Auditing A Practical Approach First Canadian Edition by Robyn Moroney, Fiona Campbell, Jane Hamilton

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Auditing A Practical Approach First Canadian Edition By Robyn Moroney, Fiona Campbell, Jane Hamilton, and Valerie Warren

Email: richard@qwconsultancy.com

CHAPTER 1 INTRODUCTION AND OVERVIEW OF AUDITING SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item 1.

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Multiple Choice Questions 6 29.

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Short Answer Questions 3 47.

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Essay Questions

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Test Bank for Auditing: a practical approach, Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

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Learning Objective 1 25.

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CHAPTER STUDY OBJECTIVES 1.

Define an assurance engagement.

An assurance engagement involves an assurance provider arriving at an opinion about some information being provided by their client to a third party. A financial statement audit is one type of assurance engagement. This engagement involves an auditor arriving at an opinion about the fair presentation of the financial statements.

The audit report is addressed to the shareholders of the company being audited, but other users may read the financial statements. Learning about auditing and assurance requires an understanding of auditing and assurance terminology, including terms such as audit risk, materiality, internal controls, listed entity, and assertions.

2.

Differentiate between types of assurance services.

Assurance services include financial statements audits, compliance audits, performance audits, comprehensive audits, internal audits, and assurance on corporate social responsibility (CSR) disclosures.

3.

Explain the different levels of assurance.

The different levels of assurance include reasonable assurance, which is the highest level of assurance, moderate assurance, and no assurance. Reasonable assurance is provided on an audit of a company’s financial statements. Moderate assurance is provided on a review of a company’s financial statements that provides negative assurance. No assurance is provided in a compilation engagement.

4.

Outline different audit opinions.

An auditor can issue an unmodified and unqualified opinion, also known as a clean report, an unqualified opinion with an emphasis of matter opinion, or a modified and qualified opinion, which is issued when the financial statements contain a material (significant) misstatement (error or fraud).

5.

Differentiate between the roles of the preparer and the auditor, and discuss the different firms that provide assurance services.

It is the responsibility of a company’s governing body to ensure that their financial statements are relevant, reliable, comparable, understandable, and true and fair. It is the responsibility of the auditor to form an opinion on the fair presentation of the financial statements. In doing so the auditor must maintain professional scepticism and utilize professional judgement and due care. The firms that provide assurance services include the Big-4 international firms, the national firms (with international links), local and regional firms, and consulting firms that tend to specialize in assurance of CSR and environmental disclosures.

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Test Bank for Auditing: a practical approach, Canadian Edition

6.

Explain why there is a demand for audit and assurance services.

Financial statement users include investors (shareholders), suppliers, customers, lenders, employees, governments, and the general public. These groups of users demand audited financial statements because of their remoteness from the entity, accounting complexity, their incentives competing with those of the entity’s managers, and their need for reliable information on which to base decisions. The theories used to describe the demand for audit and assurance services are agency theory, the information hypothesis, and the insurance hypothesis.

7.

Identify the different regulators, legislation, and regulations surrounding the assurance process.

Regulators of the assurance process include the Auditing and Assurance Standards Oversight Council (AASOC), the Auditing and Assurance Standards Board (AASB), the Canadian Business Corporations Act (CBCA), Canadian Securities Administrators (CSA) and the various provincial securities commissions, and the Canadian Public Accountability Board (CPAB). Relevant legislation includes the Canadian Business Corporations Act (CBCA). The three organizations responsible for accounting designations in Canada are the Canadian Institute of Chartered Accountants (CICA), the Certified General Accountants of Canada (CGA-Canada), and the Society of Management Accountants of Canada (CMA Canada).

8.

Describe the audit expectation gap.

The audit expectation gap occurs when there is a difference between the expectations of assurance providers and financial statement or other users. The gap occurs when user beliefs do not align with what an auditor has actually done.

TRUE-FALSE STATEMENTS 1. An auditor can provide a reasonable level of assurance on information other than historical financial information.

2. A negative expression of opinion is only given when there is a disagreement with management and the auditor.

3. A compliance audit involves gathering evidence to ascertain whether the person or entity under review has followed the rules, policies, procedures, laws and regulations with which they must conform

4. An operational audit is an example of a compliance audit.

5. All modified audit reports are qualified audit opinions.

6. The most common types of assurance engagements are financial statement audits, confirmation audits, performance audits, comprehensive audits and assurance on corporate social responsibility (CSR) disclosures.

7. The nature of audit procedures refers to the reliance on evidence provided by the client and its management.

8. A reasonable level of assurance is the highest level of assurance that an auditor can provide.

9. A no assurance engagement is of little use as no assurance is given to the client.

10. It is the auditor’s responsibility to prepare the financial statements.

11. Only current investors (not potential investors) are considered to be users of the financial statements.

12. Insurance hypothesis is a means whereby the investor can guarantee the success of their investment.

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13. The expectation gap is caused by unrealistic user expectations such as the auditor providing a moderate level of assurance.

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

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MULTIPLE CHOICE QUESTIONS 14.

Mary Moras was reviewing the previous year’s audited financial statements of a clothing manufacturer. Her manager explained to her that for a financial statement audit, the clothing company was the accountable party, its shareholders were the users, and the subject matter was the financial statements. What kind of audit engagement was her manager describing? a. consulting engagement b. assurance engagement c. review engagement d. compliance engagement

15.

Vera Sobczyk spent a week at a client’s wholesale operation determining whether the client’s remittances to the tax authorities were in accordance with tax regulations.

This is an example of a(n) a. taxes payable mandate b. financial audit c. operational audit d. none of these

16.

Ming Yao reviewed the operations of a basketball academy. His objectives were to determine how effectively the academy delivered its many programs. What kind of an audit did he perform? a. operational b. compliance c. financial d. comprehensive

17.

Matt Fuller reports to the board and evaluates how the company can improve risk management practices, internal control procedures, and certain governance issues.

Who is he? a. President b. Controller c. Treasurer d. Internal Auditor

18.

Matt Stairs performed work for a client in the real estate business and issued a Notice to Reader. What degree of assurance does a Notice to Reader provide to the user of the statements? a. reasonable assurance b. moderate assurance c. no assurance

d.

none of the above

19.

Theodore Heinrich prepared a set of financial statements based on information provided to him. He checked mathematical accuracy of the data, and the client complimented him on the reasonable cost of the work he performed. Theodore performed a. a compilation b. a review c. an audit d. none of the above

20.

James Brown, the senior auditor at Yanzhou Coal Mining and Minerals, performed the following tasks: he used analytical procedures and he had discussions with management. These activities were a basis for a negative form of opinion. What did James Brown perform? a. a qualified report b. an unmodified opinion c. a compilation d. a review engagement

21.

Maggie Oh performed an audit of a client that had undergone flooding to its operations in St-Jean Sur Richelieu. The client was insured and was able to keep operating. However, there was material damage to the client’s warehouse and Maggie felt it would be appropriate to inform the users of the financial statements of this fact in the audit report. This form of audit report is called: a. an adverse opinion b. unmodified opinion – emphasis of matter c. modified opinion d. disclaimer of opinion

22.

Mary Logan was careful to undertake her audits in a most responsible manner. Her audit manager complimented her on her diligence and how well she documented her work at the different stages of the audit process. Which element of responsibility did she display? a. due care b. professional judgment c. professional scepticism d. none of these

23.

Larry Dibitonto is a partner in his firm and runs management consulting, mergers and acquisitions, insolvency, tax, and accounting services. How are these services referred to collectively? a. audit

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Test Bank for Auditing: a practical approach, Canadian Edition

b. c. d.

non-assurance services reviews none of the above

24.

While awaiting a meeting in his firm’s boardroom, the senior partner, Bill Goldsworthy, read the following statement in an article in the Globe & Mail: “The greater the perceived quality of the information contained in the financial statements, the more likely it will be relied upon by the users of that information.” This statement best describes a. the expectations gap b. agency theory c. information hypothesis d. insurance hypothesis

25.

An example of the three parties in an assurance engagement would be: a. audit client, employee, customer b. audit client, supplier, auditor c. auditor, shareholder, general public d. auditor, general public, employees.

26.

A limitation of an audit is caused by: a. the nature of financial reporting b. the nature of audit procedures c. the need for the audit to be conducted within a reasonable period of time and at a reasonable cost d. all of the above.

27.

Which of the following is NOT true about Corporate Social Responsibility assurance? a. reporting is voluntary and is becoming more widespread. b. includes both financial and non-financial information. c. is required to be performed by an auditor. d. disclosures include environmental, employee and social reporting.

28.

Which of the following would be an example of a reasonable assurance engagement? a. the review of annual financial statements. b. the audit of annual financial statements. c. the reporting of procedures performed by the auditor as agreed by the client. d. all of the above.

29.

The wording of a negative expression of opinion generally states that:

a. b. c. d.

there is nothing wrong with the subject matter. there is something wrong with the subject matter. there is nothing that has come to the attention of the auditors that would lead them to believe that the information being assured is not true and fair. there is something that has come to the attention of the auditors that would lead them to believe that the information being assured is not true and fair.

30.

In a review engagement, which of the following is least likely to occur during the engagement? a. analytical procedures b. enquiries with management and other personnel c. substantive audit procedures d. review of the internal controls of the entity.

31.

An example of an unmodified audit opinion is: a. qualified audit opinion b. adverse audit opinion c. unqualified audit opinion with an emphasis of matter. d. none of the above.

32.

Which of the following is not a type of opinion? a. qualified opinion b. modified opinion c. adverse opinion d. disclaimer of opinion

33.

The following can be said about an emphasis of matter: a. it is included when the auditor’s opinion has changed and the auditor wants to bring the users’ attention to a particular matter. b. it is only used in unqualified audit opinions. c. it is included when the auditor’s opinion has not changed and the auditor wants to bring the users’ attention to a particular matter. d. it can not be used when expressing audit opinion that has pervasive misstatements.

34.

In addition to the preparation of financial statements, it is also the responsibility of those charged with governance to: a. identify the financial reporting framework to be used in the preparation and presentation of their financial statements. b. establish and maintain internal controls that are effective in preventing and detecting material misstatements c. selecting and applying appropriate accounting policies and making reasonable accounting estimates

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Test Bank for Auditing: a practical approach, Canadian Edition

d.

all of the above.

35.

Which of the following is not true in relation to comparability: a. able to identify trends, that may influence their perception of how well the entity is doing. b. able to assess performance of the entity over time and with other entities c. able to evaluate d. all of the above are correct.

36.

Professional scepticism does not involve: a. the professional requirement that all management representations be substantiated with supporting documentation. b. seeking independent evidence to corroborate information provided by their client c. being suspicious when evidence contradicts documents held by their client or enquiries made of client personnel d. none of the above.

37.

The largest accounting firms in Canada are known collectively as the a. ‘Big-3’ b. ‘Big-4’ c. ‘Big-5’ d. ‘Big-6’

38.

As users of the financial statements, suppliers would least consider which of the following aspects of the financial statements: a. solvency of the entity b. profitability of the entity c. return on investment of the entity d. corporate social responsibility of the entity

39.

Which of the following is incorrect? A government can be considered to be a user of the general purpose financial statements because: a. it is the basis for the calculation of taxes owed to the government b. it can determine whether certain regulations have been complied with c. to gain a better understanding of the entity’s activities d. governments need to assess the entity so that they can provide the entity with grants that will benefit society.

40.

Agency theory can be described as the theory of:

a. b. c. d.

hiring an agency to review the work of the management, in this case it is the auditor. when the finance function is outsourced to an outside party, and the auditor is required to audit the outside party’s work. the relationship between the owner and the management of the business when the owner is not the manager of the business. none of the above.

41.

Insurance hypothesis tells us that: a. investors will demand that financial statements be audited as a way of insuring against some of their loss should their investment fail. b. investors can insure themselves against loss by investing in a diverse investment portfolio should an individual investment fail. c. investors cannot insure themselves against loss when investing in an entity. d. the entity can take out insurance to protect itself from such risks as employee or management fraud which can lead to material misstatements in the financial statements.

42.

The expectation gap is caused by: a. realistic auditor expectations b. unrealistic user expectations c. realistic user expectations d. unrealistic auditor expectations

43.

The expectation gap can be reduced by: a. auditors performing their duties properly b. enhanced reporting to explain what processes have been followed in arriving at an audit or a review opinion c. assurance providers reporting accurately the level of assurance being provided d. all of the above.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 14.

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SHORT ANSWER QUESTIONS S-A 44 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Rejean Tremblay feels that an internal auditor that reports to the chief financial officer of the company can be as independent as an auditor that reports to the audit committee. b) Angela Pelletier discovered a very material overstatement in the financial statements of McKenzie Growth. She felt that the misstatement would have an impact on the decisions of users of the financial statements, and indicated to her audit senior that she would be including it as an “emphasis of matter” paragraph in the audit report. c) An auditor is responsible for the preparation and fair presentation of the financial statements in accordance with International Financial Reporting Standards, and for such internal control as is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. d) An assurance engagement involves evaluation or measurement of subject matter against criteria.

Solution: a) Disagree. The internal auditor’s independence is protected best when they report to the highest level of governance, usually the Audit Committee of the Board or to the President of the company. b) Disagree. The pervasiveness of the material misstatement will require an adverse opinion.

In this case, the misstatements affect the financial statements materially and will require disclosures that are vital to a user’s understanding of the financial statements. When statements are pervasively and materially misstated, an adverse opinion is appropriate. c) Disagree. The above statement describes management’s responsibilities. An auditor has the responsibility to express an opinion on financial statements based on an audit. d) Agree. An assurance engagement is an engagement where a practitioner issues a written report and concludes on a subject matter for which the accountable party is responsible.

Therefore, a prerequisite for an assurance engagement is the existence of an accountability relationship, where one party is answerable to another for the subject matter.

S-A 45 The main assurance service the general public are familiar with are financial statement audits. Briefly describe the other services that an auditor can provide.

Solution: A compliance audit involves gathering evidence to ascertain whether the person or entity under review has followed the rules, policies, procedures, laws and regulations with which they must conform.

Performance audits are concerned with the economy, efficiency and effectiveness of an organization’s activities.

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Test Bank for Auditing: a practical approach, Canadian Edition

A comprehensive audit may encompass elements of a financial statement audit, a compliance audit and a performance audit.

Internal audits are conducted to provide assurance about various aspects of an organization’s activities.

Corporate social reporting disclosures include environmental, employee and social reporting.

S-A 46 Describe the three levels of assurance. Name the types of engagements they would come up in and the expression of opinions that would be provided by the assurance provider Solution: Level of Assurance Reasonable Limited None

Type of Engagement Audit Review Agreed-Upon Procedures

Expression of Opinion Positive Negative None

S-A 47 What does pervasive mean? When would an auditor use an audit report that was material and pervasive?

Solution: ‘Pervasive’ refers to misstatements that are not confined to individual accounts or elements of a financial statement, or, if confined, the misstatements impact an extensive portion of a financial statement or are disclosures that are vital to a user’s understanding of the financial statements.

An auditor would use an audit report that identified material and pervasive misstatements either in a situation that the auditor was either able to identify (adverse) or not able to identify (disclaimer of opinion) through sufficient and appropriate audit procedures.

S-A 48 Outline the reasons for the demand for assurance services.

Solution: Remoteness – As most users do not have access to the entity under review, this makes it difficult to determine whether the information contained in the report is a fair presentation of the entity and its activities for the relevant period.

Complexity – Most financial statement users do not have the accounting and legal knowledge to enable them to assess the complex accounting and disclosure choices being made by the entity.

Competing incentives – management may have their own incentives to present the information in a particular light which may help them achieve their own objectives. This may introduce bias in what is being presented.

Reliability – As the information is being depended upon to make important decisions, it is important that the information being presented is reliable

S-A 49 How is the expectation gap caused and how can the effects on the expectation gap be reduced?

Solution: In particular, the gap is caused by unrealistic user expectations such as: • the auditor is providing complete assurance • the auditor is guaranteeing the future viability of the entity • an unqualified (clean) audit opinion is an indicator of complete accuracy • the auditor will definitely find any fraud • the auditor has checked all transactions.

The expectation gap can be reduced by: • auditors performing their duties appropriately, complying with auditing standards and meeting the minimum standards of performance that should be expected of all auditors; • peer reviews of audits to ensure that auditing standards have been applied correctly; • auditing standards being reviewed and updated on a regular basis to enhance the work being done by auditors; • education of the public; • enhanced reporting to explain what processes have been followed in arriving at an audit (reasonable assurance) or a review (limited assurance) opinion (significant improvements have been introduced by standard setters improving assurance reporting); and • assurance providers reporting accurately the level of assurance being provided (reasonable, limited or none).

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Test Bank for Auditing: a practical approach, Canadian Edition

CASE Ca 50 Jeff Carboy owns St. LawrenceSt. Lawrence Vineyards, a successful winery in the Thousand Islands region. Annual sales are $3,500,000 and he has a $1,200,000 loan with a local bank.

Sales are split between wine sales (88%) and wine tasting and catering (12%).

Jeff has excellent personal relationships with his suppliers and has been provided with special contractual terms which allow him delays of up to 120 days to make invoice payments. These arrangements run out this year and he will have 30 days to pay after being invoiced.

The bank has made the $1,200,000 loan to St. Lawrence Vineyards based on an understanding that the company will undergo audits of its financial statements.

Jeff is an astute entrepreneur and has set up an advisory board which consists of his bank manager, another wine grower in the region, his old high school ethics instructor and track coach, himself, and his accountant.

The board has discussed certain issues including the following: The need for assurance service providers to audit his financial statements so that users can be provided with assurance that his statements are relevant and reliable.

Non-audit services that would provide advice on special projects he may be considering in the future.

A proper accounting firm to conduct an audit mandate.

Required: a) What is the objective of a financial statement audit and how does it relate to St. Lawrence Vineyards? b) Jeff Carboy’s financial statements must be relevant and reliable. What do these two terms mean in the context of this case? c) What three characteristics should St. Lawrence Vineyards’ auditors possess when conducting an audit? Explain them briefly. d) What are non-audit services? Can you describe possible non-audit services that St. Lawrence Vineyards might employ?

Solution: a) A financial statement audit provides reasonable assurance about whether the financial statements are prepared in all material respects in accordance with the financial reporting framework.

The St. Lawrence Vineyards auditors will use the rules of Canadian GAAP to ensure that the main current users (shareholders, bank, tax authorities) and potential users (suppliers, future

investors) are provided with audited statements that will provide them with assurance. The auditors will lend credibility to the information because they are independent. b) Relevant Information is relevant if it has an impact on the decisions made by users regarding the performance of the entity. For example the bank would be interested in evaluating past decisions made by St. Lawrence Vineyards management and predicting whether the entity will remain viable (that is, a going concern) into the future. This will give them confidence that the $1,200,000 loan will be repaid. Users like the bank or key suppliers of St. Lawrence Vineyards can use current information to estimate the future ability of the entity to meet its obligations.

Reliable Information is reliable when it is free from material misstatements (errors or fraud). The information must be unbiased; it must not be presented in such a way as to influence the decision-making process of the user. The best way St. Lawrence Vineyards can ensure others will perceive that its financial statements are without bias, is through an independent audit of the statements. c) When undertaking an audit, the auditor should use professional scepticism, professional judgment, and due care.

Professional scepticism Professional scepticism is an attitude adopted by the auditor when conducting the audit. It means that the auditor remains independent of the entity, its management, and its staff when completing the audit work. In a practical sense, it means that the auditor maintains a questioning mind and thoroughly investigates all evidence presented by the client. The auditor must seek independent evidence to corroborate information provided by the client and must be suspicious when evidence contradicts documents held by the client or enquiries made of client personnel (including management and those charged with governance).

Professional judgment Professional judgment relates to the level of expertise, knowledge, and training that an auditor uses while conducting an audit. An auditor must utilize their judgment throughout the audit. For example, an auditor must determine the reliability of an information source and decide on the sufficiency and appropriateness of evidence gathered, the procedures to be used in testing, and an appropriate sample size.

Due care Due care refers to being diligent while conducting an audit, applying technical and statutebacked standards, and documenting each stage in the audit process. d) Non-assurance services include management consulting, mergers and acquisitions, insolvency, tax, and accounting services.

Accounting firms are not the only providers of non-assurance services. St. Lawrence Vineyards could hire someone to review its plan to expand its vineyard operations, as an example. Other types of services: corporate social responsibility, employee safety, tax planning, insurance arrangements for key officers of the company, etc.

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Test Bank for Auditing: a practical approach, Canadian Edition

CHAPTER 2 ETHICS, LEGAL LIABILITY AND CLIENT ACCEPTANCE SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

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Test Bank for Auditing: a practical approach, Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

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Ethics, legal liability and client acceptance

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CHAPTER STUDY OBJECTIVES 1.

Describe the fundamental principles of professional ethics and list some of the specific rules professional accountants are required to follow. Each of the three professional accounting bodies has a code of professional conduct and each has the same fundamental principles of professional ethics: integrity (being straightforward and honest); objectivity (not allowing personal feelings or prejudices to influence professional judgement); professional competence and due care (maintaining knowledge and skill at an appropriate level); confidentiality (not sharing information that is learned at work); and professional behaviour (upholding the reputation of the profession). There are also specific rules that incorporate the guiding ethical principles, and which are enforceable.

Some of these rules concern: fees and pricing, advertising, contact with predecessor auditors, firm names, and professional contact.

2.

Define and explain auditor association and independence. Association is the term used to indicate a public accountant’s involvement with financial information. Public accountants should not be associated with anything false and misleading; therefore, they should take care to communicate the level of their involvement with the information.

Independence is the ability to make a decision that is free from bias, personal beliefs, and client pressures. An external auditor must not only be independent of their client, they must also appear to be independent of their client. Threats to auditor independence include self-interest, self-review, advocacy, familiarity, and intimidation threats. A selfinterest threat can occur when an auditor has a financial interest in a client. A self-review threat can occur when an auditor must form an opinion on their own work or work done by others in their firm. An advocacy threat can occur when an auditor acts on behalf of their client. A familiarity threat can occur when there is a close relationship between the auditor and their client. An intimidation threat can occur when an auditor feels threatened by their client. Safeguards to auditor independence include the code of ethics, legislation, the establishment of audit committees by clients, client acceptance, and continuance procedures, partner rotation policies, and education within accounting firms.

3.

Explain the relationship between an auditor and key groups they have a professional link with during the audit engagement. Auditors report to their clients’ shareholders. These are the owners who rely on the audited financial statements when evaluating the performance of their company. The board of directors represents the shareholders and oversees the activities of the company and its management. It is the directors’ responsibility to ensure that the financial statements being audited are fairly presented. The audit committee is responsible for liaising between the external auditor, the internal auditor, and those charged with governance to aid the board of directors in ensuring that the financial statements are fairly presented and that the external auditor has access to all records and other evidence required to form their opinion. The external auditor may use the work performed by the internal auditors after considering the function’s objectivity, technical competence and due professional care, and the effectiveness of communication between internal and external auditors.

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4.

Explain the auditor’s legal liability to their client, contributory negligence, and the extent to which an auditor is liable to third parties. Contributory negligence is where a client is found to be negligent and to have contributed to the loss suffered by the plaintiff. To successfully sue an auditor, a plaintiff must prove that a duty of care was owed by the auditor, there was a breach of that duty, and a loss was suffered as a result of that breach. Several cases are discussed in the chapter in relation to an auditor’s liability to third parties. To establish that an auditor owes them a duty of care, a third party must now establish that the auditor was aware that the third party was going to use the financial statements and that the users relied on the financial statements for the purpose they were prepared.

