Modern auditing and assurance services 5th edition leung test bank

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Testbank to accompany

Modern Auditing and Assurance Services 5e By Philomena Leung, Paul Coram, Barry J. Cooper and Peter Richardson

Prepared by

Barbara Burns Consultant

John Wiley & Sons Australia, Ltd 2011

Chapter 8: Client evaluation and planning the audit

Chapter 8 Client evaluation and planning the audit Multiple Choice 1. The initial phase of a financial statement audit involves the acceptance decision for the client in question. Which of the following is not a consideration during this phase of the audit: a. ethical considerations. b. client evaluation. c. preparation of the engagement letter. d. determining the existence of related parties.

The correct answer is d.

Feedback: Section 8.1 Acceptance and continuation of client relationships

2. Which of the following is not a consideration in the planning phase of the audit? a. obtaining an understanding of the entity's business and industry. b. assessing competence to perform the audit. c. considering audit risk. d. making preliminary judgements about materiality levels.

The correct answer is b.

Feedback: Section 8.3 Steps in planning the audit

3. In accepting an engagement, an auditor takes on professional responsibilities to: a. the public. b. the client. c. the client and the public. d. the public, the client, and other members of the profession.

The correct answer is d.

Feedback: Section 8.1 Acceptance and continuation of client relationships

4.

All of the following are ways in which an auditor can assess the integrity of management except: a. arranging a police search on the police confidential data base b. making enquiries of third parties. c. communicating with the previous auditor. d. considering previous experience with the client’s management.

The correct option is a.

Feedback: Section 8.1 Acceptance and continuation of client relationships

5. The auditor should regularly evaluate clients in respect of specified events to determine whether to continue the relationship. Which of the following is not a specified event that should prompt an evaluation? © John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

a. b. c. d.

the expiration of a time period. a significant change in the business. a change in the audit partner. the existence of conditions that would lead that auditor to reject a client had those conditions existed at the time of the initial acceptance of the audit engagement.

The correct option is c.

Feedback: Section 8.1 Acceptance and continuation of client relationships

6. In the investigation of a potential new client, if the client refuses to give permission to inquire of the existing auditor, or if the existing auditor does not respond fully, the prospective auditor should: a. consider the implications in making the acceptance or rejection decision. b. not accept the engagement. c. request a CPA Australia/ICAA-sanctioned peer review of the predecessor. d. request assistance from the ASIC. The correct option is b.

Feedback: Section 8.1 Acceptance and continuation of client relationships

7. In the investigation of a potential new client, besides inquiring of the existing auditor, the prospective auditor should make inquires of other third parties. Which of the following is least likely to be included in this inquiry? a. legal advisers/solicitors. b. bankers. c. customers. d. the chamber of commerce.

The correct option is c.

Feedback: Section 8.1 Acceptance and continuation of client relationships

8. Before accepting an engagement, the auditor should identify special circumstances and unusual risks. Which of these conditions is not directly part of a review of such a circumstance or risk? a. reviewing industry and economic data. b. identifying intended users of the audited financial statements. c. assessing a prospective client’s legal and financial stability. d. evaluating the entity’s auditability.

The correct option is a.

Feedback: Section 8.1 Acceptance and continuation of client relationships

9. In assessing independence, an audit firm may do which of the following? a. decline the engagement due to a lack of independence. b. circulate the name of a prospective client to staff to identify any relationships inconsistent with independence. c. complete a professional independence questionnaire. © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

d. all of the above.

The correct option is d.

Feedback: Section 8.1 Acceptance and continuation of client relationships

10. Which of these is not an example of an expert as defined by ASA 620 (ISA 620)? a. actuaries. b. internal auditors. c. appraisers. d. all are examples of experts as defined by ASA620/ISA620 The correct option is b.

Feedback: Section 8.1 Acceptance and continuation of client relationships

11. Which of these would not be part of a typical audit team? a. an audit partner. b. an audit manager. c. internal auditors. d. an audit senior.

The correct option is c.

Feedback: Section 8.1 Acceptance and continuation of client relationships

12. The main purpose of the audit engagement letter is to: a. avoid litigation. b. confirm the terms of the engagement. c. outline the cost of the audit d. all of the above.

The correct option is b.

Feedback: Section 8.2 Audit engagement letters

13. Which of the following is not normally found in the audit engagement letter? a. a disclaimer on detecting all material irregularities. b. the objective or purpose of the audit. c. a space for the client’s approving signature. d. the use of binding arbitration in the case of a dispute.

The correct option is d.

