved to the client's detriment ANSWER: 10 A Which of the following matters describes a "reportable condition" that should be included in the auditor's communication of the same? a A significant audit adjustment was required because a major year-end adjustment was inadvertently overlooked by the client b The client's recently installed on-line real-time computer system lacks necessary input editing features c A major customer of the client is verging on bankruptcy d The auditors not agree with the economic feasibility of the client's proposed acquisition of a new subsidiary ANSWER: 215 B An auditor is verifying a company's ownership of equipment What is the best evidence of ownership? a The current year's depreciation expense journal entry b A canceled check written to acquire the equipment c An interview with the equipment custodian verifying company ownership d The presence of the equipment on the company's balance sheet ANSWER: B 216 11 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle If a lawyer refuses to furnish corroborating information regarding litigation, claims, and assessments, the auditor should a Honor the confidentiality of the client-lawyer relationship b Consider the refusal to be tantamount to a scope limitation c Seek to obtain the corroborating information from management d Disclose this fact in a footnote to the financial statements ANSWER: 12 In auditing investments for proper valuation, the auditor should all but the following: a Confirm securities held in safekeeping off the client's premises b Vouch purchases and sales of securities by tracing to brokers' advices and canceled checks c Compare cost and market by reference to year end market values for selected securities d Recalculate gain or loss on disposals ANSWER: 13 A When examining a client's statement of cash flows for audit evidence, an auditor will rely primarily upon a Determination of the amount of working capital at year-end b Cross-referencing to balances and transactions reviewed in connection with the examination of the other financial statements c Analysis of significant ratios of prior years as compared to the current year d The guidance provided by the APB Opinion on the statement of cash flows ANSWER: 14 B B A limitation on the scope of the auditor's examination sufficient to preclude an unqualified opinion will always result when management a Prevents the auditor from reviewing the working papers of the predecessor auditor Chapter 13 Substantive Audit Testing: Financing and Investing Cycle b c d Engages the auditor after the year-end physical inventory count is completed Fails to correct a material internal control weakness that had been identified during the prior year's audit Refuses to furnish a client representation letter to the auditor ANSWER: 15 C Which of the following audit procedures provides the best evidence about the collectability of notes receivable? a Confirmation of note receivable balances with the debtors b Examination of notes for appropriate debtors' signatures c Examination of cash receipts records to determine promptness of interest and principal payments d Reconciliation of the detail of notes receivable and the provision for uncollectible amounts to the general ledger control ANSWER: 17 D When an audit is made in accordance with generally accepted auditing standards, the auditor should always a Test control procedures by reprocessing a representative sample of completed transactions b Examine all negotiable and nonnegotiable securities, regardless of location c Obtain certain written representations from management d Observe the taking of the physical inventory on the balance sheet date ANSWER: 16 217 C An audit program for the examination of the retained earnings account should include a step that requires verification of the a Market value used to charge retained earnings for a two-for-one stock split b Approval of the adjustment to the beginning balance as a result of a write-down of an account receivable c Authorization for both cash and stock dividends d Gain or loss resulting from disposition of treasury shares ANSWER: C 218 18 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle In testing the reasonableness of interest income, an auditor could most effectively use analytical tests involving a The beginning balance in the investments account for fixed income securities b The average monthly balance in the investments account for fixed income securities c The ending balance in the investments accounts for fixed income securities d Documentary support of specific entries in the account ANSWER: 19 Which of the following would provide the best form of evidential matter pertaining to the annual valuation of a long-term investment in which the independent auditor's client owns a 30% voting interest? a Market quotations of the investee company's stock b Current fair value of the investee company's assets c Historical cost of the investee company's assets d Audited financial statements of the investee company ANSWER: 20 B D Which of the following is a "Type I" subsequent event? a The client's Long Island warehouse was destroyed by fire two weeks following the balance sheet date The warehouse and its contents were uninsured and represented 15% of the client's total assets b As the result of an uninsured flood loss, one of the client's major customers declared bankruptcy The client doesn't expect