5.

Identify the factors to consider in the client acceptance or continuance decision.

Factors to consider include the integrity of a client, such as the client’s, reputation and attitude to risk, accounting policies, and internal controls. An auditor will gain an understanding of the client through communication with the client’s previous auditor (in the case of a client acceptance decision), staff , management, and other relevant parties.

The final stage in the client acceptance or continuance decision process involves the preparation of an engagement letter, which sets out the terms of the audit engagement to avoid any misunderstandings between the auditor and their client.

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TRUE-FALSE STATEMENTS 1.

Compliance with the fundamental ethical principles is mandatory for all members of the accounting profession.

2.

Independence in appearance is the ability to act with integrity, objectivity and professional scepticism.

3.

An example of an advocacy threat is encouraging others to buy shares or bonds being sold by the client.

4.

An effective audit committee will enhance the independence of the external audit function.

5.

When auditors divest themselves of shares owned in a client company, they are eliminating their self-review threat to independence.

6.

Objectivity refers to the obligation that all members of the professional bodies be straightforward and honest.

7.

The key difficulty for third parties in successfully claiming against the auditor is establishing that the client's management contributed to the third party's loss.

8.

Ensuring compliance with auditing regulations will not assist auditors in avoiding litigation.

9.

Third parties are anyone other than the client and its shareholders that use the financial statements to make a decision.

10.

Being negligent means not exercising due care.

11.

Auditors can avoid litigation by implementing policies and procedures that ensure all work is fully documented.

12.

When assessing client integrity, the auditor will consider the appropriateness of the client's interpretation of accounting rules.

13.

An engagement letter sets out the terms of the engagement.

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Test Bank for Auditing: a practical approach, Canadian Edition

An engagement letter does not include an overview of the client's responsibility for the preparation of the financial statements.

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ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

Ans. Item T 3.

F 4.

Ans. Item T 5.

T 6.

Ans. Item F 7.

F 8.

Ans. Item F 9.

F 10.

Ans. Item T 11.

T 12.

Ans. Item T 13.

T 14.

Ans. T F

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MULTIPLE CHOICE QUESTIONS 15.

Pete Marsh wrote up an advertisement for his firm. In his draft to the local newspaper he indicated that the firm was able to provide services that he knew it could not deliver.

Which part of the profession’s standards or codes of conduct was Pete breaking? a. objectivity b. professional behaviour c. confidentiality d. communication

16.

Cliff Marsden has been an audit manager at Copeland & Cahoon, CA’s the past ten years. Two years ago he performed human resources and internal audit functions for 9 months while his client underwent a major restructuring. His firm has a policy of changing audit partners and managers every five to seven years. He is reluctant to take on the audit because he believes there is an independence threat. Which threat is in play? a. integrity threat b. familiarity threat c. self-review threat d. advocacy threat

17.

Luanne Phong just joined the firm of Moses, Denson, and Etchevery (MDE). She found out that she owns shares in a client company of MDE. She is going to divest herself of these shares. Which threat to her independence will she be eliminating? a. self-interest threat b. self-review threat c. familiarity threat d. advocacy threat

18.

Jae Williams, CA lives in the same neighbourhood as one of her major clients. She and her children are involved in the Lord Reading Yacht Club, as are many of her client’s management employees. How would her independence threat best be described? a. self-interest threat b. self-review threat c. advocacy threat d. none of these

19.

Shayna Kirschfield audits a company that has market capitalization of $20,000,000.

There is also a requirement that the partners in her firm be rotated every seven years and the audit committee must pre-approve all services provided to the client by Shayna’s firm. What kind of client is this? a. small business b. diversified c. reporting issuer d. partnership

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20.

When Joe Girardi, CA tried to collect last year’s audit fees, he was told that he would receive the fees for the previous year and the current year upon finishing this year’s work and issuing a “clean” audit opinion. This was non-negotiable and he was told that if he did not want to go along with it, the client would get another auditor. When he decided to leave his client, what threat to his independence did he mitigate? a. self-interest threat b. self-review threat c. advocacy threat d. none of these

21.

The firm of McMaster and Martin, CA’s is concerned that its client’s current corporate culture may have an impact on the firm’s independence. What kinds of safeguards can the client introduce or create to reduce the threat to independence? a. introduce appropriate corporate governance mechanisms such as the establishment of an audit committee b. ensure that the responsibility for the appointment and removal of an auditor rests with independent directors on the audit committee or the board c. both a and b d. none of the above

22.

When the external auditors perform work they are responsible for auditing the financial statements. Which users are the auditors least likely to deal with in fulfilling their duties? a. executive directors of the board b. audit committee of the board c. shareholders d. internal auditors

23.

Brenda Beauchamp withdrew from a client engagement. The client sued her for not fulfilling the understanding in the engagement letter and can establish that Brenda owed him a duty of due care. How can this be done using legal means? a. the client can sue the auditor for breach of contract b. the client can claim that the auditor failed to take reasonable care in the performance of the audit c. both a and b d. none of the above

24.

Rob Wood has reviewed the engagement letter his firm has prepared for a client. Which of these elements would he be surprised to find? a. unrestricted access to persons within the entity in order to obtain audit evidence b. references to Canadian generally accepted auditing standards c. management’s responsibilities d. previous year’s internal control issues

25.

Which of the following is a fundamental principle of professional ethics?

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Test Bank for Auditing: a practical approach, Canadian Edition a. b. c. d.

confidentiality objectivity integrity all of the above

26.

Professional behaviour refers to the obligation that all members of the professional bodies: a. ensure that they do not harm the reputation of the accounting profession. b. not allow their personal feelings or prejudices to influence their professional judgment. c. refrain from disclosing information to people outside of their workplace that is learned as a result of their employment. d. be straightforward and honest.

27.

Objectivity refers to the obligation that all members of the professional bodies: a. be straightforward and honest. b. refrain from disclosing information to people outside of their workplace that is learned as a result of their employment. c. not allow their personal feelings or prejudices to influence their professional judgment. d. ensure that they do not harm the reputation of the accounting profession.

28.

Auditor independence is: a. defined as acting with integrity, objectivity and professional scepticism. b. essential when complying with the ethical principles to act with integrity and objectivity. c. both a and b. d. not fundamental to every audit.

29.

Independence in appearance is: a. the ability to act with integrity, objectivity and professional scepticism. b. the belief that independence of mind has been achieved. c. the ability to make a decision that is free from bias, personal beliefs and client pressures. d. also referred to as actual independence.

30.

Threats to the independence of auditors include: a. familiarity threats. b. self-interest threats. c. advocacy threats. d. all of the above.

31.

A self-interest threat refers to the threat that can occur when an accounting firm or its staff: a. is threatened by the client's staff or directors.

Ethics, legal liability and client acceptance b. c. d.

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has a financial interest in an audit client. needs to form an opinion on their own work or work performed by others in the firm. acts on behalf of its assurance client.

32.

Which of the following is an example of a familiarity threat to independence? a. a bank account held with the client b. performing services for the client that are then assured c. both a and b d. a former partner of the assurance firm holding a senior position with the client

33.

What type of threat to independence arises when an accounting firm acts on behalf of its assurance client? a. advocacy threat b. self-interest threat c. intimidation threat d. self-review threat

34.

Intimidation threats to independence include: a. the threat that that the client will use a different assurance firm next year. b. a close business relationship with the client. c. representing the client in a legal dispute. d. preparing information for the client that is then assured.

35.

Safeguards to independence are created by: a. accounting firms. b. the profession, legislation or regulation. c. clients. d. all of the above.

36.

An example of a safeguard to independence created by accounting firms is: a. the establishment of a code of ethics. b. legislation that requires that an auditor be independent. c. the existence of client acceptance and continuation procedures. d. the establishment of an audit committee.

37.

Having policies and procedures to ensure the quality of an accounting firm's service is an example of a safeguard to independence created by: a. the client's audit committee. b. the Canada Business Corporations Act. c. the client's board of directors. d. None of the above.

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38.

The main recipients of the financial statements and the attached audit report are acknowledged as: a. the board of directors. b. the shareholders or members. c. the audit committee. d. the provincial stock exchanges.

39.

Examples of board committees include the: a. risk committee. b. nomination committee. c. compensation committee. d. all of the above.

40.

It is the responsibility of the board of directors to: a. ensure that the financial statements are fairly presented. b. provide an opinion on the fair presentation of the financial statements. c. direct the auditors to audit specific financial statement accounts. d. none of the above.

41.

Executive directors are: a. part of the company's management team. b. full-time employees of the company. c. not members of the company's board of directors. d. a and b.

42.

Management failed to put in a system of adequate internal controls. The public accounting firm uncovered the weakness, but did not report it to the Board members of the company. What kind of liability, if any, would the auditors be exposed to? a. breach of contract b. contributory negligence c. a and b d. no liability

43.

The principles established by Justice Moffitt in the Pacific Acceptance case do not include: a. auditors are watchdogs but not bloodhounds. b. auditors must properly document procedures used. c. auditors have a duty to use reasonable skills and care. d. auditors must audit the whole year.

44.

Under tort law, to prove that an auditor has been negligent the plaintiff must establish: a. there was a breach of the duty of care. b. a loss was suffered as a result of the breach of duty of care. c. a duty of care was owed by the auditor. d. all of the above.

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45.

Auditors can avoid litigation by: a. ensuring compliance with ethical regulations. b. meeting with the client's nomination committee to discuss any significant audit issues. c. training their staff and regularly updating their knowledge. d. a and c.

46.

An auditor's assessment of their client's integrity would not include: a. whether the auditor has sufficiently competent staff to complete the audit. b. the client's attitude to audit fees and its willingness to pay a fair amount. c. the client's attitude to risk exposure and management. d. the reputation of the client and its management.

47.

The final stage in the client acceptance and continuance decision process involves: a. the auditor obtaining a management representation letter from the client. b. the auditor preparing an independence declaration statement. c. the client's audit committee meeting with the auditor. d. the preparation of an engagement letter.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 15.

16.

17.

18.

19.

Ans. b c a d c

Item 20.

21.

22.

23.

24.

Ans. d c c a d

Item 25.

26.

27.

28.

29.

Ans. d a c c b

Item 30.

31.

32.

33.

34.

Ans. d b d a a

Item 35.

36.

37.

38.

39.

Ans. d c d b d

Item 40.

41.

42.

43.

44.

Ans. a d b a d

Item 45.

46.

47.

Ans. d a d

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SHORT ANSWER QUESTIONS SA 48 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) To ensure that it is independent of prospective and continuing clients, an audit firm must review the threats to independence, and make certain that safeguards are put in place to limit or remove those threats. b) The final stage in the client acceptance and continuance decision process involves assessing independence threats. c) By signing the engagement letter, management is not necessarily considered to be responsible for the financial statements. d) To successfully sue an auditor, a plaintiff must only prove that a duty of care was owed by the auditor.

Solution: a) Agree. An audit firm should always assess independence before the client acceptance or continuance decision is made. b)

Disagree. The final stage in the client acceptance and continuance decision process involves the preparation of an engagement letter. An engagement letter is prepared by an auditor and acknowledged by a client before the commencement of an audit.

c)

Disagree. Management is considered to be responsible for the financial statements and acknowledges this responsibility when they sign the engagement letter.

d)

Disagree. To successfully sue an auditor, a plaintiff must prove not only that a duty of care was owed by the auditor, but also that there was a breach of that duty, and a loss was suffered as a result of that breach.

To establish that an auditor owes them a duty of care, a third party must now establish that the auditor was aware that the third party was going to use the financial statements and that the users relied on the financial statements for the purpose they were prepared.

SA 49 Explain the five fundamental principles of professional ethics.

Solution: The fundamental ethical principles that apply to all members of the professional bodies are to act with integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. Integrity refers to the obligation that all members of the professional bodies be straightforward and honest. Objectivity refers to the obligation that all members of the professional bodies not allow their personal feelings or prejudices to influence their professional judgment. Professional competence and due care refers to the obligation that all members of the professional bodies maintain their knowledge and skill at a level required by the professional bodies. Confidentiality refers to the obligation that all members of the professional bodies refrain from disclosing information to people outside of their workplace that is learned as a result of their employment. Professional behaviour refers to the obligation that all members of the

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professional bodies comply with rules and regulations and ensure that they do not harm the reputation of the profession.

SA 50 Distinguish between independence of mind and independence in appearance.

Solution: Independence is essential when complying with the ethical principles to act with integrity and objectivity. Independence of mind is the ability to act with integrity, objectivity and professional scepticism. It is the ability to make a decision that is free from bias, personal beliefs and client pressures. Independence of mind is also referred to as actual independence. Independence in appearance is the belief that independence of mind has been achieved. It is not enough for an auditor to be independent of mind; they must also be seen to be independent.

SA 51 Describe the three categories of safeguards to an auditor's independence.

Solution: Safeguards are mechanisms that have been developed by the accounting profession, legislators, regulators, clients and accounting firms. The accounting profession, legislation and regulation have created a range of safeguards including education of accountants about the threats to independence, the establishment of a code of ethics, and legislation that requires that an auditor be independent. Clients can put in place appropriate mechanisms that will reduce the threat to independence. These include having appropriate corporate governance mechanisms, such as the establishment of an audit committee and establishing policies and procedures dedicated to ensuring that the financial statements are true and fair. Accounting firms also have in place a range of safeguards to ensure independence such as policies and procedures to ensure the quality of their service and providing continuing education for their staff regarding these policies and procedures.

SA 52 Explain the purpose and major contents of an engagement letter between the auditor and their client.

Solution: The engagement letter is a form of contract between an auditor and their client. Its purpose is to set out the terms of the audit engagement, to avoid any misunderstandings between the auditor and their client. The letter confirms the obligations of the client and the auditor. It also includes an explanation of the scope of the audit, the timing of the completion of various aspects of the audit, an overview of the client's responsibility for the preparation of the financial statements, the requirement that the auditor have access to all information required, independence considerations and fees.

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ESSAY QUESTIONS ES 53 Audit committees have been widely recommended as being an important mechanism for enhancing the external auditor's independence. What are the important characteristics of audit committees and discuss why these characteristics are considered so important to a committee's effective and efficient operation.

ES 54 The key difficulty for third parties in legal action against auditors has been establishing that a duty of care was owed to them by their auditor. Explain the development of the relevant legal principles relating to an auditor's duty of care to third parties with reference to specific case law.

ES 55 Independence is considered one of the key characteristics of auditors. Explain why auditor independence is so important to the effectiveness of an audit and explain the various threats to an auditor's independence.

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CASE Ca 56 The WRI Audit Committee has a policy of changing audit firms every five years to ensure that they receive fresh approaches from different audit firms. Accordingly, the WRI Board has asked Morgan Faustini, & Feaster to replace its previous audit firm.

WRI is a manufacturer and distributor of wire ropes, industrial cables, and rigging cables and has a reputation for its ability to fill special orders and to ship across Canada from its Thunder Bay facility on time and at competitive prices. They have a reputation among their customers for going the extra mile and have kept a loyal customer base for over a century.

Jack Bonami, a new partner at Morgan, Faustini & Feaster, a growing CA firm in northern Ontario, is excited about WRI becoming a potential new client. The previous week he met with the Canadian President of WRI, Bob Rooper.

Jack Bonami quickly decided that Bob Rooper was a man of integrity and his frank and open opinions would make it a pleasure to deal with him. He also appeared to have a competent management team in place.

Jack also wanted to make an impression on his new firm by bringing in several new clients in the next year or two, as a good portion of his future compensation will be derived from new business.

He is also aware that any negligence on his part during the client acceptance phase would reflect on his professional judgment and open the firm to possible litigation.

The senior partner, Bob Morgan, has invited Jack Bonami to join him in his office to discuss WRI. Required: a) You are Bob Morgan, the Senior Partner at Morgan, Faustini & Feaster. What would be on your “checklist” of client acceptance questions? Prepare an exhaustive inventory of all the questions you would ask Jack before deciding to accept or reject WRI. b) The firm recently lost a lawsuit and has parted ways with the partner-in-charge of the aggrieved client. What can Bob Morgan do to avoid litigation?

Solution: a) The first step involves the assessment of client integrity. When assessing client integrity, the auditor will consider the following questions: 1. What is the reputation of the client, its management, directors, and key stakeholders 2. What are the reasons provided for switching audit firms (client acceptance decision) 3. What is the client’s attitude to risk exposure and management 4. What is the client’s attitude to the implementation and maintenance of adequate internal controls to mitigate (minimize) identified risks 5. To what extent is the client’s interpretation of accounting rules appropriate 6. To what extent is the client willing to allow the auditor full access to information required to form their opinion 7. What is the client’s attitude to audit fees and its willingness to pay a fair amount for the

Ethics, legal liability and client acceptance

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work completed.

Here is a possible checklist of questions with regard to the firm’s possible existing prohibitions that would preclude the firm or any staff member from performing the engagement: 8. We would ask about the prohibitions listed below: A. Financial interests in entity.

B. Loans and guarantees to/from client.

C. Close business relationships with client.

D. Family and personal relationships with client.

E. Future or recent employment with entity serving as officer, director, or company secretary of client.

F. Provision of non-assurance services such as corporate finance or legal services that involve dispute resolution.

G. Performance of management functions for the client.

H. Making journal entries or accounting classifications without first obtaining management’s approval.

I. Acceptance of gifts or hospitality from client (other than clearly insignificant).

J. Fee quote that is considerably less than market price for the engagement.

K. Provision of legal services.

L. Preparation of source documentation.

M. Provision of corporate finance services.

Are we satisfied there are no significant “threats” to independence? Address each of the following threats in relation to the firm and any member of the engagement team: A. Self-interest (i.e., where loss of client fees would be material).

B. Self-review (i.e., the nature and extent of bookkeeping services required or where a judgment from a previous engagement needs to be evaluated in reaching conclusions).

C. Advocacy (i.e., acting as an advocate on behalf of client in litigation or in share promotion).

D. Familiarity (i.e., being too sympathetic to the client’s interests).

E. Intimidation (i.e., being deterred from acting objectively and exercising professional scepticism).

Bob Morgan would also ask about whether there are any safeguards to reduce the above threat(s) to independence identified to an acceptable level. b)

One of the ways that an auditor can avoid litigation is to follow up on any significant weaknesses in the client’s internal control procedures in a previous year’s audit.

There are a number of ways that an auditor can avoid litigation. These include: A. hiring competent staff B. training staff and updating their knowledge regularly C. ensuring compliance with ethical regulations D. ensuring compliance with auditing regulations E. implementing policies and procedures that ensure: – appropriate procedures are followed when accepting a new client – appropriate staff are allocated to clients – ethical and independence issues are identified and dealt with on a timely basis

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Test Bank for Auditing: a practical approach, Canadian Edition – all work is fully documented – adequate and appropriate evidence is gathered before forming an opinion F. meeting with a client’s audit committee to discuss any significant issues identified as part of the audit G. Following up on any significant weaknesses in the client’s internal control procedures in a previous year’s audit.

CHAPTER 3 AUDIT PLANNING I SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO

Item

1.

2.

1 6

3.

4.

2 2

5.

6.

12.

13.

14.

15.

16.

1 1 2 1 1

17.

18.

19.

20.

21.

2 3 4 4 5

22.

23.

24.

25.

26.

45.

3,4,6,7 46.

1

47.

LO Item LO Item True-False Statements 4 7.

4 9.

4 8.

5 10.

Multiple Choice Questions 7 27.

2 32.

8 28.

2 33.

1 29.

2 34.

1 30.

2 35.

6 31.

4 36.

Short Answer Questions 2 48.

4 49.

Essay Questions

50.

1

51.

6

52.

2,7 Case

53.

2,8

LO

Item

LO

5 7

11.

8

4 4 4 4 5

37.

38.

39.

40.

41.

5 5 7 7 7

5

Item

LO

42.

43.

44.

7 8 8

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SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

12.

TF MC

13.

15.

MC MC

16.

24.

MC MC

3.

4.

TF TF

14.

17.

MC MC

27.

28.

MC MC

18.

MC

45.

SA

5.

6.

TF TF

7.

19.

TF MC

20.

31.

MC MC

8.

TF

9.

TF

21.

MC

2.

TF

26.

MC

45.

SA

10.

22.

TF MC

39.

40.

MC MC

41.

42.

MC MC

11.

TF

23.

MC

43.

MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 25.

MC 50.

46.

SA Study Objective 2 29.

MC 47.

30.

MC 52.

Study Objective 3 Study Objective 4 32.

MC 34.

33.

MC 35.

Study Objective 5 36.

MC 37.

Study Objective 6 51.

ES Study Objective 7 45.

SA 52.

ES Study Objective 8 44.

MC 53.

SA = Short Answer Ca = Case

Type Item

Type Item Type

ES

SA ES

53.

Ca

MC MC

45.

48.

SA SA

MC

38.

MC

Ca

ES = Essay

49.

SA

Audit Planning I

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CHAPTER STUDY OBJECTIVES 1.

Identify the different stages of an audit. The stages of an audit include planning, performing, and reporting. During the planning stage, an auditor will gain an understanding of their client, identify risks, develop an audit strategy, and set their planning materiality. During the performing stage, an auditor will execute their detailed testing of account balances and transactions. The final stage of every audit involves reviewing all of the evidence gathered throughout the audit and arriving at a conclusion regarding the fair presentation of the client’s financial statements. The auditor will then write an audit report that reflects their opinion based upon their findings.

2.

Explain the process used in gaining an understanding of the client. An auditor will gain an understanding of their client to aid in the risk identification process. This process involves consideration of issues at the entity level, the industry level, and the broader economic level. At the entity level, an auditor will identify the client’s major customers, suppliers, and stakeholders (that is, banks, shareholders, and employees). The auditor will also determine whether their client is an importer or exporter, who the client’s competitors are, what the client’s capacity is to adapt to changes in technology, and what the nature of any warranties provided to customers is. At the industry level, an auditor is interested in their client’s position within its industry. At the economic level, an auditor will assess how well positioned the client is to cope with current and changing government policy and economic conditions.

3.

Explain how related parties can impact risk. Related parties include parent companies, subsidiaries, joint ventures, associates, company management, and close family members of key management. Since related parties are not independent of each other, these transactions may not be in the normal course of business. This increases the risk of material misstatement and may impact the overall financial results. Therefore, related party transactions require some specific consideration throughout the audit and specific procedures should be performed and documented.

4.

Define fraud risk and understand audit procedures to reduce this risk. Fraud is an intentional act through the use of deception to obtain an unjust or illegal advantage. The two kinds of fraud are financial reporting fraud and misappropriation of assets fraud.

There are a number of techniques the auditor uses to assess the risk of fraud. The audit fi le must document the fraud risk assessment and procedures performed to support that assessment.

5.

Explain the going concern assumption. The going concern assumption is made when it is believed that a company will remain in business for the foreseeable future. An auditor will consider the appropriateness of this assumption during the planning stage and then throughout the audit.

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Test Bank for Auditing: a practical approach, Canadian Edition

6.

Describe corporate governance. Corporate governance is the rules, systems, and processes within companies used to guide and control. Among other things governance structures are used to assess the level of risk faced and to design controls to reduce identified risks.

7.

Explain how a client’s information technology (IT) can affect risk. There are a number of risks associated with IT. During the planning stage of the audit, the auditor will assess the likelihood that their client’s financial statements are misstated due to limitations in its IT system.

8.

Explain how client closing procedures can affect reported results. There are a number of risks associated with a client’s closing procedures. Closing procedures are the processes used by a client at year end to ensure that transactions are recorded in the appropriate accounting period. From an audit perspective, there is a risk that the client’s closing procedures are inadequate.