Feedback: Section 8.2 Audit engagement letters 14. Which of these is not an ethical consideration for the auditor in deciding whether to accept an audit engagement? a. identifying intended users of the audited financial statements. b. evaluate circumstances that would compromise their independence. c. assessing their competence to perform the audit. d. determine their ability to use due care in performing the audit. © John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

The correct option is a.

Feedback: Section 8.1 Acceptance and continuation of client relationships

15. A common fee structure for audit engagements is: a. fixed fee from a tendering process. b. contingent fee. c. daily charge-out rates plus expenses. d. out-of-pocket plus normal profit.

The correct option is a.

Feedback: Section8.1 Acceptance and continuation of client relationships

16. Setting materiality levels, assessing audit risk and its components and obtaining an understanding of the internal control structure are all part of which audit stage? a. client evaluation. b. audit planning. c. collecting audit evidence d. issuing the audit report.

The correct option is b.

Feedback: Section 8.3 Steps in planning an audit

17. The reliance on client internal audit personnel on the audit is: a. strictly prohibited by professional standards. b. acceptable whenever a client has employed them. c. acceptable if the auditor reviews and tests their work. d. acceptable if the auditor re-performs all their work.

The correct option is c.

Feedback: Section 8.1 Acceptance and continuation of client relationships

18. Which of these steps in planning the audit is out of sequence? a. obtaining an understanding of the entity’s internal control structure. b. obtaining an understanding of the entity and its environment. c. making preliminary judgements about materiality levels. d. considering the audit risk The correct option is a.

Feedback: Section 8.3 Steps in planning the audit 19. Concerning errors, irregularities and illegal acts, the auditor should plan the audit with an attitude of: a. cautious mistrust. b. seasoned pessimism. c. professional scepticism. d. adversarial pursuit.

The correct option is c.

Feedback: Section 8.3 Steps in planning the audit © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

20. When assessing the industry conditions of a client, which of the following would not normally be assessed? a. the market for the client’s products. b. competitors. c. price competition. d. economy-wide factors.

The correct option is d.

Feedback: Section 8.4 Understanding the entity and its environment

21. The least likely source of information for the auditor in obtaining an understanding of the client’s industry conditions is: a. industry Audit Guides. b. trade journals. c. industry statistics compiled by government or private agencies. d. data accumulated by the audit firm The correct option is a.

Feedback: Section 8.4 Understanding the entity and its environment 22. Which of these would not be of direct interest to an auditor who was obtaining knowledge of the entity’s business operations? a. method of obtaining revenues. b. employment. c. stock exchange listing requirements d. transactions with related parties.

The correct option is c.

Feedback: Section 8.4 Understanding the entity and its environment 23. Knowledge of the entity’s financing activities includes understanding the entity’s: a. debt structure. b. inventory management policies c. location of property, plant and equipment. d. all of the above The correct option is a.

Feedback: Section 8.4 Understanding the entity and its environment 24. Which of these best describes the auditor’s planning responsibilities concerning related parties? a. review procedures for identifying related parties. b. identify the existence of related parties c. obtain a list of all board members and place in the working papers. d. investigate the background of all related parties.

The correct option is b.

Feedback: Section 8.4 Understanding the entity and its environment

© John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

25. When obtaining knowledge about the entity’s objectives and strategies and the related business risks, an auditor should consider: a. industry developments. b. new products and services. c. expansion of the business. d. all of the above.

The correct option is d.

Feedback: Section 8.4 Understanding the entity and its environment

26. The purpose of using analytical procedures in auditing is to: a. identify inefficiencies in operations. b. test internal controls. c. identify unexpected fluctuations and relationships. d. none of the above.

The correct option is c.

Feedback: Section 8.5 Analytical procedures in planning

27. Which of the following would not be considered an analytical procedure? a. comparing source dockets with journal entries. b. comparing payroll costs with the number of employees. c. comparing actual sales to budgeted sales d. comparing financial ratio results with industry averages.

The correct option is a.

Feedback: Section 8.5 Analytical procedures in planning 28. Auditors must consider whether there are any fraud risk factors present when they are obtaining an understanding of the entity and its environment. Which of the following is not considered a fraud factor? a. incentives/pressures. b. attitudes/rationalisation. c. opportunities. d. length of employment.

The correct option is d.

Feedback: Section 8.6 Consideration of fraud risk in planning 29. A high risk condition for the fraud risk factor ‘opportunity’ would be: a. known or expected future layoffs b. that the company is close to its debt covenants. c. behavior indicating displeasure or dissatisfaction with the company or its treatment of an employee d. large amounts of cash on hand.

The correct option is d.