to recover more than 5% of the outstanding receivable which accounts for 30% of total accounts receivable The flood and bankruptcy declaration both occurred after the balance date but before the release of the audit report No additional provision for loss had been made as of year end c Three weeks after the balance sheet date, a major strike was called by the labor union representing 80% of the client's work force d After the balance sheet date, but prior to release of the audit report, a product liability judgment against the client was rendered by a judge The judgment assessed damages and fines totaling 30% of audited net income The events giving rise to the judgment occurred prior to the balance sheet date The client does not plan to appeal the decision Chapter 13 Substantive Audit Testing: Financing and Investing Cycle ANSWER: 21 A Which of the following matters should not be included in the auditor's letter of communication with the client's audit committee? a An audit adjustment was required reducing inventory by 40% b Management was reluctant to answer the auditor's questions concerning the economic substance of material related party transactions c Contrary to a previous understanding, the client did not have an adjusted trial balance completed prior to the commencing of audit field work Moreover, several errors were detected by the audit team as a result of significant weaknesses in internal control d An internal control weakness discovered during the previous year's audit was corrected during the current year ANSWER: 23 D Which of the following statements regarding the audit of negotiable notes receivable is not correct? a The auditor should confirm all notes receivable as of the balance sheet date b Materiality of the amount involved is a factor considered when selecting the accounts to be confirmed c Physical inspection of a note by the auditor does not provide conclusive evidence d Notes receivable discounted with recourse need to be confirmed ANSWER: 22 219 D Apex, Incorporated issued common stock to acquire another company, in an acquisition that was accounted for as a pooling of interests The auditor examining this transaction would be least interested in a The net book value of the acquired company b The par value of the stock that was issued c Whether or not the acquisition was approved by the board of directors of Apex, Incorporated d Whether the fair market value of the acquired assets were independently appraised ANSWER: D 220 24 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle An internal auditor discovered an error in a receivable due from a major stockholder The receivable's balance accounts for less than one percent of the company's total receivables Would the auditor be likely to consider the error material? a Yes, if relative risk is low b No, if there will be further transactions with this stockholder c Yes, because a related party is involved d No, because a small dollar amount is in error ANSWER: 25 Two months before the year end, the bookkeeper erroneously recorded the receipt of a long-term bank loan by a debit to cash and a credit to sales Which of the following is the most effective procedure for detecting this type of error? a Analyze the notes payable journal b Analyze bank confirmation information c Prepare a year-end bank reconciliation d Prepare a year-end bank transfer schedule ANSWER: 26 B Of the following statements regarding further analysis of materiality thresholds during audit review, which one is true? a Audit adjustments reducing net income may suggest a need to lower individual item and aggregate materiality thresholds b Audit adjustments reducing net income may suggest a need to lower the individual item threshold, but should not affect aggregate materiality thresholds c Audit adjustments that increase net income may suggest a need to lower aggregate materiality thresholds d An increase in the assessment of control risk suggests a need to lower the individual item materiality threshold ANSWER: 27 C A A written understanding between the auditor and the client concerning the auditor's responsibility for the discovery of illegal acts is usually set forth in a(an) a Client representation letter b Letter of audit inquiry Chapter 13 Substantive Audit Testing: Financing and Investing Cycle c d Management letter Engagement letter ANSWER: 28 D A letter from the company's attorney in response to inquiries about possible litigation is best described as: a Confirmation evidence b Analytical evidence c Documentary evidence d Physical evidence ANSWER: 29 221 A The auditor can best verify a client's bond sinking fund transactions and year-end balance by a Confirmation with individual holders of retired bonds b Confirmation with the bond trustee c Recomputation of interest expense, interest payable, and amortization of bond discount or premium d Examination and count of the bonds retired during the year ANSWER: B 30 Which of the following procedures would an auditor ordinarily perform during the review of subsequent events? a An analysis of related party transactions for the discovery of possible fraud b A review of the cut-off bank statements for the period after the year-end c An inquiry of the client's legal counsel concerning litigation d An investigation of material weaknesses in internal control previously communicated to the client ANSWER: 31 C Which of the following is not