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TRUE-FALSE STATEMENTS 1.

The planning stage of an audit involves the performance of detailed tests of controls and substantive testing of transactions and accounts.

2.

A client's corporate governance structure is assessed when planning an audit.

3.

Auditors must gain an understanding of their client at the outset of every audit.

4.

The more competitive an audit client's industry, the less pressure is placed on the client's profits.

5.

Fraud is an intentional act to obtain an unjust or illegal advantage through the use of deception.

6.

Misappropriation of assets fraud involves intentionally misstating items or omitting important facts from the financial statements.

7.

An example of an attitude or rationalization used to justify a fraud is high volume of transactions close to year-end.

8.

Under the going concern assumption, assets are valued on the basis that they will continue to be used for the purpose of conducting a business.

9.

Mitigating factors that reduce going concern risk include the ability to raise additional funds through the sale of shares.

10.

Application controls are policies and procedures that relate to many applications.

11.

An auditor is not concerned with transactions and events being recorded in the correct accounting period.

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Test Bank for Auditing: a practical approach, Canadian Edition

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

Ans. F T

Item 3.

4.

Ans. T F

Item 5.

6.

Ans. T F

Item 7.

8.

Ans. F T

Item 9.

10.

Ans. T F

Item 11.

Ans. F

Item

Ans.

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MULTIPLE CHOICE QUESTIONS 12.

Mario Moreau was at a client’s offices and was preparing his work for the following day.

He was considering the risk that a material misstatement due to significant error or fraud could occur in the client's financial statements. Which of the three main stages of the audit was he performing? a. planning stage b. performing stage c. reporting stage d. none of the above

13.

Will Durant was meeting with his manager to plan audit strategy in order to determine the amount of time to spend testing the client's internal controls and conducting detailed testing of transactions and account balances. Determining the audit strategy occurs during which phase of the audit? a. client acceptance stage b. planning stage c. performing stage d. reporting stage

14.

Kaz Nowakowski performed several procedures, including observation and inspection of the company’s plans and business strategies. He also made inquiries of those individuals that were involved in the governance of the company, the internal auditors, and operating personnel. These procedures will help Kaz to a. determine fraud possibilities. b. prepare year end closing procedures. c. gain an understanding of the client. d. none of the above.

15.

When Sean Green started the preliminary risk identification process at a local dairy during the planning stage of the audit he endeavoured to gather sufficient appropriate evidence. Which of the following elements were involved in the preliminary risk identification? a. going concern risk b. client’s corporate governance c. understanding the IT environment d. all of the above

16.

During the planning stage of a grocery chain, Seren Dagdeviren tried to determine which procedures would be appropriate. Which of these procedures, if any, would you use in the planning phase of the audit? a. observation and inspection b. analytical procedures c. both a and b d. none of the above

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Test Bank for Auditing: a practical approach, Canadian Edition

17.

When Sheila Copes, CGA audited a new client she asked questions about what the client does, how the client functions, the ownership structure of the client and its sources of financing. She was getting an understanding of the client at the a. entity level. b. industry level. c. economy level. d. all of the above.

18.

Claudia Martel knows that financial reporting fraud transactions require disclosure.

However, she is not sure whether related party transactions require disclosure. You advise her that related party transactions require a. disclosure. b. no disclosure. c. disclosure only if there is risk of fraud. d. auditor judgment.

19.

Mary Martini’s team has been asked to tackle three ongoing frauds and her partner has asked her to follow up only on the financial reporting fraud. Which of the following items will she be pursuing? a. theft of stock by employees or customers b. employees remaining on the payroll after ceasing employment c. recording fictitious sales d. unauthorized refunds to customers

20.

Saad Zuberov is a rookie auditor who has asked you about financial reporting frauds and how they differ from misappropriation of assets frauds. Identify for Saad Zuberov which one of the following frauds consists of misappropriation of assets. a. improper asset valuation b. unrecorded liabilities c. both a and b d. none of these

21.

Eva Islam, CA is auditing a company where it is experiencing strikes regularly, has been under investigation with non-compliance with legislation and is falling behind competitors.

What kind of risk is being assessed? a. fraud risk b. going concern risk c. a and b d. none of the above

22.

Gerry Jones has been asked to review manual or automated procedures that typically operate at a business process level and apply to the processing of transactions by individual applications. What kind of controls is Gerry going to be assessing? a. output controls b. general controls

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a and b application controls

23.

Checking the accuracy of accrual calculations around year-end is an example of how auditors can assess the adequacy of their client's closing procedures. a. risk identification and strategy b. understanding the client c. risk and materiality assessment d. all of the above

24.

The execution stage of an audit involves: a. evaluating the results of the detailed testing and forming an opinion on the fair presentation of the client's financial statements. b. the assessment of the audit firm's quality control procedures. c. the performance of detailed tests of controls and substantive testing of transactions and accounts. d. gaining an understanding of the client.

25.

Preliminary risk identification can be affected by: a. fraud risk. b. corporate governance. c. Both a and b d. None of the above.

26.

Corporate governance means: a. the viability of a company to remain in business for the foreseeable future. b. the rules, systems and processes within companies used to guide and control them. c. an intentional act through the use of deception to obtain an unjust or illegal advantage. d. the processes used by a client when finalizing the accounts for an accounting period.

27.

When gaining an understanding of their client, at which level do auditors not usually consider the relevant issues? a. audit committee level b. economy level c. entity level d. industry level

28.

Which of the following is an example of information used by auditors in gaining an understanding of a client at the entity level? a. The level of competition in the client's industry b. Whether the client is an importer or exporter of goods c. The client's ability to withstand currency fluctuations

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Test Bank for Auditing: a practical approach, Canadian Edition d.

The level of government support in the client's industry

29.

In assessing the client's relationship with its employees, the auditor will consider: a. The level of unionization among the workforce. b. The attitude of staff to their employer. c. How well a client pays its employees. d. All of the above.

30.

Which of the following statements regarding the level of demand for the goods sold or services provided by companies is correct? a. If a client's products or services are seasonal, this will affect revenue flow. b. If a client operates in an industry subject to changing trends, the client does not risk inventory obsolescence. c. If a client's products or services are seasonal, this will not affect revenue flow. d. When a product or process is subject to technological change, there is never a risk that the client will be left behind by its competitors.

31.

Red flags that auditors can use to alert them to the possibility that a fraud may have occurred include: a. Strong internal controls. b. Routine transactions. c. A high turnover of key employees. d. Effective internal auditing staff.

32.

When assessing fraud risk, an auditor will adopt an attitude of: a. Confidentiality. b. Professional scepticism. c. Belief in management. d. None of the above.

33.

Which of the following is an example of a misappropriation of assets fraud? a. Unauthorized discounts or refunds to customers b. Inappropriate application of accounting principles c. Unrecorded liabilities d. Improper asset valuations

34.

When assessing the risk of fraud, an auditor can consider: a. Attitudes and rationalization to justify a fraud. b. Incentives and pressures to commit fraud. c. Opportunities to perpetuate a fraud. d. All of the above.

35.

Attitudes and rationalization to justify a fraud include: a. Significant related party transactions.

Audit Planning I b. c. d.

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An excessive focus on profit maximization.

A significant decline in demand for the client's products or services.

A high volume of transactions close to year-end.

36.

The going concern assumption is made when it is believed that: a. A company will become insolvent within the next accounting period. b. The board of directors does not believe the company's financial statements are fairly presented. c. A company will remain in business for the foreseeable future. d. A company is a separate legal entity.

37.

If auditors identify risk factors that indicate that the going concern assumption is in doubt, they will: a. Undertake procedures to gather evidence regarding each risk factor. b. Refuse to continue as the auditor of their client. c. Report the client to the Canada Revenue Agency. d. Reduce the extent of further audit testing that they undertake.

38.

Which of the following is not an example of a mitigating factor that reduces the risk that the going concern assumption may be in doubt? a. The ability to raise additional funds via borrowings b. A letter of guarantee from a parent company c. The ability to sell an unprofitable segment of the business d. Significant rapid increase in competition

39.

Risks associated with information technology include: a. Loss of data. b. Errors in programs. c. Unauthorized access to computers. d. All of the above.

40.

Unauthorized access to a company's data can occur when: a. Inadequate backups of data are maintained. b. There are poor password protection procedures. c. Computer programs are tested thoroughly. d. There are sufficient security procedures.

41

Which of the following is not an example of a risk when a client installs a new IT system? a. Client staff are not adequately trained to use the new system effectively. b. The system may not be appropriate for the client. c. The client has appropriate procedures for selecting new IT systems. d. Data may be lost or corrupted.

42.

Which of the following statements relating to application controls is correct?

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Test Bank for Auditing: a practical approach, Canadian Edition a. b. c. d.

They impact on the procedures used for data entry, data processing and output.

They include procedures for purchasing new computers.

They are not designed to prevent or detect a material misstatement in the financial statements.

They include the use of passwords and other security measures to minimize the risk of unauthorized access.

43.

Auditors can assess the adequacy of their client's closing procedures by: a. Checking the accuracy of accrual calculations around year-end. b. Looking at earnings trends to assess whether reported income is in line with similar periods in prior years. c. a and b. d. None of the above.

44.

If auditors believe there is a risk that expenses incurred before year-end will be excluded from the current year's expenses, they will: a. Send out confirmation requests to a sample of the client's debtors. b. Trace transactions recorded close to year-end to source documentation. c. Perform analytical review analysis on the client's statement of financial position. d. None of the above.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 12.

13.

14.

15.

16.

Ans. a b c d c

Item 17.

18.

19.

20.

21.

Ans. a a c d b

Item 22.

23.

24.

25.

26.

Ans. d d c c b

Item 27.

28.

29.

30.

31.

Ans. a b d a c

Item 32.

33.

34.

35.

36.

Ans. b a d b c

Item 37.

38.

39.

40.

41.

Ans. a d d b c

Item 42.

43.

44.

Ans. a c b

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Test Bank for Auditing: a practical approach, Canadian Edition

SHORT ANSWER QUESTIONS SA 45 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Related party transactions require proper identification and consideration when considering risk. However, there is no requirement to disclose related party transactions unless they have an impact on material misstatements. b) When assessing fraud risk, auditors should adopt an attitude of professional scepticism to ensure that any indicator of a potential fraud is properly investigated. c) The responsibility for preventing and detecting fraud rests with those charged with governance at the client as well as the auditors. d) The auditor should not ask management and those charged with governance if they are aware of a known fraud or suspect there has been fraud. e) Elvie Lee explained to her friend how application controls work: “Application controls are designed to prevent and detect a material misstatement in the financial statements.”

Solution: a) Disagree. It is the responsibility of the auditor to ensure that related parties are identified and appropriately disclosed, in line with relevant accounting standards.

According to the CICA Handbook, related parties include parent companies, subsidiaries, joint ventures, associates, company management and close family members of key management. Since related parties are not independent of each other, these transactions may not be in the normal course of business. This not only increases the susceptibility of the financial statements to material misstatement due to fraud and error, it may also impact the overall financial statement results. Therefore, financial statement users need sufficient information to assess the impact of these transactions on the financial statements overall. b)

Agree. Adopting an attitude of professional scepticism implies that auditors must remain independent of their client, maintain a questioning attitude and search thoroughly for corroborating evidence to validate information provided by the client. Auditors must not assume that their past experience with client management and staff is indicative of the current risk of fraud.

c)

Disagree. The responsibility for preventing and detecting fraud rests with those charged with governance at the client.

It is the responsibility of the auditor to assess the risk of fraud and the effectiveness of the client's attempts to prevent and detect fraud through their internal control system.

d)

Disagree. The auditor should ask management and those charged with governance these key questions. If the company being audited has an internal audit department, the internal auditors should also be asked this question. The results of these enquiries should be documented.

e)

Agree. These controls are designed to prevent and/or detect a material misstatement in the financial statements by ensuring all transactions are recorded only once and rejected transactions are identified and corrected. Application controls impact on the procedures used for data entry, data processing and output or reporting. They include reconciliations between input and output data and automated checks on data entered to ensure accuracy.

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SA 46 Explain the three main stages of an audit of financial statements.

Solution: The main stages of an audit are planning, performing and reporting. The planning stage involves gaining an understanding of the client, identifying factors that may impact the risk of a material misstatement in the financial statements, performing a risk and materiality assessment and developing an audit strategy. The risk of a material misstatement is the risk that the financial statements include a significant error or fraud. The execution (or performing) stage of the audit involves the performance of detailed tests of controls and substantive testing of transactions and accounts. The reporting stage involves evaluating the results of the detailed testing in light of the auditor's understanding of their client and forming an opinion on the fair presentation of the client's financial statements.

SA 47 Why must auditors gain an understanding of their client at the start of every audit?

Solution: The purpose of auditors gaining an understanding of their client is to assess the risk that the financial statements contain a material misstatement due to: the nature of the client's business, the industry in which the client operates, the level of competition within that industry, the client's customers and suppliers, and the regulatory environment in which the client operates.

SA 48 What is fraud and what are some of the red flags that can alert auditors to the possibility that a fraud may have occurred?

Solution: Fraud is an intentional act to obtain an unjust or illegal advantage through the use of deception.

An auditor can use red flags to alert them to the possibility that a fraud may have occurred.

These red flags include: a high turnover of key employees, key finance personnel refusing to take leave, overly dominant management, poor compensation practices, inadequate training programs, a complex business structure, no (or ineffective) internal auditing staff, a high turnover of auditors, unusual transactions, weak internal controls.

SA 49 What should auditors do if there are risk factors that indicate that the going concern assumption is at risk?

Solution: If the auditor identifies risk factors that indicate that the going concern assumption is in doubt, they will undertake procedures to gather evidence regarding each risk factor. For example, if a client has lost a number of key, long-standing personnel, an auditor may assess the quality of the remaining staff and the likelihood that the client will be able to hire suitable replacements in the near future. If the auditor believes there is an unresolved going concern issue outstanding, an assessment is made of the appropriateness of management disclosures in the notes to the

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Test Bank for Auditing: a practical approach, Canadian Edition

financial statements regarding that issue. An auditor will assess the process used by management to evaluate the extent of the going concern risk. If a company has a history of losses and difficulties, an auditor will expect management to take a great deal of time and care in their going concern assessment. Once the auditor has an understanding of the process used by management, which may include the careful preparation of detailed cash flow projections and budgets, they will assess the adequacy of that process and conduct additional procedures if necessary.

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ESSAY QUESTIONS ES 50 CAS 300 Planning an Audit of Financial Statements requires that auditors plan their audits. Why is planning such an important stage of every audit and explain the various aspects of the preliminary risk identification process?

ES 51 Corporate governance is the rules, systems and processes within companies used to guide and control them. Why are auditors concerned with the corporate governance structures of their clients and what is the current status of corporate governance regulation in Canada?

ES 52 When gaining an understanding of their clients, auditors consider the particular information technology risks faced by their clients. Explain the particular risks associated with information technology and discuss the main controls that companies can have in place to mitigate these risks.

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Test Bank for Auditing: a practical approach, Canadian Edition

CASE Ca 53 Last year the review of Mansbridge Broadcasting did not go well for Raymond, Racicot, & Renaud, CA. In an attempt to meet budget, Peter Bossy, the auditor-in-charge, left out the review of closing procedures. His Group Partner’s review notes were professional but his annual review commentary was not as complimentary. Peter was not convinced that he was at fault and felt that according to his firm’s mandate, as spelled out in the engagement letter, it was the client’s responsibility to ensure the adequacy of closing procedures.

This year the firm will be starting the audit of a new broadcasting client and the partner is planning the risk assessment procedures. His partner’s review note reads: “Ensure that Peter Bossy gains a detailed knowledge of the Quebecor Media broadcasting operations at the entity level.”

Required: a) Comment on the partner’s Mansbridge Broadcasting concerns and explain how the closing process is supposed to work. b) Discuss the entity-level audit procedures Peter will have to follow in order to gain an understanding of Quebecor Media operations and why the entity-level procedures you identify are important.

Solution: a) Although the closing procedures are the responsibility of the client, the auditor has a responsibility to ensure that material misstatements do not occur. Reviewing closing procedures is important because from an audit perspective there is a risk that the client's closing procedures are inadequate.

Discussion on Peter Bossy’s and his firm’s responsibilities: (i) Auditors are concerned that transactions and events have been recorded in the correct accounting period. Although this is the responsibility of those charged with governance, it is the responsibility of the auditors to ensure that their client has applied its closing procedures appropriately. (ii) If an auditor determines that the client's closing procedures are weak, an auditor will plan on spending more time conducting detailed testing around year-end. (iii) There are a number of ways that Peter Bossy can assess the adequacy of the client's closing procedures. checking the accuracy of accrual calculations around year-end. look at earnings trends to assess whether the reported income is in line with similar periods in prior years. trace transactions recorded close to year-end to source documentation and confirm that all transactions are recorded in the appropriate accounting period. b)

Knowledge about the entity is gained through interviews with client personnel, including those charged with governance. Peter Bossy will ask questions about what the client does, how the client functions, the ownership structure of the client and its sources of financing.

Procedures to gain understanding of client: Major customers are identified so that the auditor may consider whether those customers

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have a good reputation, are on good terms with the client (that is, likely to remain a customer in future) and are likely to pay the client on a timely basis. Dissatisfied customers may withhold payment, which affects the allowance for doubtful accounts and the client's cash flow, or decide not to purchase from the client in the future, which can affect the going concern assumption. If a client has only one or a few customers this risk is increased. The auditor also considers the terms of any long-term contracts between their client and their client's customers.

Major suppliers are identified to determine whether they are reputable and supply quality goods on a timely basis and payment on a timely basis. If the client is having trouble paying its suppliers, it may have trouble sourcing goods as suppliers may refuse to transact with a company that does not pay on time.

The client's capacity to adapt to changes in technology and other trends is assessed. If the client is not well positioned to adjust to such changes, it risks falling behind competitors and losing market share, which in the longer term can affect the going concern assumption.

The nature of any warranties provided to customers is assessed. If the client provides warranties on products sold, the auditor needs to assess the likelihood that goods will be returned and the risk the client has underprovided for that rate of return (adequacy of the warranty provision).

The terms of discounts given by the client to its customers and received by the client from its suppliers are reviewed. An assessment is made of the client's bargaining power with its customers and suppliers to determine whether discounting policies are putting profit margins at risk, which may place the future viability of the client at risk.

An assessment is made of the client's reputation with its customers, suppliers, employees, shareholders and the wider community. A company with a poor reputation places future profits at risk. It is also not in the best interests of the auditor to be associated with a client that has a poor reputation.

An understanding is gained of client operations. The auditor will note where the client operates, the number of locations it operates in and the dispersion of these locations. The more spread out the client's operations are, the harder it is for the client to effectively control and coordinate its operations, increasing the risk of errors in the financial statements.

The auditor will need to visit locations where the risk of material misstatement is greatest to assess the processes and procedures at each site. If the client has operations interstate or overseas, the auditor may plan for a visit to those sites by staff from affiliated offices at those locations where risk is greatest. For example, an auditor is more likely to visit client operations if the client opens a new, large site, or if the business is located in a country where there is a high rate of inflation or where there is a high risk of theft.

An understanding is gained of the nature of employment contracts and the client's relations with its employees. The auditor will consider how a client pays its employees, the mix of wages and bonuses, the level of unionization among the workforce and the attitude of staff to their employer. The more complex a payroll system, the more likely that errors can occur.

When staff are unhappy, there is greater risk of industrial action, such as strikes, which disrupt client operations.

The client's sources of financing are reviewed. An assessment is made of a client's debt sources, the reliability of future sources of financing, the structure of debt and the reliance on debt versus equity financing. An auditor assesses whether their client is meeting interest

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Test Bank for Auditing: a practical approach, Canadian Edition

payments on funds borrowed and repaying funds raised when they are due. If the client does not meet the conditions of a debt covenant, the borrower may recall the debt, placing the client's liquidity position at risk, and increasing the risk that the client may not be able to continue as a going concern.

The client's ownership structure is assessed. The auditor is interested in the amount of debt funding relative to equity, the use of different forms of shares and the differing rights of shareholder groups. The client's dividend policy and its ability to meet dividend payments out of operating cash flow are also of interest.

CHAPTER 4 AUDIT PLANNING II SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

3 10.

4 13.

8.

3 11.

4 14.

9.

3 12.

4 15.

Multiple Choice Questions 26.

1 31 2 36.

27.

1 32 2 37.

28.

1 33.

2 38.

29.

1 34.

2 39.

30.

1 35.

2 40.

Short Answer Questions 52.

2 53.

3 54.

LO Item

1.

2.

3.

1 1 1

4.

5.

6.

2 2 2

5 5 5

16.

17.

18.

19.

20.

1 2 3 3 3

21.

22.

23.

24.

25.

3 3 1 5 5

50.

1,2,3

51.

1

Essay Questions 56.

1

57.

4

58.

5 Case

59.

3,5

LO Item

LO

5 5 5 5

3 3 3 3 3

41.

42.

43.

44.

45.

4 4 4 4 5

4

55.

4

46.

47.

48.

49.

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Test Bank for Auditing: a practical approach, Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

TF TF

3.

16.

TF MC

23.

26.

MC MC

4.

5.

TF TF

6.

17.

TF MC

31.

32.

MC MC

7.

8.

9.

TF TF TF

18.

19.

20.

MC MC MC

21.

22.

36.

MC MC MC

10.

11.

TF TF

12.

41.

TF MC

42.

43.

MC MC

13.

14.

TF TF

15.

24.

TF MC

25.

45.

MC MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 27.

MC 29.

28.

MC 30.

Study Objective 2 33.

MC 35.

34.

MC 50.

Study Objective 3 37.

MC 40.

38.

MC 50.

39.

MC 53.

Study Objective 4 44.

MC 55.

54.

SA 57.

Study Objective 5 46.

MC 48.

47.

MC 49.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC

50.

51.

SA. SA

MC SA

52.

SA

MC SA SA

59.

Ca

58.

59.

ES Ca

SA ES MC MC

ES = Essay

56.

ES

Audit planning II

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CHAPTER STUDY OBJECTIVES 1.

Define audit risk. Audit risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. The three components of audit risk are inherent risk, control risk, and detection risk.

2.

Describe the concept of materiality. Information is considered to be material if it impacts the decision-making process of users of the financial statements.

3.

Describe how an auditor determines the audit strategy. The audit strategy is a key component of the planning stage of the audit. It sets the scope, timing, and direction of the audit and provides the basis for developing a detailed audit plan. An audit strategy will depend on the auditor’s preliminary inherent and control risk assessment.

4.

Outline how clients measure performance. By understanding how a client measures its own performance, an auditor can plan the audit to take into consideration areas where the client may be under pressure to achieve certain outcomes.

5.

Describe how an auditor uses analytical procedures when planning an audit.

Analytical procedures are conducted at the planning stage of the audit to identify unusual fluctuations, help identify risks, help when gaining an understanding of a client, identify the accounts at risk of material misstatement, and reduce audit risk by concentrating audit eff ort where the risk of material misstatement is greatest. There are many processes that can be used when conducting analytical procedures. The processes discussed in this chapter included simple comparisons, trend analysis, common-size analysis, and ratio analysis.

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Test Bank for Auditing: a practical approach, Canadian Edition

TRUE-FALSE STATEMENTS 1.

Audit risk is the risk that a client's system of internal controls will not prevent or detect a material misstatement.

2.

If inherent risk and control risk are low, the auditor can set detection risk as high.

3.

When classifying risks, significant consideration is given to whether the risk involves simple routine transactions.

4.