Feedback: Section 8.6 Consideration of fraud risk in planning © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

30. Working papers provide all of the following except: a. evidence that the audit was properly planned and carried out. b. a means of supervising the audit. c. the principal support for the financial statements. d. support for the conclusions reached.

The correct option is c.

Feedback: Section 8.7 Audit documentation

31. Working papers could be expected to contain all of the following except: a. a working trial balance. b. schedules and analyses. c. audit memoranda and corroborating information. d. a complete copy of all the auditing standards.

The correct option is d.

Feedback: Section 8.7 Audit documentation

32. Which of these would be considered an audit adjusting entry? a. a significant amount of inventory was found which had not been included in the accounts and subsequently was identified by the auditors. b. payroll owing for the last five days of the financial year was recorded by management. c. the accounts receivable balance is debited by the auditors to separately show customer accounts with credit balances relating to customer advances. d. depreciation on the office equipment was recorded by the accountant.

The correct option is a.

Feedback: Section 8.7 Audit documentation

33. The title of a certain working paper is “Proposed adjusting and reclassifying entries.” The use of the word “proposed” indicates that the: a. listed adjustments are not considered necessary. b. listed adjustments are not considered material. c. client disagrees with the adjustments listed. d. client must first approve them.

The correct option is d.

Feedback: Section 8.7 Audit documentation

34. Which of these would not normally be included in the permanent file portion of the working papers? a. extracts or copies of the company replaceable rules. b. a copy of prior years’ working trial balances. © John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

c. analysis of accounts that are important to the audit each year. d. analytical review schedules from previous years.

The correct option is b.

Feedback: Section 8.7 Audit documentation

35. Which of these would be considered a reclassifying entry? a. a significant amount of inventory was found which had not been included in the accounts and subsequently was by the auditors. b. payroll owing for the last five days of the financial year was recorded by management. c. the accounts receivable balance is debited by the auditors to separately show customer accounts with credit balances relating to customer advances. d. depreciation on the office equipment was recorded by the accountant The correct option is c.

Feedback: Section 8.7 Audit documentation

36. Anne has been preparing the audit working papers for the audit of XYZ Company and she is being very careful to use all of the basic techniques. She has given each section a heading, documented evidence and summarised the conclusions. What basic technique has Anne not included in the working papers? a. index numbers. b. cross-referencing. c. signatures and dates. d. all of the above.

The correct option is d.

Feedback: Section 8.7 Audit documentation

37. Williams, Sparks and Kent audit partners have been conducting the audit for Just Fine Ltd, an importer of fine chocolate. The auditors have requested the clients accounting staff to prepare some of the schedules and analyses. Who retains the property rights for these working papers? a. the auditors, as they are the independent contractors. b. Just Fine Ltd, as it is their staff who performed the work. b. ASIC, as all working papers must be lodged with them. c. the accounting staff, as they are acting as agents.

The correct option is a.

Feedback: Section 8.7 Audit documentation 38. How long does the Corporations Act require audit working papers to be kept for? a. it is not specified in law. b. for as long as they are useful. c. for 7 years. d. permanently. © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

The correct option is c.

Feedback: Section 8.7 Audit documentation 39. When auditing for fraud the auditors should do all of the following except: a. consider any unusual or unexpected relationships that have been identified in performing analytical procedures. b. conduct a brainstorming session to discuss the risk of fraud. c. only investigate areas where all three fraud risk factors are present. d. examine journal entries and other adjustments for evidence of possible material fraud.

The correct option is c.

Feedback: Section 8.6 Consideration of fraud risk in planning

Short Answer Short Answer 8-1 Identify the primary considerations that apply to accepting an audit engagement. For each consideration, indicate the primary steps involved in the decision to accept or reject the engagement.

Answer 8-1 Considerations in accepting an audit engagement: Client Evaluation Evaluate integrity of management Communicate with existing auditors Make enquiries of other third parties Review previous experience with existing clients Identify special circumstances and unusual risks

Ethical Considerations Evaluate independence Assess competence to perform audit

Engagement Prepare engagement letter

Determine ability to use due care

© John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

Identify intended users of the audited statements Assess potential client’s legal and financial stability Evaluate entity’s audibility Reference: Section 8.1 Acceptance and continuation of client relationships

Short Answer 8-2 To adequately plan an audit, the auditor should obtain sufficient knowledge of the entity and its selection and application of accounting policies. This includes obtaining knowledge about the entity’s business operations, investments, financing and financial reporting. For each of these areas, list two activities that the auditor would need to gain an understanding of.