an audit procedure which the independent auditor would perform with respect to litigation, claims, and assessments a Inquire of and discuss with management the policies and procedures adopted for identifying, evaluating, and accounting for litigation, claims, and assessments b Obtain from management a description and evaluation of litigation, claims, and assessments that 222 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle existed at the balance sheet date c Obtain assurance from management that it has disclosed all unasserted claims that the lawyer has advised are probable of assertion and must be disclosed d Confirm directly with the client's lawyer that all claims have been recorded in the financial statements ANSWER: 32 D The auditee has acquired another company by purchase Which of the following would be the best audit procedure to test the appropriateness of the allocation of cost to tangible assets? a Determine whether assets have been recorded at their book value at the date of purchase b Evaluate procedures used to estimate and record fair market values for purchased assets c Evaluate the reasonableness of recorded values by use of replacement cost data d Evaluate the reasonableness of recorded values by discussion with operating personnel ANSWER: B 33 A CPA has received an attorney's letter in which no significant disagreements with the client's assessments of contingent liabilities were noted The resignation of the client's lawyer shortly after receipt of the letter should alert the auditor that a Undisclosed unasserted claims may have arisen b The attorney was unable to form a conclusion with respect to the significance of litigation, claims, and assessments c The auditor must begin a completely new examination of contingent liabilities d An adverse opinion will be necessary ANSWER: 34 A An audit procedure that provides evidence about proper valuation of marketable securities arising from a short-term investment of excess cash is a Comparison of carrying value with current market quotations b Confirmation of securities held by broker c Recalculation of investment carrying value by applying the equity method Chapter 13 Substantive Audit Testing: Financing and Investing Cycle d 223 Calculation of premium or discount amortization ANSWER: A 35 Hall accepted an engagement to audit the 2002 financial statements of XYZ Company XYZ completed the preparation of the 2002 financial statements on February 13, 2003, and Hall began the field work on February 17, 2003 Hall completed the field work on March 24, 2003, and completed the report on March 28, 2003 The client's representation letter normally would be dated a February 13, 2003 b February 17, 2003 c March 24, 2003 d March 28, 2003 ANSWER: 36 The auditee has just acquired another company by purchasing all its assets As a result of the purchase, "goodwill" has been recorded on the auditee's books Which of the following comparisons would be the most appropriate audit test for the amount of recorded goodwill? a The purchase price and the book value of assets purchased b The figure for goodwill specified in the contract for purchase c Earnings in excess of 15% of net assets for the past five years d The purchase price and the fair market value of assets purchased ANSWER: 37 D All corporate capital stock transactions should ultimately be traced to the a Minutes of the Board of Directors b Cash receipts journal c Cash disbursements journal d Numbered stock certificates ANSWER: 38 C A A logical substantive test for accrued interest receivable would be to 224 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle a b c d Compare the interest income with published interestinvestment records Verify the interest income by a calculation based on the face amount of notes and the nominal interest rate Verify the cost, carrying value, and market value of notes receivable Recalculate interest earned and compare it to the amounts received ANSWER: D 39 In verifying the amount of goodwill recorded by a client, the most convincing evidence which an auditor can obtain is by comparing the recorded value of assets acquired with the a Assessed value as evidenced by tax bills b Seller's book value as evidenced by financial statements c Insured value as evidenced by insurance policies d Appraised value as evidenced by independent appraisals ANSWER: D 40 An auditor who wishes to substantiate the gross balance of the account "Trade Notes Receivable" is considering the advisability of performing the four procedures listed below Which pair of procedures is best suited to this objective? I Age the receivables II Confirm the notes with the makers III Inspect the notes IV Trace a sample of postings from the sales journal to the notes receivable ledger a I and III b I and IV c II and III d II and IV ANSWER: 41 C Jones was engaged to examine the financial statements of Gamma Corporation for the year ended June 30, 2002 Having completed an examination of the investment securities, which of the following is the best method of verifying the accuracy of recorded dividend income? Chapter 13 Substantive Audit Testing: Financing and Investing Cycle a b c d Tracing recorded dividend income to cash receipts records and validated deposit slips Utilizing analytical review techniques and statistical sampling Comparing recorded dividends with amounts appearing on federal information forms 1099 Comparing