Materiality is assessed during the planning stage of every audit.

5.

Information is considered quantitatively material if it exceeds an auditor's preliminary materiality assessment.

6.

By setting a higher planning materiality level, an auditor increases the quality and quantity of evidence that needs to be obtained.

7.

There is an inverse relationship between audit risk and detection risk as set by the auditor.

8.

A walkthrough involves an auditor tracing a transaction through a client's accounting system.

9.

If the client has one or more appropriate controls in place, the audit strategy is to conduct few or no tests of controls for the identified risk.

10.

Profitability is the ability of a company to pay its debts as they fall due.

11.

Companies enter into debt covenants with lenders when taking on significant loans.

12.

Key performance indicators used by a client to monitor its performance provide an auditor insight into which accounts are potentially at risk of misstatement.

13.

Trend analysis involves a comparison of account balances to a single line item.

Audit planning II

4–5

14.

Analytical procedures are conducted at the planning stage of an audit to enhance the understanding of the auditor's client.

15.

Inventory turnover measures how many times a year a company collects cash from its debtors.

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Test Bank for Auditing: a practical approach, Canadian Edition

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. F T F

Item 4.

5.

6.

Ans. T T F

Item 7.

8.

9.

Ans. T T F

Item 10.

11.

12.

Ans. F T T

Item 13.

14.

15.

Ans. Item F T F

Ans. Item

Ans.

Audit planning II

4–7

MULTIPLE CHOICE QUESTIONS 16.

Martin Shawbridge, a manager at Cox, Durham, & Elliott, CA’s was given the mandate to deal with the following risks: fraud risks, complex transactions, significant related party transactions. How would you classify these risks? a. audit risk b. inherent risk c. control risk d. significant risk

17.

When information exceeds an auditor's preliminary materiality assessment, it is deemed to be: a. performance materiality. b. specific materiality. c. quantitatively material. d. none of the above.

18.

An auditor has gained a detailed understanding of the client's system of internal controls and has conducted extensive tests of those controls. She later assesses control risk as low. What is she planning to perform? a. a combined audit strategy b. an audit of financial controls c. a substantive audit strategy d. a modified audit strategy

19.

When a control is effective, the next step is to a. identify what could go wrong. b. test the control. c. perform a walkthrough. d. reduce reliance on detailed substantive procedures.

20.

When Betty discovered she had a low risk client with low inherent risk and low control risk, how did she set her detection risk? a. low b. high c. medium d. detection risk is not related to inherent risk and control risk

21.

Sami Zubair’s client does not have in place appropriate controls for a risk he has identified. What should Sami do? a. Conduct few or no tests of controls. b. Report the weaknesses to those charged with governance. c. Increase his reliance on substantive tests. d. All of the above.

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Test Bank for Auditing: a practical approach, Canadian Edition

22.

Moises Alou has reviewed internal controls at a spring training facility in Florida and has deemed control risk to be high. Which kind of audit strategy may be appropriate for Moises? a. combined audit strategy b. substantive audit strategy c. a and b d. none of the above

23.

Millie Buenavista made the following two statements concerning inherent risk: (i) Inherent risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. (ii) Inherent risk deals with the susceptibility of the financial statements to material misstatements without considering internal controls. a. Both statements are correct. b. Neither statement is correct. c. Only statement (i) is correct. d. Only statement (ii) is correct.

24.

Emmanuela Zhu was explaining the importance of analytical procedures to her staff.

She made two statements: (i) Analytical procedures are conducted throughout an audit. (ii) Analytical procedures are an efficient method for estimating account balances. a. Both statements are correct. b. Neither statement is correct. c. Only statement (i) is correct. d. Only statement (ii) is correct.

25.

Mark Holewsky was explaining how important it was for his staff to use analytical procedures in order to cut down on substantive testing. He mentioned two factors that he felt were important when conducting analytical procedures: (i) reliability of client data (ii) the ability to make comparisons over time Which of these two factors can help him achieve his objective? a. (i) b. (ii) c. (i) and (ii) d. neither (i) nor (ii)

26.

Which of the following statements is correct about audit risk? a. It is impossible to completely eliminate audit risk. b. Audit risk is the risk that an auditor expresses an inappropriate opinion when the financial statements are materially stated. c. Audit risk can be reduced at the planning stage of an audit by identifying the key risks faced by the client. d. All of the above.

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27.

When classifying risks, significant consideration is not given to whether the risk: a. is related to significant economic or accounting developments. b. involves simple transactions. c. involves significant related party transactions. d. involves fraud.

28.

If there is a risk that management's assertion that recorded inventory exists is not valid, the auditor will: a. spend more time testing for the existence of recorded inventory. b. spend less time testing for the existence of recorded inventory. c. spend more time testing for the completeness of inventory. d. not adjust their audit strategy.

29.

Control risk is: a. the risk that a client's system of internal controls will prevent or detect a material misstatement. b. the susceptibility of an assertion to a material misstatement assuming there are no related controls. c. the risk that a client's system of internal controls will not prevent or detect a material misstatement. d. none of the above.

30.

By setting high detection risk, an auditor will: a. eliminate the possibility that fraud will be detected. b. reduce the level of reliance placed on their detailed substantive procedures. c. increase the level of reliance placed on their detailed substantive procedures. d. reduce the level of testing of the client's internal control system.

31.

Which of the following statements about materiality is incorrect? a. The preliminary assessment of materiality guides audit planning and testing. b. Materiality is used to guide the validity of information contained in the financial statements. c. Materiality is a key auditing concept that is assessed during the planning stage of every audit. d. Information is considered material if it has no impact on the decision-making process of financial statement users.

32.

An item that is considered material due to its magnitude is referred to as being: a. quantitatively material. b. of no interest to the auditor. c. qualitatively material. d. none of the above.

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33.

Qualitative materiality refers to information that: a. impacts a user's decision-making process due to its magnitude. b. impacts a user's decision-making process for a reason other than its magnitude. c. is less than an auditor's preliminary materiality assessment. d. exceeds an auditor's preliminary materiality assessment.

34.

Which of the following is an example of an item considered qualitatively material? a. a change in an accounting method b. related party transactions c. being in danger of breaching a debt covenant d. all of the above

35.

By setting a lower planning materiality level an auditor: a. decreases the quality and quantity of evidence that needs to be gathered. b. does not change the audit strategy they use. c. increases the quality and quantity of evidence that needs to be gathered. d. can be certain that they will detect all instances of fraud that have occurred.

36.

An audit strategy: a. is determined by the client. b. involves determining the amount of time to be spent testing the client's internal controls and conducting detailed substantive testing. c. sets the scope, timing and direction of the audit. d. both b and c.

37.

The audit strategy for a client with high inherent risk and high control risk will include: a. no or very limited tests of controls. b. decreased reliance on substantive tests. c. increased testing of controls. d. increased reliance on controls.

38.

A transaction walkthrough involves: a. taking a tour of the client's manufacturing facility. b. vouching recorded transactions back to the source documents. c. tracing a transaction through a client's accounting system. d. none of the above.

39.

An audit strategy will include increased reliance on tests of controls when: a. inherent risk and control are high. b. inherent risk and control risk are low. c. the auditor believes there is a high risk that their client's internal controls will not prevent or detect material misstatements. d. there is a high susceptibility of assertions to material misstatements.

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40.

By assessing control risk as high, an auditor has determined that their client's system of internal controls: a. is unlikely to be effective in mitigating inherent risks identified. b. is very effective at preventing or detecting material misstatements. c. is very strong. d. will eliminate the possibility of material fraud or error.

41.

Which of the following statements regarding key performance indicators (KPIs) is correct? a. They reflect the success factors of an organization. b. They can be quantified. c. Some KPIs are common to many clients, including return on assets. d. All of the above.

42.

Common measures of a company's profitability include: a. price-earnings ratio. b. earnings per share. c. both a and b. d. quick ratio.

43.

Which of the following statements relating to debt covenants is incorrect? a. Covenants are written into loan contracts. b. If a company breaches a debt covenant it will not need to renegotiate or repay the loan. c. Covenants restrict a company's activities. d. Companies enter into debt covenants with banks when they borrow a significant amount.

44.

Liquidity refers to: a. the ability of a company to earn a profit. b. a comparison of account balances to a single line item. c. the ability of a company to pay its debts when they fall due. d. none of the above.

45.

Analytical procedures are conducted at the planning stage of the audit to: a. aid in the identification of risk. b. identify where fraud has occurred. c. enhance the understanding of a client. d. both a and c.

46.

Analytical procedures are used at which of the following stages of an audit? a. final review b. planning c. execution d. all of the above

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47.

Which of the following is not an example of a profitability ratio? a. current ratio b. gross profit margin c. return on assets d. profit margin

48.

Which of the following is an example of a liquidity ratio? a. gross profit divided by net sales b. profit divided by average assets c. cost of sales divided by average inventory d. current assets divided by current liabilities

49.

In conducting analytical procedures, which of the following information sources are not generally considered to be reliable? a. audited information b. information generated by an accounting system with ineffective internal controls c. information generated using consistent accounting methods d. information generated by an accounting system with effective internal controls

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

Ans. d c a d b

Item 21.

22.

23.

24.

25.

Ans. d b d a c

Item 26.

27.

28.

29.

30.

Ans. d b a c b

Item 31.

32.

33.

34.

35.

Ans. d a b d c

Item 36.

37.

38.

39.

40.

Ans. d a c b a

Item 41.

42.

43.

44.

45.

Ans. d c b c d

Item 46.

47.

48.

49.

Ans. d a d b

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SHORT ANSWER QUESTIONS SA 50 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Roxanne Deboer, the in-charge auditor, was explaining to her junior auditors why she was setting inherent risk high. “It is appropriate to set higher inherent risk for this company as our client is in an industry that is very competitive.” b)

In selecting an appropriate materiality base, an auditor can choose an item from the balance sheet or income statement.

c)

Tyler Rappaport has mentioned to his staff auditors that audit risk is based on factors that relate to the entity, while materiality is based on the user needs. As a result, materiality and audit risk are two concepts that need to be considered separately when considering material misstatements.

Paloma Schenker has determined control risk at a biochem company to be high. She plans to use a combined audit strategy.

d)

Solution: a) Agree. An organization in a highly competitive environment will have a higher inherent risk than an entity in an industry with few competitors. By the same token, a geographically dispersed company will have a higher inherent risk than an organization with a single location. b)

Agree. Balance sheet bases are generally total assets or equity. Income statement bases are profit before tax, revenue or gross profit. An auditor will select an appropriate base using their professional judgment based on their knowledge of the client and the needs of financial statement users for their decision making.

c)

Disagree. Materiality and audit risk both require consideration in identifying and assessing the risk of a material misstatement. They both have to be considered when determining the nature, timing and extent of the audit work performed, and they are both considered when evaluating the effect of uncorrected misstatements on the financial statements and in forming the opinion in the auditor's report.

d)

Disagree. When control risk is high, the audit strategy most likely to be adopted will be that of substantive testing.

When assessing control risk as low, an auditor will generally plan to perform a combined audit strategy where a detailed understanding of their client's system of internal controls is obtained as the auditor plans to rely on that system to identify, prevent and detect material misstatements.

SA 51 Explain audit risk and the three components of the audit risk model.

Solution:

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Audit risk is the risk that an auditor expresses an inappropriate audit opinion when financial statements are materially misstated. This means that an auditor reports that in their opinion the financial statements are fairly presented when in fact, they contain a significant error or fraud.

While it is impossible to eliminate audit risk, an auditor will aim to reduce it to an acceptably low level. Inherent risk is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming there are no related controls. Control risk is the risk that a client's system of internal controls will not prevent or detect a material misstatement. Detection risk is the risk that the auditor's testing procedures will not be effective in detecting a material misstatement should there be one.

SA 52 What is the relationship between materiality and audit risk?

Solution: There is an inverse relation between risk and materiality. For example, if an auditor decides to use profit before tax as the base, materiality is generally set closer to 5 per cent for a client that is considered to be risky and closer to 10 per cent for a client that is not considered risky. By setting a lower planning materiality level, an auditor increases the quality and quantity of evidence that needs to be gathered. When gathering evidence, one of the criteria may be to test material items. The lower the materiality level set, the more items will fall into this definition. Also, by setting a lower materiality level, an auditor increases their sensitivity to a potential misstatement. When analyzing test results, an auditor will assess potential misstatements in aggregate with reference to their planning materiality. The lower the materiality, the more likely the auditor will conclude that misstatements are material and further testing is required.

SA 53 Explain the audit approach used by an auditor when they assess control risk as high.

Solution: By assessing control risk as high, an auditor will adopt a predominantly substantive approach.

When this audit strategy is adopted, an auditor will gain the minimum necessary knowledge of the client's system of internal controls as required by the auditing standards, but generally conduct no tests of those controls. If a client's system of internal controls is non-existent, very poor or unlikely to be effective in mitigating an identified inherent risk, there is generally no point testing the internal controls as the auditor will not be planning on relying on them. Instead, an auditor will increase their level of reliance on detailed substantive procedures, which involves intensive testing of year-end account balances and transactions from throughout the year. An exception is where an auditor has identified a significant risk. In this case, an auditor will gain an understanding of their client's controls relevant to that risk. For example, if a client has significant transactions that involve estimation, an auditor will review the processes used by management to make those estimations. If a client does not have adequate controls to address significant risks, this is considered a noteworthy deficiency in a client's system of internal controls.

SA 54 Describe the profitability and liquidity approaches to measuring a client's performance.

Solution:

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Test Bank for Auditing: a practical approach, Canadian Edition

It is common for companies to use profitability measures to assess their performance and that of their senior staff. Companies will track their revenue and expenses over time and assess any variability. They will compare their revenue and expenses with close competitors and assess their ability to compete, as well as provide valuable insights to management as to whether results are matching expectations based on known factors such as seasonality or economic downturns. This also provides the auditor with valuable insights into the expectations of management. Liquidity is the ability of a company to meet its needs for cash in the short and long term. It is vital for a company to have access to cash to pay its debts when they fall due. If it cannot meet these obligations, a company may go into liquidation. Companies require cash to pay their employees' wages, utility bills, supplier bills, interest payments on money lent, dividends to shareholders and so on. In the longer term companies need cash to repay longterm debt and undertake capital investment.

SA 55 Discuss the purpose and some common examples of profitability ratios.

Solution: Profitability ratios reflect a company's ability to generate earnings and ultimately the cash flow required to pay debts, meet other obligations and fund future expansion. Common profitability ratios include the gross profit margin, profit margin, return on assets and return of shareholders' equity. The gross profit margin indicates whether a seller of goods has a sufficient mark-up on goods sold to pay for other expenses. The profit margin indicates the profitability of a company after taking into account all operating expenses. The return on assets (ROA) indicates the ability of a company to generate income from its average investment in total assets. The return on shareholders' equity (ROE) indicates the ability of a company to generate income from the funds invested by its common (ordinary) shareholders.

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ESSAY QUESTIONS ES 56 Audit risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially stated. Why is the concept of audit risk so important to auditors and what can they do to reduce it to an acceptably low level?

ES 57 Gaining an understanding of a client includes auditors learning how their clients measure their performance. How is this information used by auditors in audit planning and what are examples of non-financial performance measures commonly used by auditors?

ES 58 Analytical procedures are used by auditors to evaluate their clients' financial information by studying plausible relationships among both financial and non-financial data. Explain how analytical procedures are used at the different stages of an audit.

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CASE Ca 59 John Primo, the senior auditor at Delahanty, Forbes, CA’s was planning for the audit of Canadian Light Source (CLS) and decided to use benchmarking as an analytical procedure.

His manager agreed with John’s approach and suggested information sources that would ensure the reliability of the data for his benchmarking exercise.

As John walked out of the office he ran into Gina Stevenson, a newly hired auditor. He congratulated her on her decision to use a substantive approach to her accounts receivable section of the audit program.

Gina was also going to be reviewing certain internal controls in the CLS audit program. She asked him to whom she should report weaknesses in the client’s internal controls.

Required: a) Which information sources are generally considered to be reliable when conducting benchmarking exercises? b) What circumstances would have made Gina use a substantive approach? c) To whom will Gina report weaknesses in a client's system of internal controls?

Solution: a) In conducting analytical procedures, the following information sources are generally considered to be reliable: • information generated by an accounting system that has effective internal controls • information generated by an independent reputable external source • audited information • information generated using consistent accounting methods • information from a source internal to the client that has proven to be accurate in the past (for example, when preparing budgets). b)

By assessing control risk as high, Gina will adopt a predominantly substantive audit approach.

When this audit strategy is adopted, it is implied that Gina has gained the minimum necessary knowledge of the client's system of internal controls as required by the auditing standards, but generally she will not have conducted tests of those controls.

If CLS's system of internal controls is non-existent, very poor or unlikely to be effective in mitigating an identified inherent risk, there is generally no point testing the internal controls as Gina will not be planning on relying on them. Instead, Gina will increase her level of reliance on detailed substantive procedures, which involves intensive testing of year-end account balances and transactions from throughout the year.

c)

If the auditor tests the controls and believes them to be ineffective, the auditor cannot rely on the controls. In this case, the auditor reports the weaknesses identified to those charged with governance, makes recommendations on improving the controls and increases the reliance placed on detailed substantive procedures.

CHAPTER 5 AUDIT EVIDENCE SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

4 10.

5 13.

8.

4 11.

6 14.

9.

5 12.

6 15.

Multiple Choice Questions 28.

3 34.

2 40.

29.

5 35.

2 41.

30.

1 36.

2 42.

31.

1 37.

2 43.

32.

1 38.

2 44.

33.

1 39.

3 45.

Short Answer Questions 57.

2 58.

2 59.

LO Item

1.

2.

3.

1 1 2

4.

5.

6.

2 3 3

7 8 8

16.

17.

18.

19.

20.

21.

1 1 2 2 1,2 1

22.

23.

24.

25.

26.

27.

1 2 2 2 2 2

55.

1,2,6

56.

1

Essay Questions 61.

2

62.

2

63.

4 Case

64.

4,5

LO Item

LO

8 8 8

2 1 4 4 4 5

46.

47.

48.

49.

50.

51.

5 5 6 6 6 7

6

60.

8

52.

53.

54.

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SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

TF TF

16.

17.

MC MC

20.

21.

MC MC

3.

4.

18.

TF TF MC

19.

20.

23.

MC MC MC

24.

25.

26.

MC MC MC

5.

TF

6.

TF

28.

MC

7.

TF

8.

TF

42.

MC

9.

TF

10.

TF

29.

MC

11.

TF

12.

TF

48.

MC

13.

TF

51.

MC 52.

Study Objective 8 MC 53.

MC 54.

14.

TF

15.

TF

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 22.

MC 31.

30.

MC 32.

Study Objective 2 27.

MC 36.

34.

MC 37.

35.

MC 38.

Study Objective 3 39.

MC Study Objective 4 43.

MC 44.

Study Objective 5 45.

MC 46.

Study Objective 6 49.

MC 50.

Study Objective 7

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC

33.

41.

MC. MC

55.

56.

SA SA

MC MC MC

40.

55.

57.

MC SA SA

58.

61.

62.

SA ES ES

MC

63.

ES

64.

Ca

MC

47.

MC

64.

Ca

MC

55.

SA

59.

SA

MC

60.

SA

ES = Essay

Audit evidence

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CHAPTER STUDY OBJECTIVES 1.

Outline the audit assertions. When preparing the financial statements, management will make assertions about each account and related disclosures in the notes. Auditors use these assertions to assess the risk of material misstatement and design audit procedures. The assertions used when testing transactions and events, including income statement items, are occurrence, completeness, accuracy, cut-off , and classification. Th e assertions used when testing balance sheet items are existence, rights and obligations, completeness, and valuation and allocation.

2.

Identify and describe different types of audit evidence and define sufficient appropriate audit evidence. The different types of audit evidence include external confirmations, documentary evidence, representations, verbal evidence, computational evidence, physical evidence, and electronic evidence. External confirmations are sent directly by an auditor to a third party. Documentary evidence may be generated internally by the client or externally by third parties. Representation letters are requested from a client’s lawyers or management. Verbal evidence is the discussions between the auditor and client personnel or third parties. Computational evidence is gathered when an auditor checks the mathematical accuracy of figures included in the financial statements.

Physical evidence involves the inspection of tangible assets. Electronic evidence includes data held on a client’s computer, files sent by e-mail to the auditor, and items scanned and faxed. Sufficiency refers to the quantity of evidence gathered.

Appropriateness refers to the relevance and reliability of audit evidence gathered.

3.

Determine the persuasiveness of audit evidence. The persuasiveness of evidence used to corroborate the details included in a client’s accounts varies. Internally generated evidence held by the client is the least persuasive, as the client can alter or hide this evidence. Externally generated evidence held by the client is more persuasive, as it is created by an independent third party. Externally generated evidence sent directly to the auditor is the most persuasive, as the client does not handle this evidence.

4.

Explain the issues to consider when using the work of an expert. When an auditor decides to use the work of an expert, the report produced by the expert forms part of the evidence used by an auditor when forming their audit opinion. An expert is someone with the skills, knowledge, and experience required to help an auditor. Th e auditor determines the scope of the work to be carried out, and assesses the capability of the expert, the objectivity of the expert, and the expert’s report.

5.

Explain the issues to consider when using the work of another auditor. An auditor may need to use the work of another auditor when their client operates in a number of locations, has divisions or subsidiaries spread around the country or the globe, or has significant assets in other places. When this is the case, the principal auditor may need to rely on evidence provided by another auditor for certain components of the client’s financial statements.

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Test Bank for Auditing: a practical approach, Canadian Edition

6.

Describe the evidence-gathering procedures most often used by auditors. An auditor will inspect records, documentation, and tangible assets. They will observe client staff undertaking various procedures. An auditor will make enquiries of client personnel and third parties. Confirmations are sent to third parties, including banks, lawyers, lenders, and debtors. An auditor will recalculate numbers appearing in client fi les and records to check mathematical accuracy. They will re-perform some processes used by the client to check the effectiveness of internal controls and the validity of amounts estimated by client personnel. Analytical procedures are used throughout the audit to appraise the relationships between financial and non-financial information.

7.

Explain how auditors arrive at a conclusion based upon the evidence gathered.

The final audit procedure is to assess the evidence gathered throughout the audit and draw a conclusion on the fair presentation of a client’s financial statements.

8.

Describe how auditors document the details of evidence gathered in working papers. Audit evidence is documented in an auditor’s working papers. Audit working papers include the client’s name, the period under audit, a title describing the contents of the working paper, a file reference indicating where the working paper fits in the audit file, the initials of the preparer of the working paper together with the date the working paper was prepared, the initials of the reviewer(s) of the working paper together with the date(s) the working paper was reviewed, and cross-referencing between working papers indicating where further work and evidence are summarized elsewhere. Working papers are stored in either the permanent file or the current file. The permanent file includes client information and documentation that apply to more than one audit. The current file includes client information and documentation that apply to the current audit.

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TRUE-FALSE STATEMENTS 1.

When preparing the financial statements, auditors make assertions about each account and related disclosures in the notes.

2.

The cut-off assertion means that the entity holds or controls the rights to assets and liabilities are the obligations of the entity.

3.

Audit evidence is the information that an auditor uses when arriving at their opinion on the fair presentation of their client's financial statements.

4.

Negative confirmations ask the recipient to reply only if they disagree with the information provided.

5.

Internally generated evidence is considered the most persuasive when the source of the evidence is considered to be reliable, trustworthy and independent of the client.

6.

Correspondence with the client's lawyers is an example of externally generated evidence sent directly to the auditor.

7.