Answer 8-2 Any two of each of the following: Business Operations • method of obtaining revenues • products or services and markets • conduct of operations • location of production facilities, warehouses and offices • employment • transactions with related parties Investments • capital investments activities, including investments in plant and equipment and technology, and any recent or planned changes • acquisitions, mergers or disposals of business activities • investments and disposition of securities and loans • investments in non-consolidated entities, including partnerships, joint ventures and special-purpose entities Financing • debt structure, including covenants, restrictions, guarantees and off-balance sheet financing arrangements • group structure – major subsidiaries and associated entities, including consolidated and non-consolidated structures • leasing of property, plant and equipment for use in the business • beneficial owners • use of derivative financial instruments Financial Reporting • accounting principles and industry-specific practices • revenue recognition practices • accounting for fair values • inventories • industry-specific significant accounts and transaction classes • accounting for unusual or complex transactions © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

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financial statement presentation and disclosure

Reference: Section 8.4 Understanding the entity and its environment

Short Answer 8-3 You are the senior auditor on a particular engagement. The new staff assistant who has been assigned to work on the cash area is about to begin constructing her first audit work paper.

Briefly list and discuss the essential points relating to the mechanics of working paper preparation that you would like the staff assistant to follow in completing her assignment.

Answer 8-3 Each working paper should contain the following: • Heading Ä including the name of the entity, a descriptive title and the balance date or period covered by the audit.

• Index number Ä which serves as the unique page number for identification purposes. The index system should be logical and easy to follow in moving through the work papers.

• Cross-referencing – data on a working paper that are taken from another working paper, or carried forward to another working paper, should be cross-referenced with the index numbers of those working papers.

• Evidence – all evidence obtained and examined during audit procedures needs to be documented. It is common for a series of ticks and symbols to be used to identify the different procedures applied.

• Conclusion – the results of audit procedures should be summarised, indicating whether they confirm the particular assertion being tested.

• Signature and dates – of the preparer and the reviewer to establish responsibility for the work performed and the review, and when it occurred.

Reference: Section 8.7 Audit documentation Short Answer 8-4 Smith & Jones audit firm is determining whether to accept an audit engagement with Simple Things Ltd. As this would be a new engagement the audit firm sought the client’s permission to contact the current auditor. The client did not give their permission, explaining that they did not want the current auditors to know they were thinking of changing.

Recently Simple Things Ltd had been in the media for management not disclosing an environmental disaster that occurred at one of their plant sites. The incident is still under investigation but if the company is found to be at fault then they may be subject to numerous lawsuits from the many private landholders near the plant.

From the information provided above, identify any reasons for not accepting the audit engagement with Simple Things Ltd. Answer 8-3 The client did not give permission to contact the current auditor.

• The reason for not giving permission could be cause for concern about the integrity of management as they are not being upfront with their current auditors.

• Management’s integrity is also questionable in relation to not disclosing the environmental disaster. © John Wiley & Sons Australia, Ltd 2011

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Testbank to accompany Modern Auditing and Assurance Services 4e

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The client has a high risk of litigation due to the current investigation and probable lawsuits from the environmental disaster.

• The future financial stability of the company is in doubt due to the high risk of litigation and probable fines and damages they may have to pay.

Reference: Section 8.1 Acceptance and continuation of client relationships

Short Answer 8-4 Name five items that should be included in an engagement letter.

Answer 8-4 Any five of the following: • A reminder to management that it is responsible for preparing the financial statements and providing the auditors with access to accounting records and other related information.

• The objective and purpose of the audit.

• Reference to professional standards to which the auditor will adhere.

• An explanation of the nature and scope of the audit and the auditor’s responsibilities.

• A statement to the effect that weaknesses in the entity’s accounting system identified in the course of the audit will be brought to management’s attention but may not be provided to third parties.

• An indication that management will be asked to provide certain written representations to the auditor.

• A requirement to sight all other disclosures to be issued with the financial statements.

• A statement that management is responsible for safeguarding the entity’s assets and that the audit should not be relied on for detecting all material misstatements.

• A description of any other services provided by the auditor.

• The basis on which fees will be calculated and any billing arrangements.

• A request for the client to confirm the terms of the engagement by signing and returning a copy of the letter to the auditor.

Reference: Section 8.2.Audit engagement letters

Short Answer 8-5 For each of the following, identify whether they are part of an entity’s business operations, investments or financing.

1 2 3 4 5 6 7 8 9 10

The entity is a guarantor for a subsidiary’s bank loan.

The entity is planning a takeover of a smaller company.

The entity recently loaned money to one of its management.

The entity recently began using derivatives.

The employee union negotiated a 5% pay rise on behalf of its members.