recorded dividends with a standard financial reporting service's record of dividends ANSWER: 42 225 D An auditor's program to examine long-term debt most likely would include steps that require a Comparing the carrying amount of the debt to its yearend market value b Correlating interest expense recorded for the period with outstanding debt c Verifying the existence of the holders of the debt by direct confirmation d Inspecting the accounts payable subsidiary ledger for unrecorded long-term debt ANSWER: B COMPLETION: 43 Two alternative means for determining that recorded securities exist are and ANSWER: 44 INSPECTION (EXAMINATION), CONFIRMATION When examining securities, the auditor should prepare a workpaper (count sheet) that lists such data as serial number of the securities certificate, registered owner, and number of shares or par value This workpaper should then be compared with the client's investment record for agreement In this regard, the auditor tests for existence of securities by tracing from (investment record or count sheet) to the (investment record or count sheet); and the auditor tests for completeness by tracing from the to the 226 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle ANSWER: INVESTMENT RECORD, COUNT SHEET, COUNT SHEET, INVESTMENT RECORD 45 Auditing intracompany transactions for consistency and completeness is known as a test for ANSWER: 46 DISCLOSURE An audit workpaper listing unresolved matters and the ultimate disposition of these matters is commonly referred to as a(n) workpaper ANSWER: 50 ACCRUALS, DISCLOSURES Although a Type II subsequent event does not require adjustment, it may require ANSWER: 49 AUDITED Examining long-term debt agreements helps the auditor identify necessary and ANSWER: 48 ACCOUNTING SYMMETRY If investments in unconsolidated subsidiaries are accounted for under the equity method, the auditor may need to insist that the financial statements of these subsidiaries be ANSWER: 47 OPEN ITEMS The vehicle that is designed to make management more aware of their primary responsibility for fairness of financial presentation is known as the ANSWER: CLIENT REPRESENTATION LETTER MATCHING: 51 Match each of the listed objectives with the auditing procedure that best meets the objective A Examine securities and record serial numbers for later comparison with recorded accountability B Examine audited financial statements of 30% owned subsidiary Chapter 13 Substantive Audit Testing: Financing and Investing Cycle 227 C Verify by reference to Standard & Poor’s or Moody’s D Inquire of management as to nature of investments and reasons for holding them E Obtain bank confirmations F Examine minutes of board of directors’ meetings G Recalculate on a test basis H Examine loan agreements I Examine copy of corporate charter in permanent file K Trace from securities count sheets to investment ledger _1 Has dividend revenue been properly reflected in the accounts? _2 Are securities properly classified as to current or noncurrent? _3 Have liabilities and capital stock transactions been properly authorized _4 Have details relating to preferred and common stock been adequately disclosed? _5 Has unamortized discount on bonds payable been properly determined and reflected in the financial statements? _6 Are securities properly valued using the equity method? _7 Have all securities examined been recorded? _8 Do the securities purported to be owned by the client exist? _9 Have all loans been recorded? _10 Do any of the client’s borrowing arrangements impose restrictions on dividends or on additional borrowing? SOLUTION: C D F I G B 228 10 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle K A E H PROBLEM/ESSAY: 52 For each of the following situations, (1) identify the financial statement effect(s) of the error or fraud, (2) describe procedures enabling the auditor to detect the misstatement, and (3) draft the audit adjustment(s) suggested by the procedures (a) An unsecured loan for $3.2 million was granted to Maria Juarez, the chief executive officer of Compton, Inc., at the beginning of 2002 On December 31, 2002, the company drew a check for $3.2 million on Bank A for deposit in Bank B The transaction was recorded by a debit to “cash in Bank B” and a credit to “loans receivable-officers.” The check was not listed as outstanding on Bank A It did appear as a credit on the December 31 bank statement received from Bank B On January 2, 2003, the company made a journal entry debiting “loans receivable-officers” and crediting “cash in Bank A” for $3.2 million The loan accounted for 35% of the entity’s total assets (b) George Luminas, chief executive officer of Jako Manufacturing, used a wholly-owned subsidiary to channel funds for his personal use To effect the transfer, he had the subsidiary borrow money by issuing notes guaranteed by Jako to various banks The borrowed funds, $2,300,000, were then transferred to Jako and Jako made cash advances of $1,200,000 to the subsidiary which then transferred the funds to Luminas in the form of unsecured loans The transfers from the subsidiary to Jako were recorded as “ customer deposits” and the advances from Jako to the subsidiary were debited to the “customer deposits” account To avoid auditor detection of the economic substance of these transactions, Jako did not include the subsidiary in its consolidated financial statements; nor did the company inform