The greater the risk of material misstatement of the item under consideration, the more likely an auditor will turn to an expert for their advice.

8.

An expert is expected to be less objective if they are not associated with the client.

9.

A component auditor is an auditor who, at the request of the group engagement team, performs work on financial information related to a component for the group audit.

10.

The component partner sets out the work to be conducted by the group engagement partner.

11.

Observation is an evidence gathering procedure that involves checking the mathematical accuracy of client records.

12.

Analytical procedures involve an evaluation of financial information by studying plausible relationships among both financial and non-financial data.

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Test Bank for Auditing: a practical approach, Canadian Edition

13.

The decision of what constitutes sufficient appropriate audit evidence is a matter for professional judgment.

14.

The permanent file includes client information and documentation that apply to more than one audit.

15.

The permanent file includes detailed descriptions of evidence gathered for a particular year's audit.

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5–7

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. F F T

Item 4.

5.

6.

Ans. T F T

Item 7.

8.

9.

Ans. T F T

Item 10.

11.

12.

Ans. F F T

Item 13.

14.

15.

Ans. Item T T F

Ans. Item

Ans.

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Test Bank for Auditing: a practical approach, Canadian Edition

MULTIPLE CHOICE QUESTIONS 16.

Andy Szypula, the audit manager, was explaining to his new audit team how management assertions work when assessing the risk of material misstatements. He made two statements to his audit team: (i) Auditors use assertions for account balances. (ii) Auditors use assertions for presentations and disclosures.

Which of these statements were true? a. (i) only b. (ii) only c. both (i) and (ii) d. neither (i) nor (ii)

17.

Olga Chevalier, CGA was reviewing presentation and disclosure assertions for Athabasca Oil Sands. Which one of the following would not be a presentation and disclosure assertion? a. completeness b. classification and valuation c. accuracy and valuation d. occurrence

18.

Mike Noseworthy, CA was excited to see his audit manager and blurted out: (i) It is our responsibility as auditors to arrive at an audit opinion by gathering sufficient appropriate evidence. (ii) Appropriateness is the quantity and sufficiency is the quality of audit evidence gathered.

Which of these statements were true? a. (i) only b. (ii) only c. both (i) and (ii) d. neither (i) nor (ii)

19.

Dean Tomaszczyk was training junior audit staff and mentioned the importance of third party documentation. Which of the following are not external confirmations? a. supplier invoices b. bank confirmations c. payable confirmations d. receivable confirmations

20.

Donna Hum was explaining the importance of documentary evidence. Which assertion was she referring to when she obtained details of the price paid for inventory and traced it to the supplier’s invoice to verify the amount recorded? a. completeness b. accuracy c. classification and understandability

Audit evidence d.

5–9

none of the above

21.

Lilia Hussey made two statements to Sami Moneymaker about cut-off procedures: (i) Testing cut-off transactions is particularly important for transactions close to year end. (ii) Cut-off procedures help determine whether transactions have been recorded in the correct accounting period.

Which of these statements were true? a. (i) only b. (ii) only c. both (i) and (ii) d. neither (i) nor (ii)

22.

Lucy Wong’s work at Axcan Pharma consisted of reading lease agreements to ensure that leases were disclosed accurately in the notes to the financial statements. Which assertion was she fulfilling? a. completeness b. persuasiveness c. accuracy d. classification and understandability

23.

Irvin Schatz, CGA had his client Brown Boveri, send out a legal letter to their lawyers.

The legal letter would have contained requests for: a. the lawyer’s opinion on the client’s legal matters. b. legal matters that the lawyer is in disagreement with the client. c. both a and b. d. none of the above matters are included in legal letters.

24.

Nicholas Doulas, the partner-in-charge of the Fairfax Financial Holdings audit wrote a management representation letter. It would have included: a. written details of verbal representations made by management during the audit. b. a representation that there have been no material frauds and errors. c. a and b. d. none of the above.

25.

Abe Freed, a struggling public accountant was being coached by his father. His father told him that he was using a poor form of evidence as a basis for his conclusions. What type of evidence was he referring to? a. computational evidence b. verbal evidence c. physical evidence through inspection d. all of the above

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Test Bank for Auditing: a practical approach, Canadian Edition

26.

Evan Contador was reviewing ways of obtaining electronic evidence at Enbridge Inc. He was considering the different sources of evidence that might qualify and be defined as electronic evidence. Which elements are considered electronic evidence? a. physical evidence gathered through inspection b. computational evidence c. files sent via email to the auditor d. none of these

27.

Marianne Gilespie, the senior auditor at Manulife Financial was sorting out several sources of internally generated evidence. Which one of the following would not qualify as internally generated evidence? a. minutes of meetings b. journals and ledgers c. the annual operating plan presented to the Board of Directors d. bank confirmations

28.

Fran Zora has been auditing Manitoba Telecom Services for the past five years. She has gathered a lot of externally generated evidence because of its persuasiveness and reliability as evidence. Which one of the following evidences lacks trustworthiness and independence from the client? a. purchase requisitions b. bank confirmations c. correspondence with the client’s lawyers d. none of these

29.

Steven Marinaro, CGA is performing complex calculations to help him determine reserves in the Alberta Oil Sands. Which of the following evidence gathering procedures will Steve use when using the work of another auditor? a. recalculation b. observation c. confirmations d. all of the above

30.

Which of the following is not an assertion used for transactions and events? a. cut-off b. existence c. classification d. occurrence

31.

When testing for accuracy, an auditor searches for evidence: a. to verify that a recorded transaction or event took place and relates to the entity. b. that all disclosures that should have been included in the financial statements have been included. c. that transactions and events have been recorded at appropriate amounts. d. to verify that recorded assets are owned by the entity.

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5 – 11

32.

Completeness is an assertion used: a. when testing balance sheet items. b. for transactions and events. c. for presentation and disclosure. d. all of the above.

33.

Which assertion do auditors test when they test for the adequacy of the provision for doubtful debts? a. valuation and allocation b. rights and obligations c. classification d. occurrence

34.

When there is a significant risk that an account will be misstated and the client's system of internal controls is not considered effective at reducing that risk: a. less high quality evidence is gathered when conducting substantive tests. b. detection risk is set as high. c. detection risk is set as low. d. none of the above.

35.

External confirmations can be sent to: a. third parties holding the client's inventory. b. the client's audit committee. c. the client's lawyers. d. both a and c.

36.

Which of the following statements regarding a legal representation letter is incorrect? a. The letter can include a request to provide details of any legal matters that the lawyer is in disagreement with the client. b. The letter is sent by the auditor to its lawyers asking them to complete the letter and send it directly to the client. c. The letter is sent by the client to its lawyers asking them to complete the letter and send it directly to the auditor. d. The letter can include any legal matters involving the client.

37.

Which of the following forms of evidence is used when gaining an understanding of the client and its internal control systems? a. verbal b. computational c. physical d. external confirmations

38.

Internally generated evidence held by the client includes: a. bank statements.

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Test Bank for Auditing: a practical approach, Canadian Edition b. c. d.

correspondence with the client's lawyers. copies of invoices sent to customers. expert valuations.

39.

Which broad category of corroborating evidence is the least persuasive to an auditor? a. externally generated evidence sent directly to the auditor b. internally generated evidence c. externally generated evidence held by the client d. none of the above

40.

An auditor verifies amounts recorded in their client's records using: a. electronic evidence. b. verbal evidence. c. confirmations. d. all of the above.

41.

The first stage when an auditor considers the use of an expert is: a. assessing the objectivity of the expert. b. assessing the need to use an expert. c. assessing the expert's report. d. determining the scope of the work to be carried out.

42.

When an auditor uses the work of an expert, who has the responsibility for arriving at an overall conclusion regarding the fair presentation of a client's financial statements? a. the auditor b. the expert c. the client's management d. the client's audit committee

43.

Which of the following is an example of a situation where an auditor may use the work of an expert? a. A geologist engaged to evaluate the quantity and quality of mineral deposits b. An actuary engaged to verify insurance premiums c. Both a and b d. None of the above

44.

Assessing an expert's report involves the auditor: a. setting the nature, timing and extent of work to be completed by the expert. b. assessing the consistency of information included in the expert's report with their understanding of the client. c. evaluating the expert's qualifications as a member of a relevant professional body. d. deciding that they do not have the expertise necessary to test and evaluate the accuracy of reported information.

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45.

The group engagement partner is: a. requested by the component auditor to perform certain audit work on behalf of the group engagement team. b. not responsible for providing an opinion on the fair presentation of the client's financial statements. c. not the auditor responsible for signing the audit report. d. the auditor responsible for signing the audit report.

46.

Which of the following statements regarding using the work of another auditor is correct? a. The group engagement partner will spend more time reviewing the component auditor's work when the component is at risk of material misstatement. b. The group engagement partner will spend more time reviewing the component auditor's work if the component auditor has a good reputation. c. The group engagement partner will spend less time reviewing the component auditor's work when the component is at risk of material misstatement. d. The component auditor sets out the work to be conducted by the group engagement partner.

47.

If the component auditor cannot access sufficient evidence, the engagement partner will: a. consider issuing an adverse audit opinion. b. always issue an unqualified audit opinion. c. consider issuing a modified audit opinion due to a scope limitation. d. none of the above.

48.

Auditors use a re-performance procedure: a. only when testing controls. b. only during the audit planning stage. c. only when conducting substantive testing. d. when testing controls and when conducting substantive testing.

49.

Observation involves an auditor: a. asking questions to gain an understanding of various matters throughout the audit. b. watching a procedure being carried out by another party. c. checking the mathematical accuracy of client records. d. redoing processes conducted by the client.

50.

Why do auditors inspect records and documents? a. to check the dates of transactions b. for evidence that management have authorized significant purchases c. to check that a transaction occurred d. all of the above

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Test Bank for Auditing: a practical approach, Canadian Edition

51.

If an auditor decides that a client has internal controls that can reduce the likelihood of a material misstatement for an identified risk, the auditor will: a. test those controls. b. qualify the audit report. c. adopt a predominantly substantive approach. d. not test those controls.

52.

An audit working paper generally includes: a. the client's name. b. cross-referencing between working papers. c. a file reference. d. all of the above.

53.

Which of the following would not be included in an auditor's permanent file? a. the client's organizational chart b. copies of long-term contracts c. copies of accounts receivable confirmation letters d. prior years' audit reports

54.

During the execution stage of the audit, an auditor will document: a. details of audit tests undertaken. b. their understanding of their client. c. related parties identified. d. analytical procedures used to aid in risk identification.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

21.

Ans. c d a a b c

Item 22.

23.

24.

25.

26.

27.

Ans. d c c b c d

Item 28.

29.

30.

31.

32.

33.

Ans. a d b c d a

Item 34.

35.

36.

37.

38.

39.

Ans. c d b a c b

Item 40.

41.

42.

43.

44.

45.

Ans. d b a c b d

Item 46.

47.

48.

49.

50.

51.

Ans. a c d b d a

Item 52.

53.

54.

Ans. d c a

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Test Bank for Auditing: a practical approach, Canadian Edition

SHORT ANSWER QUESTIONS SA 55 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Mona Harmon has just completed a risk assessment and has identified key risk factors at Bonavista Emergis. When asked by one of her staff members “What’s next?”, she replies: “Now that we have identified the risks, its time to perform some planning in order to obtain sufficient appropriate audit evidence.” b) Teresa Dziuba was assigned to the Heathcliff Energy audit. She was ensuring that when recognizing revenues, all transactions and events that should have been recorded have been recorded. She was testing the occurrence assertion. c) Steve Slopak, the group partner was reviewing the work of Manny Fernandez on the Lake Shore Gold account. Manny asked Steve for an explanation on how audit risk would affect his work. Steve answered: “Audit risk affects the quantity and quality of evidence gathering.” d) Frank Tutino, CA made the following true statement: “The appropriateness of audit evidence refers to its relevance and reliability.” He then added: (i) “Reliable information is logically connected to an assertion” (ii) “Relevant information reflects the true state of the information” Solution: a) Agree. Once an auditor has identified the key risk factors for their client, they will plan their audit to obtain sufficient appropriate audit evidence to ensure that relevant accounts and related note disclosures are reported accurately. b)

Disagree. When testing for completeness (not occurrence), an auditor searches for transactions or events and makes sure these have been recorded. This assertion is particularly important when the auditor believes there is a risk of understatement and that some transactions or events that should have been recorded have not been recorded; for example, expenses incurred but not recorded to understate expenses and overstate profit.

c)

Agree. Audit risk affects the quantity and quality of evidence gathered by an auditor during the execution stage of the audit. When there is a significant risk that an account will be misstated and the client's system of internal controls is not considered to be effective at reducing that risk, detection risk is set as low and more high-quality evidence is gathered when conducting substantive tests of that account.

d)

Disagree. Frank mixed up his definitions of reliable and relevant information, as relevant information is logically connected to an assertion, and reliable information reflects the true state of the information.

SA 56 Identify and explain the key assertions used for transactions and events, including income statement items, for an accounting period.

Solution:

Audit evidence

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The key assertions for transactions and events are occurrence, completeness, accuracy, cut-off and classification. When testing for occurrence, an auditor searches for evidence to verify that a recorded transaction or event, such as revenue or an expense item, took place and relates to the entity. When testing for completeness, an auditor searches for transactions or events and makes sure these have been recorded. When testing for accuracy, an auditor searches for evidence that transactions and events have been recorded at appropriate amounts. When testing for cut-off, an auditor searches for evidence that transactions have been recorded in the correct accounting period. When testing for classification, an auditor ensures that transactions and events have been recorded in the proper accounts.

SA 57 Describe the purpose and examples of external confirmations.

Solution: An external confirmation is sent directly by an auditor to a third party, who is asked to respond to the auditor on the matter(s) included in the confirmation letter. There are two broad types of external confirmations: positive and negative confirmations. Positive confirmations ask the recipient to reply in all circumstances. Negative confirmations ask the recipient to reply only if they disagree with the information provided. External confirmations can be sent to the client's bank, lawyers, lenders and debtors, and third parties holding the client's inventory. A bank confirmation letter is a request for information about the amount of cash held in the bank or in overdraft, details of any loans with the bank, details of any pledges of assets made to guarantee loans and interest rates charged. An external confirmation may be sent to a client's lawyer (legal confirmation) if the lawyer holds documents on behalf of the client that are of relevance to the audit. While rare, an external confirmation may be sent to a client's suppliers and lenders (payable confirmation) to confirm the details of amounts owed to creditors and significant loans.

External confirmations can be sent to debtors (receivable confirmation) to verify the receivables balance.

SA 58 Explain the three broad categories of corroborating evidence.

Solution: There are three broad categories of corroborating evidence. The categories are internally generated evidence, externally generated evidence held by the client, and externally generated evidence sent directly to the auditor. Internally generated evidence held by the client includes records of cheques sent, copies of invoices and statements sent to customers, purchase orders, company documentation regarding policies and procedures, contracts, minutes of meetings, journals, ledgers, trial balances, spreadsheets, worksheets, reconciliations, calculations and computations. Internally generated evidence is the least persuasive as it can only be used to verify that a client has accurately converted this information into the financial statements.

Externally generated evidence held by the client includes supplier invoices and statements, customer orders, bank statements, contracts, lease agreements and tax assessments. These sources of evidence are quite persuasive as they are produced by third parties, however it is possible that the client can manipulate these documents, which reduces their reliability to the auditor. Externally generated evidence sent directly to the auditor includes bank confirmations, accounts receivable confirmations, correspondence with the client's lawyers, including confirmations and representations, and expert valuations. These sources of evidence are considered to be the most reliable and best quality as they are independent of the client.

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Test Bank for Auditing: a practical approach, Canadian Edition

SA 59 Describe the major evidence gathering procedures most often used by auditors.

Solution: The major evidence gathering procedures are observation, enquiry, recalculation, reperformance and analytical procedures. Observation involves watching a procedure being carried out by another party. Enquiry involves asking questions, verbally or in written form, to gain an understanding of various matters throughout the audit. Recalculation involves checking the mathematical accuracy of client records. Re-performance involves redoing processes conducted by the client. Analytical procedures are an evaluation of financial information by studying plausible relationships among both financial and non-financial data.

SA 60 Explain the purpose of working papers and the difference between the permanent file and current file.

Solution: Working papers provide a record of the audit work completed and evidence gathered in forming their audit opinion. Working papers are used to document the details of each audit. The two main files held for each client are the permanent file and the current file. The permanent file includes documents that pertain to a client for more than one audit. These will include copies of long-term contracts and agreements, a client's organizational chart and details of the client's board directors and its subcommittees. The current file includes the details of work completed and evidence gathered that relate to the current audit. This includes correspondence between the auditor and their client, and their client's bankers and lawyers that pertain to the current audit period, as well as extracts from the minutes of meetings, such as the board of directors' meetings, which pertain to the current audit.

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ESSAY QUESTIONS ES 61 Audit evidence is the information that an auditor uses when arriving at their opinion on the fair presentation of their client's financial statements. Why is evidence so important to a financial statement audit?

ES 62 CAS 502 Audit Evidence - Specific Considerations for Litigation and Claims requires an auditor to gather sufficient appropriate audit evidence regarding any legal matters involving their client.

How can auditors gather such evidence and what impacts can legal matters have on the client's financial statements?

ES 63 CAS 620 Using the Work of an Auditor's Expert provides guidelines for auditors when using the work of an expert. Identify examples of situations where auditors may use experts and evaluate the benefits and risks associated in each situation.

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Test Bank for Auditing: a practical approach, Canadian Edition

CASE Ca 64 Henry Nowakowski, the auditor-in-charge of Vinacomin, a Vietnamese mining company, was reviewing the expert’s report on the valuation of reserves for the world’s largest bauxite deposits.

The mining plans of Vinacomin have met with strong criticism from scientists, environmentalists, and the Vietnamese population.

The bauxite operations had required the use of local auditors of another international public accounting firm. The group engagement partner, Judith Wooden, met with Henry to discuss the reliance their firm would be placing on the component auditors. She was concerned that the component auditors conclusions were not based on adequate evidence. The financial statements being audited by the component auditors are a material part of the consolidated statements of Vinacomin.

Required: a) What role does Henry have in assessing the expert’s report on the bauxite deposits? b) What role does Henry and his firm have before they make a decision to use the work of another auditor? c) What is the engagement partner’s role once her firm has assigned the work to a component auditor?

Solution: a) It is important that an expert's report be written in such a way that an auditor, who is not an expert in the field being reported on, can understand the technical content of the report.

The report should detail each stage of the process used in arriving at the overall opinion or conclusion of the report. It should include information about the data sources or estimation models used, or calculations conducted. The auditor assesses the appropriateness of the data sources used — it is essential that the expert uses data sources that are reputable and reliable. The auditor assesses the consistency of any assumptions made with those made in prior years and with other known information. The auditor assesses the consistency of information included in the expert's report with their understanding of the client. Finally, the auditor assesses the consistency of the conclusions drawn with corroborating evidence gathered by the audit team. b)

When making a client acceptance or continuance decision an auditor such as Henry will consider their capacity to undertake the audit. The primary auditors should also consider the proportion of the financial statements for which they will have to rely on another auditor (component auditor). The group engagement partner's firm should audit the majority of a client's financial statements and be knowledgeable about the components of the financial statements that they do not audit themselves. If this is not the case, the firm should not accept or continue to audit the client.

When assigning work to a component auditor, the group engagement partner will consider the capacity of the other auditor to undertake the work. The group engagement partner will also consider the reputation of the component auditor and ensure that they are a member of a reputable professional body. It is the responsibility of the group engagement partner to ensure that the work completed by a component auditor meets the group engagement partner's requirements and standards.

Audit evidence c)

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CAS 600 sets out the responsibilities of the group engagement partner when using the work of a component auditor. The group engagement partner sets out the work to be conducted by a component auditor. The two auditors may discuss the detailed procedures to be used and the group engagement partner then reviews the main conclusions drawn in the working papers of the component auditor. The extent of review of the component auditor's work depends on a number of factors. The group engagement partner will have to spend more time because the component of the client's financial statements being audited by a component auditor is material and/or at risk of material misstatement. The group engagement partner will spend less time if the component auditor has a good reputation and/or has done audit work for the group engagement partner in the past.

The group engagement partner uses the evidence provided by a component auditor when drawing a final conclusion on the fair presentation of a client's financial statements. The findings of a component auditor on a component of the financial statements will be placed in the context of the audit as a whole. If the group engagement partner is concerned about the conclusions arrived at by a component auditor they will discuss the findings with the component auditor. They may also discuss the implications of those findings with those charged with governance at the client to gain a more complete understanding of the component of the financial statements audited by the component auditor. If the group engagement partner decides that the conclusions arrived at by the component auditor indicate a material misstatement in the component audited, the group engagement partner will consider issuing a modified audit opinion if the impact of the misstatement is material to the financial statements taken as a whole.

Because the group engagement partner, Judith Wooden is concerned that the component auditor has not been able to gather sufficient appropriate audit evidence regarding the component of the financial statements audited, she will ask that further evidence be gathered. If the component auditor cannot access sufficient evidence, Judith Wooden will consider issuing a modified audit opinion due to a scope limitation. This will occur when the group engagement partner is unable to obtain additional evidence on the elements of the component audited by a component auditor.

CHAPTER 6 OVERVIEW OF TESTS OF CONTROLS, SUBSTANTIVE PROCEDURES AND SAMPLING

SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

5 10.

6 13.

8.

6 11.

7 14.

9.

6 12.

8 15.

Multiple Choice Questions 28.

1 34.

3 40.

29.

1 35.

4 41.

30.

1 36.

4 42.

31.

2 37.

4 43.

32.

1 38.

5 44.

33.

1 39.

5 45.

Short Answer Questions 55.

4 56.

6 57.

LO Item

1.

2.

3.

1 1 2

4.

5.

6.

3 4 4

8 6 9

16.

17.

18.

19.

20.

21.

1 1 1 1 1 1

22.

23.

24.

25.

26.

27.

1 4 1 6 1 6

53.

1,4,5,6 54.

1

Essay Questions 59.

6

60.

2

61.

6 Case

62.

5,6,9

LO Item

LO

9

6 6 6 6 6 7

46.

47.

48.

49.

50.

51.

7 7 8 9 8 9

7

58.

9

52.

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Test Bank for Auditing: a practical approach, Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

1.

2.

16.

TF TF MC

17.

18.

19.

MC MC MC

20.

21.

22.

3.

TF

31.

MC

60.

4.

TF

34.

MC

Type

Item Type Item Study Objective 1 MC 24.

MC 29.

MC 26.

MC 30.

MC 28.

MC 32.

Study Objective 2 ES Study Objective 3

5.

6.

TF TF

23.

35.

MC MC

36.

37.

MC MC

7.

TF

38.

MC

39.

MC

8.

9.

10.

TF TF TF

14.

25.

27.

TF MC MC

40.

41.

42.

MC MC MC

11.

TF

45.

MC

46.

MC

12.

TF

13.

TF

48.

MC

15.

TF

49.

MC

51.

MC

Note: TF = True-False MC = Multiple Choice

Study Objective 4 53.

SA 55.

SA Study Objective 5 53.

SA 62.

Study Objective 6 43.

MC 56.

44.

MC 59.

53.

SA 61.

Study Objective 7 47.

MC 57.

Study Objective 8 50.

MC Study Objective 9 52.

MC 58.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC MC

33.

53.

54.

MC SA SA

62.

Ca

62.

Ca

Ca SA ES ES SA

SA

ES = Essay

Overview of tests of controls, substantive procedures and sampling

6–3

CHAPTER STUDY OBJECTIVES 1.