Credit policy has been increased from 30 days to 60 days due.

The entity is planning to upgrade their manufacturing plant.

The bank has imposed a debt covenant on the entity.

The entity recently sold of shares in a utilities company.

The entity has introduced a pricing policy of cost + 20%

Answer 8-5 © John Wiley & Sons Australia, Ltd 2011

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1 2 3 4 5 6 7 8 9 10

Financing.

Investments.

Business operations.

Financing.

Business operations.

Business operations.

Investments.

Financing.

Investments.

Business operations.

Reference: Section 8.4 Understanding the entity and its environment

Short Answer 8-6 Identify whether the following high risk conditions are an example of incentives/pressures, opportunities or attitudes/rationalisation risk factors: 1 2 3 4 5 6 7 8 9 10

The company is very vulnerable to interest rate fluctuations Management has significant financial interests in the entity Many asset values are based on significant estimates that involve subjective judgements Management does not place a high priority on ethical standards Management shows an excessive interest in increasing the entity’s share price The organisational structure is overly complex There is a high turnover of internal audit and information technology staff The entity’s industry is highly competitive Internal controls are not effectively monitored Management attempts to justify marginal or inappropriate accounting on the basis of materiality on a recurring basis.

Answer 8-6 1 Incentives/pressures 2 Incentives/pressures 3 Opportunity 4 Attitudes/rationalisation 5 Attitudes/rationalisation 6 Opportunity 7 Opportunity 8 Incentives/pressures 9 Opportunity 10 Attitudes/rationalisation Reference: Section 8.6 Consideration of fraud risk in planning

Short Answer 8-7 Explain the importance of analytical procedures and why auditors may also use non-financial measures in these procedures.

Answer 8-7 © John Wiley & Sons Australia, Ltd 2011

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a) Analytical procedures are an important for obtaining a more detailed understanding of the entity and for identifying areas of potential risk. The procedures allow the identification of unexpected relationships and other unusual items. These indicate areas of greater risk and the auditors can plan for them accordingly. Auditors also use non-financial information in performing analytical procedures as financial numbers may have been manipulated to show normal relationships. Therefore, the use of nonfinancial information can help identify areas of possible fraud when they identify unexpected relationships and fluctuations.

Reference: Section 8.5 Analytical procedures in planning

Short Answer 8-8 Clements & Partners are the audit firm of Manufacturing Co. and have been for 3 years. The audit firm is considering if there are any ethical or legal requirements that would prevent them from accepting the audit engagement of Manufacturing Co. again this year. The audit partner has noted the following information which may be relevant to this decision.

I. One of the junior staff members of the audit firm is related to a supervisor at Manufacturing Co. II. One of the audit partners owns 100 shares in Manufacturing Co. III. Clements & Partners provided taxation services to Manufacturing Co. in the last financial year.

IV. Frank Thomas, one of the audit partners at the firm, is the Uncle of one of the new directors of Manufacturing Co. V. The audit partner on this engagement for the last 3 years has been James Underwood.

Identify if any of the above would prevent the audit firm from accepting the engagement.

Answer 8-8 I. Due to the status of the two employees there is unlikely to be any independence issues as neither would be able to exert any influence over the audit or its conclusions.

II. It is unlikely that 100 shares is a material amount that would compromise independence. If it is possible that it could then that audit partner should not be involved in the audit or have their work reviewed if it is unavoidable.

III. Taxation services are not considered to pose any risk to auditor independence.

IV. This relationship does represent a possible conflict of interest. However, if Frank Thomas is not involved in the audit then there is no breach of independence.

V. As the engagement has not lasted for five years there is no breach of independence.

Therefore there is no indication that the engagement would not comply with ethical or legal considerations.

Reference: Section 8.1 Acceptance and continuation of client relationships

Short Answer 8-9 In order for an auditor to gain an understanding of an entity and its environment it should consider the entity’s industry conditions, regulatory environment and any economy wide factors. Give two examples of what an auditor may consider in each. © John Wiley & Sons Australia, Ltd 2011

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Chapter 8: Client evaluation and planning the audit

Answer 8-9 Any two of each of the following: Industry conditions • Understanding the market for a client’s products • Understanding the competition • Understanding the entity’s and competitors’ capacity relative to market conditions • Price competition Regulatory environment • The existence of tariffs or trade barriers • Regulatory approval of products • Industry specific accounting and disclosure requirements • Industry specific regulatory requirements Economy-wide factors • General level of economic activity • Interest rates • Availability of financing • Inflation levels Reference: Section 8.4 Understanding the entity and its environment

© John Wiley & Sons Australia, Ltd 2011

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