the auditors of the existence of either the subsidiary or the loan guarantee These are the only transactions completed by the subsidiary during the year under audit The following balances appear on the books of Jako and the wholly-owned subsidiary: Jako: Customer Deposits $1,100,000 credit Subsidiary: Notes Payable-Banks $2,300,000 credit Receivable from Parent $2,300,000 debit Payable to Parent $1,200,000 credit Receivable from Officers $1,200,000 debit 229 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle SOLUTION: (a) (1) This set of journal entries is an example of fraudulent misrepresentation in the form of kiting and the effect is to overstate cash in bank and understate loans receivable (2) The auditors should detect the fraud by obtaining cutoff bank statements from both banks and performing analysis of interbank transfers for a few days before and after the balance sheet date (3) Recommended audit adjustment: Loans receivable-officers Cash in Bank A $3,200,000 $3,200,000 (b) (1) In addition to misrepresenting Jako’s financial position, these transactions constitute misappropriation fraud by the CEO, assuming Luminas has no intention of repaying the loans The effect is to understate “loans payable to banks” - given the loan guarantee and the lack of subsidiary financial resources, these are really loans made by the banks to Jako “Loans receivable from officers” is also understated (2) The following auditing procedures should identify the related party and related party transactions: a Examination of directors’ minutes should reveal authorization to establish the subsidiary b Analysis of the “customer deposits” account and confirmation of balances with customers should disclose the substance of this account c Bank confirmation letters expressly requesting information regarding any existing loan guarantees should enable the auditors to detect the loans (3) Recommended audit adjustment: Customer deposits Receivable from officers Notes payable-banks $1,100,000 $1,200,000 $2,300,000 53 Assume that you are the audit manager in charge of the Greg’s Auto Parts audit, and that Sara Engles, the in-charge senior 230 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle auditor, has presented you with an "open items" audit workpaper describing the following unresolved issues: Greg’s Auto Parts, as of March 31, 2003, its fiscal year-end, had inventory on consignment in the warehouse of its principal customer in Dallas awaiting sale during the Spring buying season Engles had the client request the customer to confirm the existence and ownership of the inventory, but a reply has not been received as of the close of audit field work, May 17, 2003 The goods represent 11% of the total finished goods inventory Engles requested a copy of the debt restructuring agreement that would permit reclassifying certain current liabilities as “short-term obligations expected to be refinanced.” The copy was not received as of the close of audit field work If not reclassified, Greg’s balance sheet will show a current ratio of 1:1 and a quick ratio of 1:2 A loan to Ben Williams, Greg’s Auto Parts’ chief executive officer, is purportedly secured by collateral consisting of negotiable securities As of the close of audit field work, Engles has yet to examine this collateral A request for broker’s confirmation has not been received The loan is classified as a current asset and represents 20% of total current assets Required: a For each of the open items described above, identify the primary audit risk if the issue is not satisfactorily resolved b How would you resolve each item (i.e., what audit procedure(s) would you recommend?) SOLUTION: RISK: If the inventory does not exist, or if it is not owned by Greg’s Auto Parts, ending inventory and net income will be overstated AUDITING PROCEDURES: Ask the client to request the customer to return the confirmation Also arrange to have correspondent auditors in Dallas inspect the inventory on a test basis RISK: If the debt has not been restructured, the auditors, given the current and quick ratios, may need to add a Chapter 13 Substantive Audit Testing: Financing and Investing Cycle 231 paragraph to their audit report expressing doubt as to the ability of Greg’s Auto Parts to continue as a going concern AUDITING PROCEDURES: Ask the client to request the creditor to confirm the existence of the agreement directly to the auditors along with a signed copy of the agreement RISK: If this is in reality an unsecured loan, and if Williams is either unable or unwilling to repay it promptly, the client’s current debt paying ability becomes even more precarious AUDITING PROCEDURES: Arrange for inspection of the securities either by Engles or by correspondent auditors if the broker is located some distance from the client’s headquarters  ...214 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle Generally accepted auditing standards require the auditor to apply analytical procedures in both the planning and review stages... Auto Parts audit, and that Sara Engles, the in-charge senior 230 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle auditor, has presented you with an "open items" audit workpaper... (investment record or count sheet); and the auditor tests for completeness by tracing from the to the 226 Chapter 13 Substantive Audit Testing: Financing and Investing Cycle ANSWER: INVESTMENT RECORD,