Understand the difference between tests of controls and substantive tests. The purpose of tests of controls is to assess the effectiveness of a client’s system of internal controls throughout the accounting period being audited. The purpose of substantive testing is to gather direct evidence that the financial statements are free from material misstatement.

2.

Explain the factors that impact the nature, timing, and extent of audit testing. The nature of audit testing refers to the purpose of the test and the procedure used. The timing of audit testing refers to the stage of the audit when procedures are performed and the date, such as within or outside the accounting period, that audit evidence relates to. The extent of audit testing refers to the amount of audit evidence gathered when testing controls and conducting detailed substantive procedures.

3.

Explain how audit sampling is used in an audit. When creating an audit plan and designing audit procedures, an auditor also decides how to select appropriate items for testing. When there are numerous transactions or items within an account balance available for testing, an auditor must decide how best to select a sample that is representative of the entire population of items available for testing.

4.

Understand the difference between sampling and non-sampling risk. Sampling risk is the risk that the sample chosen by the auditor is not representative of the population of transactions or items within an account balance available for testing and, as a consequence, the auditor arrives at an inappropriate conclusion. Non-sampling risk is the risk that an auditor arrives at an inappropriate conclusion for a reason unrelated to sampling issues, such as an auditor using an inappropriate audit procedure.

5.

Differentiate between statistical and non-statistical sampling. Statistical sampling involves random selection and probability theory to evaluate the results. Non-statistical sampling is any sample selection method that does not have these characteristics.

6.

Describe sampling methods and the factors to be considered when choosing a sample. Sampling methods include random selection, systematic selection, haphazard selection, block selection, and judgemental selection. Before selecting a sample, an auditor will set parameters pertaining to control and detection risk, planning materiality, population, tolerable error rate, and the required level of confidence. Once these parameters are set, an auditor may select a sample using a statistical or non-statistical sampling technique.

7.

Determine the factors that influence the sample size when testing controls. When testing controls, the factors that influence the sample size include the extent to which the risk of material misstatement is reduced by the operating effectiveness of controls, the

6–4

Test Bank for Auditing: a practical approach, Canadian Edition rate of deviation from the prescribed control activity that the auditor is willing to accept, the rate of deviation from the prescribed control activity that the auditor expects to find in the population, the auditor’s required confidence level, and the number of sampling units in the population.

8.

Determine the factors that influence the sample size when substantive testing.

When conducting substantive testing of transactions and balances, the factors that influence the sample size include the auditor’s assessment of the risk of material misstatement, the use of other substantive procedures directed at the same assertion, the auditor’s required confidence level, the tolerable error, the amount of error the auditor expects to find in the population, the stratification of the population, and the number of sampling units in the population.

9.

Outline how to evaluate the results of tests conducted on a sample. When testing controls, the auditor will compare the rate of deviation with the tolerable rate of deviation and determine whether they believe that the control tested is effective in preventing and/or detecting a material misstatement. When testing transactions and balances, the error in the sample will be projected onto the population and then compared to the tolerable error rate. The auditor will then determine whether the class of transactions or account balance being tested appears to be materially misstated.

Overview of tests of controls, substantive procedures and sampling

6–5

TRUE-FALSE STATEMENTS 1.

An audit plan includes the audit procedures to be used when testing controls and when conducting detailed substantive audit procedures.

2.

Tests of controls are audit procedures designed to detect material misstatements at the assertion level.

3.

The timing of audit testing refers to the stage of the audit when procedures are performed and the date that audit evidence relates to.

4.

Sampling is required when an audit procedure is tested on an entire group of transactions or all items within an account balance.

5.

Sampling risk is the risk that the sample chosen by the auditor is not representative of the population available for testing.

6.

The risk that the auditor concludes that a material misstatement exists when it does not is likely to result in an increase in audit effort when it is not required.

7.

Non-statistical sampling involves random selection and probability theory to evaluate the results.

8.

Stratification is when an auditor selects a sample for testing by dividing the number of population items by the sample size, resulting in the sampling interval.

9.

Block selection involves the selection of items that are grouped together within the population of items available.

10.

Tolerable error is the minimum error an auditor is willing to accept within the population tested.

11.

An increase in the number of sampling units in the population will result in a decrease in the sample size.

12.

When auditors conclude that an internal control is effective, they will rely on the control to prevent and detect a material misstatement and reduce their detailed substantive procedures.

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Test Bank for Auditing: a practical approach, Canadian Edition

13.

When conducting substantive testing, an increase in the auditor's assessment of the risk of material misstatement will result in an increase in the size of the sample.

14.

Stratification of the population will result in less efficient sampling and increase the sample size required.

15.

Projected error refers to the extrapolation of the errors detected when testing a sample to the population from which the sample was drawn.

Overview of tests of controls, substantive procedures and sampling

6–7

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. T F T

Item 4.

5.

6.

Ans. F T T

Item 7.

8.

9.

Ans. F F T

Item 10.

11.

12.

Ans. F F T

Item 13.

14.

15.

Ans. Item T F T

Ans. Item

Ans.

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Test Bank for Auditing: a practical approach, Canadian Edition

MULTIPLE CHOICE 16.

Vita Zitkauskas, the senior on the audit of Magna International, was explaining how audit strategy and audit plans have an impact on tests of controls and substantive procedures.

She made two statements: (i) Audit strategy details the audit procedures to be used when testing controls and when conducting detailed substantive audit procedures. (ii) The audit plan provides the basis for developing an audit strategy.

Which statements were true, if any? a. (i) only b. (ii) only c. (i) and (ii) d. neither (i) or (ii)

17.

Helen Lam assessed control risk to be low. What is the appropriate audit strategy she should adopt? a. predominantly substantive audit approach b. control testing strategy c. combined audit strategy d. substantive year end testing

18.

Oliver DiPietro was testing the controls of Blue Coast Wholesale Fish Market. When testing controls, which one of the following evidence gathering procedures is used? a. vouching of transactions b. confirmations of accounts receivable c. tracing of transactions to source documents d. enquiry of client personnel

19.

Michael Fernandez has decided to perform substantive procedures at a major retailer.

Which one of the following is not a substantive procedure? a. re-performing control procedures to test their effectiveness b. inspecting documents to verify the dates of the transactions c. bank confirmations regarding interest rates on borrowings by client d. recalculating an interest expense using confirmed interest rates

20.

Ricky Alfaro wanted to ensure that all the transactions at his client were recorded. For which assertion was he conducting these detailed substantive procedures? a. occurrence b. completeness c. cut-off d. none of the above

21.

Milushka Icaza, who was representing her CGA firm at a conference, made the following statement about assertions: When our auditors conduct substantive procedures, we

Overview of tests of controls, substantive procedures and sampling

6–9

search for evidence that recorded accounts exist and that all accounts that should have been recorded, indeed have been recorded. Which assertions was she talking about? a. rights and obligations and recording b. valuation and allocation and recording c. occurrence and completeness d. none of the above

22.

Richard Nucci used analytical procedures at his client, Ultimate Vacations. Which one of these is not an analytical procedure? a. Send confirmations to major customers. b. Estimate revenue for Ultimate Vacations by multiplying trips sold by average price of vacation packages. c. Discuss unusual fluctuations with client personnel. d. Compare wages month by month for this year and last year.

23.

Walter Polonia was explaining to his junior staff the implications of sampling risk when conducting substantive testing. He made the following two statements: (i) “If we conclude that a material misstatement does not exist when it does, then we have an increased control risk.” (ii) “If we conclude that a material misstatement exists when it does not we have an inefficient audit.”

Which statements, if any, were true? a. (i) b. (ii) c. (i) and (ii) d. neither (i) or (ii)

24.

Christopher Mikos has been involved in testing controls at Highbridge Falls. Which of these control tests would be deemed ineffective? a. reading a client’s policy manual b. entering invalid passwords to to see whether access is denied c. both a and b d. none of the above are effective controls

25.

Daniel Beauchamp did not perform a true sample when he went to his client to examine sales invoices. He did not use any specific method for choosing the invoices. He let his eye catch the items he thought might make up his sample. What technique did he use? a. random selection b. block selection c. haphazard selection d. stratified sample selection

26.

Lucy Pelletier was training a team of new auditors and delivered some interesting rules of thumb about control risk and detection risk: (i) “The required level of confidence is a function of control risk when testing controls and detection risk when conducting substantive tests.”

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Test Bank for Auditing: a practical approach, Canadian Edition (ii) “When detection risk is determined to be low, an auditor will require a low level of confidence that the transactions and accounts are not materially misstated.

Which of the above two statements are true? a. (i) only b. (ii) only c. both (i) and (ii) d. neither (i) or (ii)

27.

George Melkonian wanted to determine whether his auditing class knew how different factors influence sample size. He made two statements: (i) “An increase in the expected rate of deviation of the population to be tested will decrease sample size.” (ii) “An increase in the tolerable rate of deviation will decrease sample size.”

George asked his class to indicate which of the statements, if any, were false. a. (i) b. (ii) c. (i) and (ii) are false d. neither of the two statements is false

28.

Control risk is the risk that: a. an auditor expresses an inappropriate audit opinion when a financial statement is materially misstated. b. an auditor's substantive procedures will not detect material misstatements. c. a client's system of internal controls will not prevent or detect a material misstatement. d. none of the above.

29.

Tests of controls are conducted to establish that: a. controls operate consistently throughout the period. b. there are no material misstatements in the financial statements. c. controls operate effectively. d. both a and c.

30.

When conducting detailed substantive procedures, auditors search for evidence that: a. the client's internal control system is operating effectively. b. all transactions have been recorded in the correct accounts. c. no fraud has occurred during the year. d. they have remained independent of their clients.

31.

For high-risk accounts, the timing of most audit procedures will be: a. whenever the client says it is most convenient for them to be conducted. b. at, or after, year-end. c. before year end. d. during the interim audit testing stage.

Overview of tests of controls, substantive procedures and sampling

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32.

Substantive audit procedures include: a. detailed tests of balances. b. analytical procedures. c. detailed tests of transactions. d. all of the above.

33.

When control risk is high, the audit strategy is to: a. do little or no tests of controls and increase reliance on substantive testing of transactions and account balances. b. assume the client's management is dishonest and immediately report them to the CRA. c. increase reliance on tests of controls and reduce reliance on substantive testing of transactions and account balances.. d. refuse to continue with the remainder of the audit due to the high risk of fraud.

34.

Sampling is not required when: a. it is the first year that the auditor has done the audit for a client. b. the auditor is conducting tests of controls. c. an audit procedure is conducted on an entire group of transactions. d. the client requests the auditor not to collect samples of certain transactions.

35.

When testing controls, sampling risk is the risk that the auditor: a. concludes that their client's internal controls are ineffective when they are effective. b. concludes that their client's internal controls are effective when they are ineffective. c. both a and b. d. none of the above.

36.

Non-sampling risk arises when an auditor: a. does not use sampling. b. uses an inappropriate audit procedure. c. tests all of the items in a population. d. spends too much time testing the accounts most at risk of material misstatement.

37.

When testing controls, non-sampling risk is the risk that an auditor: a. designs tests that are ineffective. b. does not select a sample. c. both a and b. d. none of the above.

38.

Which of the following statements regarding statistical sampling is correct? a. It is easier to use than non-statistical sampling. b. It involves haphazard selection.

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Test Bank for Auditing: a practical approach, Canadian Edition c. d.

It is generally used for low risk accounts.

It involves random selection.

39.

Which of the following is not an advantage of non-statistical sampling? a. It allows an auditor to select a sample that they believe is appropriate. b. It allows an auditor to measure sampling risk. c. It is lower cost than statistical sampling. d. It requires less staff training.

40.

Random selection involves: a. dividing a population into groups of sampling units with similar characteristics. b. the selection of a sample without the use of a methodical technique. c. the selection of a sample that is free from bias and where each item in a population has an equal chance of selection. d. the selection of items that an auditor believes should be included in their sample for testing.

41.

Which sampling method involves the selection of items that are grouped together within the population of items available? a. systematic selection b. haphazard selection c. random selection d. block selection

42.

When testing controls, the tolerable error is: a. the tolerable rate of deviation that an auditor will accept before concluding that a control is effective. b. the minimum rate of deviation that an auditor will accept. c. the tolerable rate of deviation that an auditor will accept before concluding that a control is ineffective. d. the maximum amount of error in an account balance that an auditor will accept before concluding that an account is materially misstated.

43.

Which of the following statements is incorrect? a. When detection risk is set as high, an auditor will require a high level of confidence that the transactions and accounts are not materially misstated. b. An auditor may decide to stratify the population before selecting a sample .from it. c. An auditor will use professional judgment to determine the tolerable error and required level of confidence. d. An auditor will use professional judgment when considering what would be considered an error within the population tested.

44.

Before selecting a sample, an auditor will use professional judgment to: a. set the required level of confidence.

Overview of tests of controls, substantive procedures and sampling b. c. d.

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set the tolerable error rate. select an appropriate population for testing. all of the above.

45.

Which of the following is a factor that influences the sample size when testing controls? a. an increase in the auditor's assessment of the risk of material misstatement b. an increase in the tolerable rate of deviation c. stratification of the population when appropriate d. an increase in tolerable misstatement

46.

When testing controls, a decrease in the sample size will occur when there is: a. an increase in the tolerable rate of deviation. b. a decrease in the tolerable rate of deviation. c. an increase in the extent to which the auditor's risk assessment takes into account relevant controls. d. an increase in the number of sampling units in the population.

47.

What impact will there be on sample size when there is an increase in the number of sampling units in the population? a. increase b. decrease c. negligible d. none of the above

48.

When conducting substantive testing, which of the following is not a factor that influences the sample size? a. an increase in the tolerable rate of deviation b. an increase in the auditor's assessment of the risk of material misstatement c. stratification of the population when appropriate d. an increase in tolerable misstatement

49.

An account is at a higher risk of misstatement when it requires: a. complex calculations. b. estimation. c. both a and b. d. simple valuation techniques.

50.

What impact will there be on sample size for substantive testing when there is an increase in the tolerable misstatement? a. decrease b. negligible c. increase d. none of the above

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Test Bank for Auditing: a practical approach, Canadian Edition

51.

When evaluating sample test results, which of the following statements is incorrect? a. If an auditor discovers errors when testing transactions or account balances, they will need to project the error to the population being tested. b. An auditor will not consider whether the population was stratified before being sampled. c. If an error is considered to be unique it will be removed before projecting remaining errors to the population. d. If the rate of deviation exceeds the tolerable rate the auditor will extend their testing.

52.

If the total projected error in an account balance was $3,248 and the tolerable error was set at $10,000, the auditor would: a. conclude that the errors uncovered are material. b. decide that further audit work was required. c. conclude that the errors detected are not material. d. conduct other tests aimed at the assertion being tested.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

21.

Ans. d c d a b c

Item 22.

23.

24.

25.

26.

27.

Ans. a b a c a a

Item 28.

29.

30.

31.

32.

33.

Ans. c d b b d a

Item 34.

35.

36.

37.

38.

39.

Ans. c c b a d b

Item 40.

41.

42.

43.

44.

45.

Ans. c d c a d b

Item 46.

47.

48.

49.

50.

51.

Ans. a c a c a b

Item 52.

Ans. c

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SHORT ANSWER QUESTIONS SA 53 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Karen Elliott was explaining to her group partner that the completeness assertion implies that transactions and events that have been recorded have occurred and pertain to the entity. b) Joseph Cabana was explaining to Carl Metz how sampling risk works for the audit team: “Sampling risk is the risk that as auditors we will arrive at a conclusion that has nothing to do with sampling issues.” c) Robert Scardera was vehemently arguing about the benefits of using non-statistical versus statistical sampling methods for a client in the excavation business. Here is what he had to say about non-statistical sampling: “Non-statistical sampling is easier to use than statistical sampling, it requires less staff training, it has lower cost, and it allows an auditor to make a sample choice that they believe is appropriate.” d) Elaine Mathers has started her sample selection of sales transactions for a gemstone conglomerate. She believes that she can improve audit efficiency by stratifying the sample.

Solution: a) Disagree. The occurrence assertion implies that transactions and events that have been recorded have occurred and pertain to the entity. The completeness objective infers that all transactions that should have been recorded, indeed have been recorded. b)

Disagree. Joseph Cabana was describing non-sampling risk. Sampling risk is the risk that an auditor will conclude that a material misstatement exists when it does not or a material misstatement does not exist when it does.

c)

Agree. All the elements Robert brings up are generally true. Statistical sampling can have the disadvantage of the cost involved in using it. Most audit firms use a combination of statistical and non-statistical sampling as both methods provide appropriate audit evidence and allow the auditor to form a conclusion on the items being tested.

d)

Agree. Stratification can be used ahead of random selection to improve audit efficiency.

This means that an auditor partitions a population ahead of sampling, by identifying sub populations with similar characteristics. For example, for accounts receivable, the auditor may stratify high dollar items or balances that are overdue. After stratifying a population, items can be randomly selected within each stratum. Thus, stratification can be used to ensure the sample includes items that have the characteristics required by the auditor, such as the inclusion of material or risky items in the sample, while remaining a statistical sampling technique, when items are randomly selected.

SA 54 Explain the differences between the main objectives of tests of controls and substantive procedures.

Solution:

Overview of tests of controls, substantive procedures and sampling

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Tests of controls are conducted to establish that controls: operate effectively, meaning that the rate of deviation from prescribed control procedures are minimized and controls effectively prevent and detect material misstatements, and operate consistently throughout the accounting period.

When conducting detailed substantive procedures, an auditor searches for evidence that recorded transactions occurred and relate to the client (occurrence assertion), that all transactions have been recorded (completeness assertion), that all transactions have been recorded at appropriate carrying amounts (accuracy assertion), that all transactions have been recorded in the correct accounting period (cut-off assertion) and that all transactions have been recorded in the correct accounts (classification assertion). Detailed substantive procedures also involve an auditor searching for evidence that recorded accounts such as assets, liabilities and equity accounts exist (existence assertion), that all accounts that should have been recorded have been recorded (completeness assertion), that recorded accounts represent items owned by the client or amounts owed by the client to third parties (rights and obligations assertion) and that recorded accounts appear at appropriate carrying amounts (valuation and allocation assertion).

SA 55 Explain sampling risk as it relates to both tests of controls and substantive procedures.

Solution: Sampling risk is the risk that the sample chosen by the auditor is not representative of the population of transactions or items within an account balance available for testing and, as a consequence, the auditor arrives at an inappropriate conclusion. When testing controls, sampling risk is the risk that an auditor relies on their client's system of internal controls when they should not do so (that is, the auditor concludes that their client's internal controls are effective when they are ineffective), and the risk that an auditor concludes that their client's internal controls are less reliable than they really are (that is, the auditor concludes that their client's internal controls are ineffective when they are effective). When conducting substantive tests, sampling risk is the risk that an auditor concludes that a material misstatement does not exist when it does or an auditor concludes that a material misstatement exists when it does not.

SA 56 Describe the major types of sampling techniques available to auditors.

Solution: There are a range of sampling techniques available to auditors which include random selection, systematic selection, haphazard selection, block selection and judgment selection. Random selection requires that the person selecting the sample does not influence the choice of items selected. The resulting sample is then free from bias and each item within the population has an equal chance of being selected for testing. Random number generators can be used to select a sample. Systematic selection involves the selection of a sample for testing by dividing the number of items in a population by the sample size, resulting in the sampling interval (n). Once the sampling interval has been determined a starting point is selected, which is an item in the population below the sampling interval, and then the sample is selected by selecting the first item and then every nth item after that. Haphazard selection involves the selection of a sample by an auditor without using a methodical technique. Block selection involves the selection of items that are grouped together within the population of items available. Judgmental selection involves the selection of items that an auditor believes should be included in their sample for

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Test Bank for Auditing: a practical approach, Canadian Edition

testing. When testing controls, judgment may be used to ensure that transactions processed when a new computer is installed are included in the sample. When conducting substantive testing, judgment may be used to include in the sample large or unusual items.

SA 57 Identify and explain the factors that influence the sample size for tests of controls.

Solution: There are a number of factors that will influence the sample size when testing controls. The first factor is an increase in the extent to which the risk of material misstatement is reduced by the operating effectiveness of controls. If an auditor believes that a control will be effective in reducing an identified risk of material misstatement, their audit strategy will be to increase testing of that control to ensure it is effective. When concluding that a control is effective, an auditor will rely on that control to prevent and detect a material misstatement, and reduce their detailed substantive procedures. The second factor is an increase in the rate of deviation from the prescribed control activity that the auditor is willing to accept. There is an inverse relationship between the tolerable rate of deviation and sample size. If an auditor intends to rely on a control to prevent and detect a material misstatement, a lower tolerable error rate will be set and the sample size will be increased to provide the auditor with the evidence required to demonstrate that the control is effective. If an auditor expects to place relatively more reliance on their substantive procedures and reduce their reliance on an internal control, they will increase the tolerable rate of deviation and reduce the sample size when testing the control.

The third factor is an increase in the rate of deviation from the prescribed control activity that the auditor expects to find in the population. If an auditor believes that the rate of deviation has increased when compared to prior audits, they will increase the sample size to accurately evaluate the impact of the changed circumstances. The fourth factor is an increase in the auditor's required confidence level. When control risk is assessed as low for a risk factor, an auditor's required level of confidence in the effectiveness of their client's internal control is higher than when control risk is assessed as medium to high. If an auditor is to rely on their client's internal control procedures to prevent or detect an identified material misstatement, their required confidence level in that control increases and they will increase the sample size when testing that control. The fifth and final factor is an increase in the number of sampling units in the population. When a population is large and fairly homogenous, there is little benefit from continuing to increase the sample size as the results from continued testing should confirm early findings.

SA 58 Explain how auditors evaluate the results of tests of controls conducted on a sample.

Solution: After an auditor has completed their audit testing, the next stage is to evaluate the results.

When testing controls, an auditor will consider whether the results of their tests applied to a sample provide evidence that the control tested is effective within the entire population. If an auditor discovers departures from prescribed controls when testing controls, a deviation rate will be calculated. The deviation rate is the proportion of departures within the sample. If the sample is representative of the population, the auditor will compare this deviation rate with their tolerable rate of deviation. If the rate of deviation exceeds the tolerable rate, the auditor will extend their testing and gather further evidence of other controls that may be aimed at reducing the identified risk of material misstatement. If after conducting more testing the auditor finds that

Overview of tests of controls, substantive procedures and sampling

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the rate of deviation remains consistent with their initial findings and other controls are similarly ineffective, the auditor will conclude that the client's system of internal controls cannot be relied upon to prevent or detect a potential material misstatement and the auditor will increase their reliance on their substantive tests of the account tested.

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ESSAY QUESTIONS ES 59 A range of sampling techniques are available to auditors. Evaluate the advantages and disadvantages of the major techniques.

ES 60 An auditor uses professional judgment when determining the nature, timing and extent of audit procedures to use for each audit. Explain why the nature, timing and extent of audit testing are crucial factors in every audit.

ES 61 The most common statistical sample selection method according to the study by Hall et al (2002) is dollar-unit sampling. Explain in detail how this method operates and evaluate the advantages and disadvantages of using it.

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CASE Ca 62 Barry Menzies walked out of the Old Country Bakery operation and chewed on a Cheese Danish. He had chosen random selection to test for proper authorization of purchasing transactions. He had just completed the initial audit testing of the purchasing transactions and had evaluated the results. His conclusion was that the deviation rate of 12 exceptions in a sample of 80 transactions was relatively high.

In addition, Barry was preparing to start the audit of another client, Rohr Industries, an airplane component manufacturer. He had discussed sampling methodology with his audit team and it had been determined that the Rohr Industries systems did not lend themselves easily to statistical sampling techniques. The audit team would have to employ non-statistical sampling.

Required: a) What is the procedure that Barry Menzies would follow when his initial testing showed a relatively high deviation rate for the Old Country Bakery transactions? b) What is non-statistical sampling? c) Describe the non-statistical sampling methods that were open to Barry and his team for the Rohr Industries audit. d) Which of Barry’s two clients’ systems would lend themselves to stratification?

Solution: a) After discovering the high deviation rate, Barry would perform the following: 1. Compare the deviation rate with the tolerable rate of deviation.

2. If the rate of deviation exceeds the tolerable rate, then Barry would extend testing and gather further evidence of other controls that may be aimed at reducing the identified risk of material misstatement.

3. If after conducting more testing Barry finds that the rate of deviation remains consistent with his initial findings and other controls are similarly ineffective, Barry would conclude that the client's system of internal controls cannot be relied upon to prevent or detect a potential material misstatement.

4. Barry would then increase his reliance on substantive tests of the account being tested. b)

Non-statistical sampling is any sample selection method that does not have the characteristics of statistical sampling. It is generally easier to use, and requires less resources and training.

c)

Haphazard selection involves the selection of a sample by an auditor without using a methodical technique. There is a risk that an auditor will avoid selecting some items or ensure other items are included in the sample. For example, an item that is going to be difficult to test because the documentation is held in another location may be deliberately excluded by the auditor, while an item that looks large or unusual and catches the auditor's eye may be included. This is a non-statistical technique as human bias may impact the sample selected, and therefore prevent the sample from being a true random sample.

Block selection involves the selection of items that are grouped together within the population of items available. This is a non-statistical technique as many populations of items are sorted in a sequence, which makes the selection of groups of items in a block inap-

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Test Bank for Auditing: a practical approach, Canadian Edition

propriate. For example, transactions are generally grouped in date order; by using block selection the items selected will not be representative of transactions made throughout the year.

Judgmental selection involves the selection of items that an auditor believes should be included in their sample for testing. When testing controls, judgment may be used to ensure that transactions processed when a new computer is installed are included in the sample.

When conducting substantive testing, judgment may be used to include in the sample large or unusual items. This is a non-statistical sampling technique. d)

Stratification consists of the process of dividing a population into groups of sampling units with similar characteristics.

This means that if Barry’s audit team can partition a population of transactions into sub populations that have similar characteristics, such as high dollar values, there will be audit efficiencies.

Stratification is usually performed ahead of random selection. There is an indication that the Rohr Industries systems do not lend themselves easily to statistical sampling techniques and that the audit team has decided to employ non-statistical sampling. Hence, stratification will be more practicable for the Old Country Bakery audit as it is already using random sampling techniques.

CHAPTER 7 GAINING AN UNDERSTANDING OF THE CLIENT’S SYSTEM OF INTERNAL CONTROLS SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

3 10.

5 13.

8.

3 11.

5 14.

9.

3 12.

6 15.

Multiple Choice Questions 28.

3 34.

2 40.

29.

5 35.

2 41.

30.

4 36.

2 42.

31.

1 37.

2 43.

32.

1 38.

2 44.

33.

1 39.

3 45.

Short Answer Questions 58.

3 59.

3 60.

LO Item

1.

2.

3.

1 1 2

4.

5.

6.

2 2 3

6 7 7

16.

17.

18.

19.

20.

21.

1 2 2 3 3 3

22.

23.

24.

25.

26.

27.

3 3 3 3 4 4

56.

2,3,4,

57.

2

Essay Questions 62.

7

63.

1

64.

6 Case

65.

3

LO Item

LO

5 6 7 7

3 3 3 3 3 3

46.

47.

48.

49.

50.

51.

3 3 4 4 5 5

5

61.

7

52.

53.

54.

55.

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Test Bank for Auditing: a practical approach, Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

TF

2.

TF

16.

MC

3.

4.

TF TF

5.

17.

TF MC

18.

34.

MC MC

6.

7.

8.

9.

TF TF TF TF

19.

20.

21.

22.

MC MC MC MC

23.

24.

25.

28.

MC MC MC MC

26.

MC

27.

MC

30.

MC

10.

TF

11.

TF

29.

MC

12.

TF

13.

TF

53.

MC

14.

TF

15.

TF

54.

MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 31.

MC 32.

Study Objective 2 35.

MC 37.

36.

MC 38.

Study Objective 3 39.

MC 43.

40.

MC 44.

41.

MC 45.

42.

MC 46.

Study Objective 4 48.

MC 49.

Study Objective 5 50.

MC 51.

Study Objective 6 64.

ES Study Objective 7 55.

MC 61.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC

33.

MC

MC MC

56.

57.

SA SA

MC MC MC MC

47.

56.

58.

59.

MC SA SA SA

MC

56.

SA

MC

52.

MC

SA

62.

ES

ES = Essay

63.

ES

65.

Ca

60.

SA

Gaining an understanding of the client’s system of internal controls

7–3

CHAPTER STUDY OBJECTIVES 1.

Define internal control. Internal control is the process designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. The term “controls” refers to any aspects of one or more of the components of internal control. Controls include entitylevel controls and transaction-level controls.

2.

Explain the seven generally accepted objectives of internal control activities.

Internal controls are designed and implemented to ensure that transactions are real, recorded, correctly valued, classified, summarized, and posted, and timely

3.

Understand and describe the elements of internal control at the entity level. The elements of internal control at the entity level are the control environment, the entity’s risk assessment process, the entity’s information system and communications, control activities, and monitoring. Internal control also includes how the controls are implemented, such as through appropriate segregation of duties.

4.

Understand and describe the elements of internal control at the transaction level, and apply them to the sales, purchases, and payroll cycles. Transaction-level controls are controls that impact a particular transaction or group of transactions.

Transactions in this sense refer to transactions that are ordinarily recorded in the general ledger for the client and span from initiation of the transaction through to the reporting of the transaction in the financial statements. Transaction-level controls are those controls that respond to things that can go wrong with transactions.

5.

Explain the different techniques used to document internal controls. The most common forms of documentation are narratives, flowcharts, combinations of narratives and flowcharts, and checklists and preformatted questionnaires.

6.

Explain the importance of identifying strengths and weaknesses in a system of internal controls. An important outcome of understanding a client’s system of internal controls is the ability to make observations, draw conclusions, and offer recommendations regarding the strengths and weaknesses observed. CAS 260 and CAS 265 require auditors to provide those charged with governance with timely observations arising from the audit. This is generally done through a management letter.

7.

Explain how to communicate internal control strengths and weaknesses to those charged with governance. A management letter (sometimes also referred to as a letter of recommendations) is a deliverable prepared by the audit team and provided to the

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Test Bank for Auditing: a practical approach, Canadian Edition client (including those charged with governance). It informs the client of the auditor’s recommendations for improving its internal controls.

Gaining an understanding of the client’s system of internal controls

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TRUE-FALSE STATEMENTS 1.

Internal control is intended to provide reasonable assurance about the achievement of an entity's objectives.

2.

Audit risk is the risk that an entity's internal control system will not prevent or detect material misstatements.

3.

The inherent limitations of internal control include the possibility of collusion by two or more individuals to circumvent a control.

4.

The internal control objective of 'valued' refers to controls in place to ensure that transactions are recorded in the correct accounting period.

5.

The internal control objective of 'real' refers to controls in place to ensure that fictitious or duplicate transactions are not included in the books and records of the organization.

6.

One of the elements of an entity's control environment is management's philosophy and operating style.

7.

Control risk refers to the risk that the auditor's testing procedures will not be effective in detecting a material misstatement.

8.

The concept that no one employee should be in a position both to perpetrate and hide errors or fraud in the normal course of their duties is known as segregation of incompatible duties.

9.

In larger entities, there are often limitations surrounding the entity's ability to put effective internal controls in place.

10.

Narratives involve the auditor describing in words each step of the flow of transactions from start to finish.

11.

Checklists and preformatted questionnaires are particularly helpful in industries that the auditor may not personally be familiar with auditing.

12.

Internal control weaknesses decrease the risk of material misstatements being undetected by management's processes and controls.

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13.

An internal control exception is an observed condition that provides evidence that the control being tested did not operate as intended.

14.

The purpose of an auditor's management letter is to inform the client of the auditor's recommendations for improving its internal controls.

15.

Significant professional judgment is never required to decide whether an identified internal control weakness is significant enough to warrant communicating to management.

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7–7

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. T F T

Item 4.

5.

6.

Ans. F T T

Item 7.

8.

9.

Ans. F T F

Item 10.

11.

12.

Ans. T T F

Item 13.

14.

15.

Ans. Item T T F

Ans. Item

Ans.

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Test Bank for Auditing: a practical approach, Canadian Edition

MULTIPLE CHOICE QUESTIONS 16.

A partner and his team performed an audit and issued an unqualified audit report. A year later his firm was sued when a shareholder found out the financial statements were misstated. This situation best describes: a. poor internal controls. b. human error. c. unethical behaviour. d. audit risk.

17.

As part of her annual review Roma Lazor reviews her client’s draft financial statements for proper disclosures and compliance to accounting standards. This best describes which control objective(s)? a. posting b. classification and understandability c. valuation d. timeliness

18.

Internal controls in large and medium sized entities can only provide an entity with reasonable assurance in achieving its financial reporting objectives. Which of the following is not an inherent limitation of internal control? a. human error that results in a breakdown in internal control b. collusion by two or more individuals to circumvent a control c. a control within a software program being overridden or disabled d. changing audit risk parameters

19.

Stanley Morgan has learned that it is important to be aware of the attitude and actions of management and those charged with governance concerning the entity's internal control and its importance in the entity. This best describes dealing with a. a key control objective. b. the control environment. c. mitigation of audit risk. d. financial statement assertions.

20.

Thea Lisowski decided to list several questions for herself about factors that influence management's attitudes towards internal control so as to assure herself that she could have more confidence in management’s abilities and integrity. When she was finished, which control environment element did she tick off on her working papers? a. management’s philosophy and operating style b. communication and enforcement of integrity and ethical values c. commitment to competence d. participation by those charged with governance

Gaining an understanding of the client’s system of internal controls

7–9

21.

As part of her yearly audit plan activities, Krystyne Sliz reviews audit working papers of previous years to determine the risk that a client's system of internal controls will not prevent or detect a material misstatement. This review refers to: a. audit risk. b. inherent risk. c. control risk. d. detection risk.

22.

Claudia Andreou was concerned when she reviewed the operations of her client and noticed that many of the employees had incompatible duties over the recording of transactions and custody of assets. This best refers to which desired control? a. information processing controls b. physical controls c. authorization controls d. segregation of incompatible duties

23.

When Melissa Lee, a senior auditor, performed an audit of an electronics firm, she reviewed the control environment, performed a risk assessment, and reviewed the key business processes and control activities. These activities are part of: a. a review of entity-level controls. b. a review of the internal control system. c. establishing audit risk. d. none of the above.

24.

When Vanessa Lanthier reviewed the different key activities in the marketing department of a wholesaler of jewellery, she was performing an entity level review of: a. monitoring controls. b. the control environment. c. internal controls. d. the risk assessment process.

25.

Harry Karas was involved in getting a big picture of his client’s entity controls. He went about finding out whether periodic evaluations of internal control are made and determining the extent to which personnel, in carrying out their regular duties, obtain evidence as to whether the system of internal controls continues to function. These activities are part of: a. internal control activities. b. documentation controls. c. monitoring of controls. d. none of the above.

26.

Marcia Salinger reviewed the following activities in the Sales cycle: She ensured that once the invoice had been created it was posted to the appropriate accounts in the sales journal and the accounts receivable sub ledger in the appropriate accounting period and that the sales journal was reconciled to the general ledger accounts. These activities are part of which of the following sales process activities?

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Test Bank for Auditing: a practical approach, Canadian Edition a. b. c. d.

invoicing customers cash receipts recording sales and trade receivables none of the above

27.

Mona Kew is reviewing the purchasing and payments process. At which stage would she determine that purchases that are being made are properly authorized? a. purchase requisition transaction b. recording purchases and related items transaction c. invoicing transaction d. purchasing transaction

28.

Rina Glickstein is unsure about the best way to evaluate her audit staff. She decides to look at their professional characteristics such as their expertise, experience, knowledge and training. What best describes what she is looking for? a. their independence b. their professional judgment c. their due care d. none of the above

29.

Anwar Maris is considering whether to use a checklist or narrative approach to describing the purchasing system of an environmental engineering company. What part of the audit process is he involved in? a. documenting internal controls b. risk assessment of company c. review of control environment d. none of the above

30.

Maxime Talbot is concerned that his client’s control system has a risk of the wrong price being charged on the purchase invoice by the supplier. At which transaction stage would this risk be reviewed? a. purchase requisition transaction b. receiving transaction c. purchasing transaction d. none of the above

31.

When internal controls are effective: a. there will be an increased reliance on substantive tests of transactions and account balances. b. control risk will also be high. c. the organization is more likely to achieve its strategic and operating objectives. d. the organization is less likely to achieve its strategic and operating objectives.

32.

Internal control encompasses which of the following elements of an organization? a. processes

Gaining an understanding of the client’s system of internal controls b. c. d.

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culture systems all of the above

33.

Which of the following statements about internal control is incorrect? a. Internal control is a very broad concept. b. Internal control eliminates the possibility of fraud and error. c. Internal control encompasses all of the elements of an organization. d. Internal control provides reasonable assurance about the achievement of the entity's objectives.

34.

The generally accepted objectives of internal control do not include: a. efficiency. b. classified. c. recorded. d. timely.

35.

The internal control objective of 'classified' means there are controls in place to ensure that: a. fictitious or duplicate transactions are not included in the books of an organization. b. correct amounts are assigned to transactions. c. transactions are recorded in the correct accounting period. d. transactions are charged and allocated to the correct general ledger account.

36.

Which assertion is not specifically addressed by internal control objectives? a. cut-off b. presentation and disclosure c. completeness d. existence

37.

If controls are in place to ensure that transactions are recorded in the correct accounting period, this satisfies which internal control objective? a. timely b. real c. valued d. posted

38.

Which of the following is an inherent limitation of internal control? a. a control within a software program being overridden or disabled b. human error that results in a breakdown in internal control c. collusion by two or more individuals to circumvent a control d. all of the above

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Test Bank for Auditing: a practical approach, Canadian Edition

39.

All of the following are components of internal control, except for: a. monitoring of controls. b. the control environment. c. audit committees. d. the information system.

40.

Which of the following is an element of the control environment? a. participation by those charged with governance b. commitment to competence c. segregation of duties d. both a and b

41.

The control environment does not: a. set the tone of an entity. b. set the foundation for all other components of internal control. c. refer to the policies and procedures that help make sure management's directives are carried out. d. influence the control consciousness of employees.

42.

For identified risks, management: a. assesses the likelihood of their occurrence. b. decides upon actions to manage them. c. estimates their significance. d. all of the above.

43.

Detection risk refers to: a. the susceptibility of an assertion to a material misstatement, assuming there are no related controls. b. the risk that the auditor's testing procedures will not be effective in detecting a material misstatement. c. the risk that a client's system of internal controls will not prevent or detect a material misstatement. d. none of the above.

44.

Which of the following statements relating to control activities is incorrect? a. They include management's philosophy and operating style. b. They are policies and procedures that help make sure management's directives are carried out. c. They help guarantee that necessary actions are taken to address risks impacting the achievement of the organization's objectives. d. They have various objectives and are applied at various organizational and functional levels.

45.

Performance reviews are control activities that include: a. authorization for access to computer programs.

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segregating incompatible duties. reviews of actual performance versus budgets. periodic counting and comparison with amounts shown on control records.

46.

In understanding the client's control activities at the entity level, consideration is given to factors such as: a. the extent to which performance of control activities relies on IT. b. the extent to which controls included in the organization's policies are being applied. c. whether adequate safeguards are in place to prevent unauthorized access to or destruction of documents, records and assets. d. all of the above.

47.

When gaining an understanding of the client's monitoring processes at the entity level, factors ordinarily considered include: a. evaluations or observations made by the external auditors. b. management's approach to correcting known significant deficiencies on a timely basis. c. both a and b. d. none of the above.

48.

Which of the following is not an example of an internal control for the sales process? a. credit committee review of credit limits on a quarterly basis b. approved purchase order is reconciled to invoice c. application control that only allows orders to be processed against existing approved customers with enough unused credit limit d. invoices automatically generated from order documents

49.

For purchasing inventory transactions, an example of a risk that arises is: a. goods that have been sold and invoiced are included in the inventory on hand. b. the wrong quantities are recorded during the inventory count. c. the wrong labour costs are added to the cost of individual inventory items. d. the wrong amount is paid against an invoice.

50.

The most common ways of auditors documenting their understanding of internal controls include: a. flowcharts. b. narratives. c. preformatted questionnaires. d. all of the above.

51.

Flowcharts involve: a. the auditor summarizing in boxes each step of a transaction from start to finish. b. the auditor describing in words each step of the flow of transactions from start to finish.

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Test Bank for Auditing: a practical approach, Canadian Edition c. d.

both a and b. none of the above.

52.

Checklists and preformatted questionnaires are particularly helpful: a. in industries that the auditor may not personally be familiar with auditing. b. when control risk is high. c. when less experienced auditors find it difficult to identify which are the critical controls. d. both a and c.

53.

An internal control exception is: a. only expected to exist when internal controls are effective. b. an observed condition that provides evidence that the control being tested did not operate as indicated. c. both a and b. d. an observed condition that provides evidence that the control being tested did operate as indicated.

54.

The purpose of the management letter is to inform: a. the auditor with concerns held by the client's management about the audit fee. b. the client's management of the auditor's opinion on the company's financial statements. c. the client's audit committee’s disagreements with management. d. the client of the auditor's recommendations for improving its internal controls.

55.

Which of the following statements is correct? a. Significant professional judgment is not necessary in deciding whether a weakness identified is significant enough to warrant communicating to management. b. A management letter is prepared by management. c. Significant professional judgment is necessary in deciding whether a weakness identified is significant enough to warrant communicating to management. d. All of the above.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

21.

Ans. d b d b a c

Item 22.

23.

24.

25.

26.

27.

Ans. d a c c c a

Item 28.

29.

30.

31.

32.

33.

Ans. b a d c d b

Item 34.

35.

36.

37.

38.

39.

Ans. a d b a d c

Item 40.

41.

42.

43.

44.

45.

Ans. d c d b a c

Item 46.

47.

48.

49.

50.

51.

Ans. d c b d d a

Item 52.

53.

54.

55.

Ans. d b d c

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Test Bank for Auditing: a practical approach, Canadian Edition

SHORT ANSWER QUESTIONS SA 56 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) During her career as a public accountant, Carolina Doukas has performed audits of large and medium sized clients. When she visited a small business client, a food wholesaler that has had a history of poor controls, she gave a lot of thought to performing her planned audit approach. She decided to use the combined audit approach. b) Tanya Konczynski was discussing with her audit manager how she could assess whether controls are being monitored. Her audit manager mentioned that the internal audit function is a primary source of assessing and monitoring control activities. c) The audit senior has been reviewing the key controls in the purchasing and payables process. She has been asked by a junior auditor: “When should the client set up the payable?” She answers: “The company can set up the payable when the goods are received in good order, and then the client can make the payment when the invoice is received.” d) The auditor decided to review transaction-level controls at year-end.

Solution: a) Disagree. When a client’s internal controls are weak, substantive testing is warranted.

Carolina would probably perform a very brief overview of the control system to assure herself that control weaknesses still exist and then move to a substantive audit approach.

The combined approach would be inappropriate given the control weaknesses that exist.

Spending time on performing tests of controls on a weak control system would be a poor use of the audit staff’s time. b)

Agree. Usually the company relies on auditors or independent managers to monitor control activities. The importance that a company places on its internal audit function provides evidence about its overall commitment to internal control. The internal audit activities most relevant to the audit include those that provide evidence about the design and effectiveness of internal control or that provide substantive evidence about potential material misstatements in the financial statements.

c)

Agree. Many companies will set up the accounts payable when the goods are received.

The receiving report gets matched up with the purchasing document and the payment is made upon receipt of the invoice. Many suppliers are also paid through electronic transfer of funds without any paper or electronic invoice, based on the receipt of goods. In effect, there is no account payable ever set up. There is a debit to Goods/Inventory and a credit to cash.

d)

Disagree. Tests of controls at the transaction level are usually performed during the interim audit. Year-end work focuses on tests of balances.

SA 57 Explain the seven generally accepted objectives of internal control activities and identify the relevant assertions.

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Solution: The internal control objectives are matched with the relevant assertions as follows: Real - there are controls in place to ensure that fictitious or duplicate transactions are not included in the books and records of the organization (occurrence, rights and obligations, and existence assertions).

Recorded - there are controls in place that will prevent or detect the omission of transactions from the books and records of the organization (accuracy, completeness, and valuation and allocation assertions).

Valued - there are controls in place to ensure that the correct amounts are assigned to the transactions (accuracy, and valuation and allocation assertions).

Classified - there are controls in place to ensure that transactions are charged and allocated to the correct general ledger account (accuracy, classification, and valuation and allocation assertions).

Summarized - there are controls in place to ensure that the transactions in the books and records are summarized and totalled correctly (accuracy, and valuation and allocation assertions).

Posted - there are controls in place to ensure that the accumulated totals in the transaction file are correctly transferred to the general ledger and subsidiary ledgers (accuracy, classification, and valuation and allocation assertions).

Timely - there are controls in place to ensure that transactions are recorded in the correct accounting period (cut-off and completeness assertions).

SA 58 Explain the key elements of the control environment.

Solution: The control environment sets the foundation for effective internal control, providing discipline and structure, and includes the following elements: Communication and enforcement of integrity and ethical values - Integrity and ethical values are essential elements of the control environment, affecting the design, administration and monitoring of key processes.

Commitment to competence - Management's commitment to competence refers to considering the skill levels required for particular jobs within the organization and making sure that staff with the required skills are hired and matched to the right jobs.

Participation by those charged with governance. The organization's control environment is influenced significantly by its board of directors and others charged with governance of the entity; for example, the audit committee members or the CEO.

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Test Bank for Auditing: a practical approach, Canadian Edition

Management's philosophy and operating style - Obtaining an understanding of management's philosophy and operating style is necessary to identify the factors that influence management's attitudes towards internal control.

Organizational structure - The client's organizational structure provides the framework within which its activities for achieving entity-wide objectives are planned, executed, controlled and monitored.

Human resource policies and practices - Human resource policies and practices relate to hiring, inducting, training, evaluating, counseling, promoting and compensating employees.

SA 59 What are control activities and explain the major categories of them?

Solution: Control activities are policies and procedures that help make sure management's directives are carried out. They help guarantee that necessary actions are taken to address risks impacting the achievement of the organization's objectives. Generally, control activities that may be relevant to an audit may be categorized as policies and procedures pertaining to the following: Performance reviews (sometimes referred to as 'performance indicators') - These control activities include reviews of actual performance versus budgets, forecasts and prior-period performance and relating different sets of data (operating or financial) to one another, together with analyses of the relationships and investigative and corrective actions.

Information processing - A variety of controls are performed to check accuracy, completeness and authorization of transactions within information processing environments.

Physical controls - These activities encompass the physical security of assets, including adequate safeguards over access to assets and records (such as secured facilities and authorization for access to computer programs and data files) and periodic counting and comparison with amounts shown on control records.

Segregation of incompatible duties. The concept that no one employee or group of employees should be in a position to perpetrate and hide errors or fraud in the normal course of their duties.

In general, the principle duties that are incompatible and should be segregated are: - authorization or approval of transactions affecting assets - custody of assets - recording or reporting of transactions.

SA 60 What are the most common forms of documentation used by auditors to document their understanding of internal controls?

Solution: The most common forms of documentation include the following: Narratives - this is the most common form of documentation, particularly in smaller environments where accounting and internal control activities are simple or where a particular

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flow of a transaction is relatively simple and straightforward. It involves the auditor describing (in words) each step of the flow of transaction from start to finish.

Flowcharts - this form of documentation is used in larger and more complex environments. It involves the auditor summarizing (in flowcharts/boxes) each step of the flow of a transaction from start to finish (that is, from initiation to reporting in the general ledger).

Combinations of narratives and flowcharts - this form of documenting internal controls is typically a page divided into two sections with the process flowchart on the left-hand side, and the narrative describing each step in the flow on the right-hand side.

Checklists and preformatted questionnaires - an internal control checklist or questionnaire is another technique used to systematically identify the most common types of internal control procedures that should be present.

SA 61 What is a management letter and what are its major purposes?

Solution: A management letter (sometimes referred to as a letter of recommendations) is a deliverable prepared by the audit team and provided to those charged with governance. The management letter discusses internal control weaknesses and other matters discovered during the course of the audit. The purpose of the management letter is to inform the client of the auditor's recommendations for improving its internal controls. Significant professional judgment is necessary in deciding whether a weakness identified is significant enough to warrant communicating to management and those charged with governance. When the auditor identifies risks of material misstatement that the entity has not controlled (or has not adequately controlled), or if in the auditor's judgment there is a material weakness in the entity's design or implementation of internal control, they are required to communicate these weaknesses as soon as practicable to those charged with governance. While it is not mandatory to provide feedback regarding internal control weaknesses in writing, the auditor ordinarily prefers to provide their recommendations in the form of a letter or report to avoid any ambiguity or confusion as to what observations, conclusions and recommendations they have made.

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Test Bank for Auditing: a practical approach, Canadian Edition

ESSAY QUESTIONS ES 62 In the United States, what have been the major impacts on companies and auditors of section 404 of the Sarbanes-Oxley Act (2002)? Has this section improved the quality of companies' internal controls?

ES 63 Why are internal controls so important to companies? What are the implications for companies if their internal controls are not operating effectively?

ES 64 CAS 260 Communication of Audit Matters with Those Charged with Governance requires auditors to communicate audit matters of governance interest arising from the audit of the financial report with those charged with governance of an entity. What are some examples of these matters and why is it important for auditors to communicate them?

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CASE Ca 65 In July 2011, Rupert Murdoch, his son, James, and ex-News International chief executive, Rebekah Brooks faced questions from British MPs over a phone hacking scandal at the former News of the World.

It had originally appeared that the News of the World had only hacked the phones of celebrities, politicians and members of the British Royal Family. However, revelations in July 2011, that victims included murdered schoolgirl Milly Dowler, relatives of deceased British soldiers, and victims of the 7/7 London bombings generated widespread public outrage and revulsion.

Advertiser boycotts contributed to the closure of the News of the World.

Reacting to the revelation, Prime Minister David Cameron said that the alleged hacking, if true, was "truly dreadful". He added that police ought to pursue a "vigorous" investigation to ascertain what had taken place. Interestingly, the Prime Minister himself came under fire for hiring a former News of the World editor, Andy Coulson. Prime Minister David Cameron called his decision a "catastrophic error of judgment" in hiring the former editor of Rupert Murdoch's News of the World as a spokesman.

Sean Hoare, 47, the journalist who had accused his former News of the World editor, Andy Coulson of complicity in the illegal activity, was found at home dead, days after he had made fresh allegations against executives under whom he had worked.

On 18 July, News Corp announced that its UK management standards committee would be removed from News International. It will now be housed in a separate building, under the chairmanship of Lord Grabiner, and reporting to News Corp director, Joel Klein.

In an analysis of the culture of the Murdoch empire in Newsweek in July 2011, one of Murdoch's former top executives was quoted as saying: "This scandal and all its implications could not have happened anywhere else. Only in Murdoch's orbit. The hacking at News of the World was done on an industrial scale. More than anyone, Murdoch invented and established this culture in the newsroom, where you do whatever it takes to get the story, take no prisoners, destroy the competition, and the end will justify the means." This same executive went on to say, "In the end, what you sow is what you reap. Now Murdoch is a victim of the culture that he created. It is a logical conclusion, and it is his people at the top who encouraged lawbreaking and hacking phones and condoned it."

In 2010, it was also suggested that the journalistic approach of newspapers such as the News of the World had brought into public focus that there had been a shift away from the traditional ethics of journalism, raising serious questions about privacy, freedom of speech, and confidentiality. There were also observations in the North American Press about the ethics employed by the News of the World. NBC New York noted that the old journalistic maxim, "Get it first. But, first, get it right," although speaking for accurate reporting does not address the situation where in the case of the News of the World information was allegedly obtained in an unethical way or by illegal means. The approach was also criticized by Stephen B. Shepard, dean of the CUNY Graduate School of Journalism, who commenting on the phone hacking scandal, said: "It's wrong. It's not a gray area. What they did was illegal and, even if it weren't, it's just plain wrong. There's no defense for it. Even the government needs a warrant to get into a house or a computer. You can't break into something like this and get away with it."

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Test Bank for Auditing: a practical approach, Canadian Edition

Required: Discuss the underpinnings of a proper control environment and where appropriate, comment on deficiencies at the former News of the World operations, or in Prime Minister Cameron’s operations, assuming the press reports are correct.

Solution: The control environment sets the tone of an entity and influences the control consciousness of its people. It is the foundation for all other components of internal control and is often thought of as a combination of the culture, structure and discipline of an organization. It reflects the overall attitude, awareness and actions of management, the board of directors, any others charged with governance, and owners concerning the importance of controls and the emphasis given to controls in determining the organization's policies, processes and organizational structure. This is sometimes referred to as the “tone at the top.” a)

Communication and enforcement of integrity and ethical values. Integrity and ethical values are essential elements of the control environment, affecting the design, administration and monitoring of key processes. It is also important that management is seen to comply with its own policies.

In the case of News of the World operations, Murdoch had previously been criticized for building a media empire that lacked any ethical base and substituting responsible journalism with "gossip, sensationalism, and manufactured controversy." Karl Grossman, a professor of journalism at State University of New York College at Old Westbury, accused Murdoch of building the most "dishonest, unprincipled and corrupt" media empire in history and of "making a travesty of what journalism is supposed to be about." Grossman also claims that News Corporation changes the culture of their newly-acquired news outlets, using them to promote Murdoch's political and financial interests. Once-acclaimed newspapers such as the New York Post and The Times of London have been accused of becoming an "instrument" to aide politicians that Murdoch favours.

b)

Commitment to competence. Management's commitment to competence refers to considering the skill levels required for particular jobs within the organization and making sure that staff with the required skills are hired and matched to the right jobs.

c)

Participation by those charged with governance. The organization's control environment is influenced significantly by its board of directors and others charged with governance of the entity; for example, the audit committee members or the CEO (if they are charged with responsibility for governance as well as being a member of management). Those charged with governance are responsible for overseeing the entity's accounting and financial reporting policies and procedures. As a result, those charged with governance have an obligation to be concerned with the entity's financial reporting to shareholders and the investing public, and to monitor the entity's accounting policies and the internal and independent (external) audit processes.

The News Corp announcement that its UK management standards committee would be removed from News International appears to be a first cosmetic attempt to provide an indication of participation by those charged with governance.

d)

Management's philosophy and operating style. Obtaining an understanding of management's philosophy and operating style is necessary to identify the factors that

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influence management's attitudes towards internal control. This understanding affects the auditor's assessment of how management makes judgements and accounting estimates, as well as providing an insight into the competence and motivations of management. The more confidence an auditor gains regarding management's abilities and integrity, the more reliance placed on the information, explanations and representations provided by management. Alternatively, doubts about management's ability and integrity will increase the level of corroborating evidence required for representations made by management. An understanding of management's operating style is therefore a fundamental input into assessing audit risk.

The effect of the phone hacking scandal originating with the News of the World also raised wider questions about the ethics employed by companies under Murdoch's ownership, as well as the effects the scandal will have on the ethics employed specifically by print journalists and to some extent the wider world of journalism. e)

Organizational structure. The client's organizational structure provides the framework within which its activities for achieving entity-wide objectives are planned, executed, controlled and monitored. Establishing an organizational structure includes considering the key areas of authority and responsibility as well as the appropriateness of lines of reporting.

1.

Assignment of authority and responsibility. Assignment of authority and responsibility includes how authority and responsibility for operating activities are assigned, and how reporting relationships and authorization hierarchies are established. It includes policies relating to appropriate business practices, knowledge and experience of key personnel, and resources provided for carrying out duties. It also includes policies and communications directed towards ensuring all employees understand the organization's objectives, know how their individual roles and actions contribute to those objectives, and recognize how they will be held accountable for their actions.

Somebody had to assign authority at News of the World and someone has to be held responsible. It starts with the tone at the top.

The Guardian reported that the News of the World had made payments in excess of £1 million to three people subject to phone hacking, including Professional Footballers' Association chairman Gordon Taylor, with the out-of-court settlements subject to secrecy clauses. Around the same time, Private Eye revealed that The Guardian had, in order to avoid "all out war" with the News of the World, chosen not to tell the same Culture, Media and Sport Committee that the £700,000 payment to Taylor was signed off in June 2008 by the directors of News Group Newspapers, the News International subsidiary owning the News of the World - thus showing awareness of the matter at the highest levels. The reports led the Press Complaints Commission to reopen its inquiry into the matter, leading The Guardian's editor Alan Rusbridger to resign from the PCC.

2.

Human resource policies and practices. Human resource policies and practices relate to hiring, inducting, training, evaluating, counselling, promoting and compensating employees. As discussed above, the competence and integrity of an entity's employees are essential elements of its control environment. The organization's ability to recruit and retain competent and responsible employees is therefore dependent to a large extent on its human resource policies and practices.

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Test Bank for Auditing: a practical approach, Canadian Edition Having resigned in 2007 as editor of the News of the World in the aftermath of the royal hacking affair, Andy Coulson quit his position as David Cameron's communications director on 21 January 2011, citing "continued coverage of events connected to my old job at the News of the World". British Prime Minister Cameron had hired the former editor of News of the World, without performing a high level of due diligence in hiring Coulson.

CHAPTER 8 EXECUTION OF THE AUDIT – TESTING OF CONTROLS SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

2 10.

3 13.

8.

3 11.

3 14.

9.

3 12.

4 15.

Multiple Choice Questions 26.

1 31.

1 36.

27.

1 32.

1 37.

28.

1 33.

1 38.

29.

1 34.

1 39.

30.

1 35.

2 40.

Short Answer Questions 53.

2 54.

3 55.

LO Item

1.

2.

3.

1 1 1

4.

5.

6.

1 2 2

4 5 5

16.

17.

18.

19.

20.

1 1 1 1 1

21.

22.

23.

24.

25.

1 1 1 1 1

51.

1,2,3

52.

1

Essay Questions 57.

1

58.

5 Case

59.

1,3

LO Item

LO

4 4 4 5 5

2 2 2 3 3

41.

42.

43.

44.

45.

3 3 3 3 3

4

56.

5

46.

47.

48.

49.

50.

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SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

3.

4.

TF TF TF TF

16.

17.

18.

19.

MC MC MC MC

20.

21.

22.

23.

MC MC MC MC

5.

6.

TF TF

7.

35.

TF MC

36.

37.

MC MC

8.

9.

TF TF

10.

11.

TF TF

39.

40.

MC MC

26.

MC

27.

MC

30.

MC

14.

TF

15.

TF

49.

MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 24.

MC 28.

25.

MC 29.

26.

MC 30.

27.

MC 31.

Study Objective 2 38.

MC 53.

51.

SA Study Objective 3 41.

MC 43.

42.

MC 44.

Study Objective 4 48.

MC 49.

Study Objective 5 50.

MC 56.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC MC MC

32.

33.

34.

51.

MC MC MC SA

52.

57.

59.

SA ES Ca

MC MC

45.

51.

MC SA

54.

59.

SA Ca

MC

56.

SA

SA

58.

ES

SA

ES = Essay

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CHAPTER STUDY OBJECTIVES 1.

Identify the different types of controls. There are four different types of controls: manual, automated (otherwise known as application controls), IT general controls (ITGCs), or a combination of control types referred to as IT-dependent manual controls.

Each of these types can be described as either a preventive control or a detective control. Preventive controls, as the name suggests, prevent errors from occurring.

Detective controls detect the error after it has occurred and rectify the error on a timely basis.

2.

Understand the different techniques for testing controls. There are four key techniques used for testing controls: enquiry (questions are asked regarding the operation of the control), observation (the operation of the control is observed to be occurring), inspection (of physical evidence resulting from the performance of the control), and re-performance (when the auditor re-performs the control to test its effectiveness).

3.

Explain how to select and design tests of controls. The selection of which controls to test is a matter of professional judgement. Deciding which controls to test will be influenced by the control objective, the type of control, the frequency at which the control is performed, and the level of assurance the auditor plans to gain from determining the control is designed and implemented effectively. As a general rule, the best controls to test are those that address the WCGWs most effectively with the least amount of testing required. Th e extent of testing of controls (that is, deciding how many to test) is also a matter of professional judgement, although there are sampling techniques available (discussed in chapter 6). The extent of testing is affected by many factors, including how oft en the control is performed, the degree to which reliance will be placed on the control as part of the audit, the persuasiveness of the evidence produced by the control, the need to be satisfied that the control operated as intended throughout the period of reliance, the existence of a combination of controls that may reduce the level of assurance that might be needed from any one control, the relative importance of the WCGW questions or statements being considered, and any other factors such as the competence of the person carrying out the control, the quality of the control environment, and any changes in the accounting system.

4.

Understand how to interpret the results of testing of controls. If the controls tested are considered to be effective and can be relied on for the purposes of reducing overall audit risk for a particular significant account and assertion, the level of additional substantive testing required is reduced. If the controls tested are considered to be ineffective and are not able to provide any audit evidence that reduces overall audit risk for a particular significant account and assertion, the level of additional substantive testing that is required is increased.

5.

Explain how to document tests of controls. The purpose of the test of controls, the selection of controls to test, the results of the controls testing performed, and the

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Test Bank for Auditing: a practical approach, 1st Canadian Edition conclusion regarding the design and implementation of the controls are all documented in the audit working papers. The working papers are then reviewed by more experienced auditors to determine if sufficient work was performed and if the appropriate conclusion was reached.

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TRUE-FALSE STATEMENTS 1.

Transaction-level controls are implemented by businesses to reduce the risk of misstatements due to error or fraud and to ensure that processes are operating effectively.

2.

The purpose of preventive controls is to discover fraud or errors that may have occurred during transaction processing and to rectify those errors.

3.

An example of a purely manual control is a locked stock cage for high dollar-value items.

4.

IT general controls are driven by the particular software application being used.

5.

Enquiry involves the auditor observing the actual control being performed.

6.

Re-performance involves the auditor re-performing the control to test its effectiveness.

7.

Tracing certain amounts on the bank reconciliation to the accounting records is an example of inspection of physical evidence.

8.

To improve efficiency, auditors test only those controls that they believe are critical to their opinion.

9.

The greater the degree of reliance on an internal control, the less they test the control to provide the required assurance.

10.

Attribute sampling is a sampling technique used to reach a conclusion about the total dollar amount of misstatement in an account balance.

11.

Benchmarking is an audit strategy that can be used to carry forward the benefit of certain application controls testing into future audit periods.

12.

Tests of account balances can often provide evidence about the continued functioning of controls.

13.

If the tests of controls confirm the auditor's preliminary evaluation of controls, the planned substantive audit procedures are not modified.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

14.

The more complex the client's operations and its internal controls, the less experienced the auditor who performs the work needs to be.

15.

If inherent risk is low and a reasonable level of assurance has been gained from controls testing, extensive substantive procedures need to be performed to estimate the dollar value of any error in an account balance.

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ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. T F T

Item 4.

5.

6.

Ans. F F T

Item 7.

8.

9.

Ans. T T F

Item 10.

11.

12.

Ans. F T T

Item 13.

14.

15.

Ans. Item T F F

Ans. Item

Ans.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

MULTIPLE CHOICE QUESTIONS 16.

Benny Pecarve is planning to visit an airline company to review the collective assessment of the client’s control environment, risk assessment process, information system, control activities and monitoring of controls. What does this mandate describe? a. entity level controls b. transaction-level controls c. both a and b d. none of the above

17.

Sue Stableford will be reviewing those controls that stop fraud or errors from occurring.

This is an example of a review of a. detective controls. b. preventive controls. c. entity-level controls. d. transaction-level controls.

18.

Ben Simon wants to ensure that sales in a retail outlet are not recorded at the wrong amount. Which preventive control will help him ensure his objective? a. the signature of the goods by the warehouse receiver on a receiving report or a bill of lading b. a credit check by the credit manager c. automatic pricing of sales invoices using a master price file d. none of the above

19.

Millicent Vonareva was reviewing her IT General Controls program for her client visit.

She noticed an item that she thought did not belong in her “Controls to prevent unauthorized access to data” section of the program. Which item did not belong there? a. Data files and critical applications are regularly backed up in offsite locations. b. Program changes are subject to formal change management procedures. c. Policies exist to ensure departing employees are denied access to software programs and databases. d. Aall the above items belonged in the “controls to prevent unauthorized access to data” section of the program.

20.

Rolland Meilleur, public accountant, is testing whether his client’s account coding on each purchase order is checked by the computer to a table of valid account numbers, and that various logic tests are performed by the computer. He is trying to mitigate the following from going wrong: a. detective controls not being in place. b. amounts being posted to the wrong accounting period. c. transactions being classified and coded to incorrect accounts. d. all of the above.

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21.

Rosie Garaga spent the past week designing audit procedures to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements of a major bookstore operation at the assertion level. What types of audit procedures did she employ? a. entity-level controls b. detective controls c. tests of controls d. preventive controls

22.

The senior auditor has no physical evidence that a control was performed, who performed it, or how effectively it was performed. What is the nature of this control? a. internal control b. entity-level control c. detective control d. preventive control

23.

The auditor had the following procedures in his audit program for a client: (i) Review performance versus forecasts (ii) Review performance indicators (iii) Review exception reports What are these instructions related to? a. detective controls b. physical controls c. internal controls d. entity-wide controls

24.

Lucia Dottore, an audit senior, performed a review of certain application controls at a clothing manufacturing client. Which one of these controls is an input control? a. Reconciliation of totals where input totals are compared to the output totals. b. Output is printed to a secure printer where access is limited. c. Reasonable checks: actual data is compared to expected data for reasonableness. d. None of the above.

25.

Theo Lillis performs the following application control procedures: (i). Control totals: Input totals are balanced and reconciled (ii). Reasonable checks: Actual data is compared to expected data for reasonableness (iii). Sequence tests: Sequential data is reviewed and exception reports are produced for missing numbers. Which of the above application controls do these procedures apply to? a. processing controls b. output controls c. input controls d. general controls

26.

The two main objectives of internal controls are:

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Test Bank for Auditing: a practical approach, 1st Canadian Edition a. b. c. d.

to support the automated parts of the business in the functioning of the controls in place. to prevent or detect misstatements in the financial statements. both a and b. none of the above.

27.

Controls can be classified as: a. information technology general controls. b. automated controls. c. manual controls. d. all of the above.

28.

Which of the following statements is correct? a. Preventing errors during processing should not be an important objective of every accounting system. b. Preventive controls can be applied to each transaction during normal processing to avoid errors occurring. c. To be effective, controls over transactions should only include detective controls. d. The purpose of preventive controls is to discover fraud or errors that may have occurred during transaction processing.

29.

Which of the following is an example of a preventive control? a. management level reviews of actual performance versus budgets b. credit manager following up on an exception report showing sales made to a customer who has exceeded their credit limit c. sales invoices are automatically priced using the information in the price master file d. a bank reconciliation

30.

A computer program that will not allow a sale to be processed if a customer has exceeded its credit limit is an example of a: a. preventive control. b. test of controls. c. detect control. d. substantive procedure.

31.

It is important that detective controls: a. identify all potentially significant errors. b. completely and accurately capture all data. c. are performed on a consistent and regular basis. d. all of the above.

32.

Which of the following is an example of a detective control? a. account coding on purchase orders being checked by the computer to a table of valid account numbers

Execution of the audit – testing of controls b. c. d.

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quarterly reviews of credit balances in accounts receivable to determine their causes amounts are not able to be paid to employees without first matching a valid tax file number to the employee master file none of the above

33.

Manual controls: a. generally rely on the client's IT applications in some way. b. support the ongoing functioning of the programmed aspects of preventive and detective controls. c. can be classified as program change controls or logical access controls. d. do not rely on the client's IT environment for their operation.

34.

An example of a program change control is: a. the accounts receivable clerk does not have access to the cash payments application. b. regular and timely back-ups of data. c. program change forms must be authorized by the IT manager. d. all of the above.

35.

Tests of controls do not include which of the following auditing techniques? a. re-performance b. confirmation c. enquiry d. observation

36.

Enquiry involves the auditor: a. using questioning skills to determine how the control is completed and whether it appears to have been carried out properly and on a timely basis. b. re-performing the control to test its effectiveness. c. the auditor observing the actual control being performed. d. testing the physical evidence to verify that a control has been performed properly.

37.

Tracing certain amounts on the bank reconciliation to the accounting records is an example of which technique for testing controls? a. observation b. enquiry c. inspection of physical evidence d. re-performance

38.

The major limitation with the observation technique for testing controls is that: a. the employee may not be truthful in telling the auditor how the control procedure is performed.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition b. c. d.

the employee may perform the control procedure more diligently when they know they are being observed.

Both a and b. none of the above.

39.

When the auditor decides to include controls testing in their audit strategy, they select those controls that: a. are the easiest to test. b. provide the most efficient and effective audit evidence. c. provide no assurance that the controls operated effectively throughout the period of reliance. d. provide the least efficient and effective audit evidence.

40.

The factors to consider when deciding the extent of testing of controls include which of the following? a. the persuasiveness of the evidence produced by the control b. the degree to which the auditors intend to rely on the control as a basis for limiting their substantive tests c. how often the control is performed d. all of the above

41.

Which of the following statements is incorrect? a. The less frequently a control is performed, the more testing the auditor needs to perform to be satisfied the control is operating effectively. b. When other controls related to a particular objective are also in place and are tested, the level of assurance that might be needed from any one control is not as high as if the auditor were relying solely on a single control. c. The less frequently a control is performed, the less testing the auditor needs to perform to be satisfied the control is operating effectively. d. The results of the tests in prior audits and the current audit to date affect the perception of risk.

42.

A sampling technique used to reach a conclusion about a population in terms of a rate of occurrence is known as: a. dollar unit sampling. b. random sampling. c. attribute sampling. d. haphazard sampling.

43.

Benchmarking is appropriate when: a. a reliable trail of program changes exists. b. a programmed control can be matched to a defined program within an application. c. the application is stable. d. all of the above.

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44.

Benchmarking is: a. based on the premise that a computer will continue to perform any given procedures in exactly the same way until such time as the program is changed. b. an audit testing strategy that can be used to carry forward the benefit of certain application controls testing into future audit periods. c. both a and b. d. none of the above.

45.

Tests of controls will usually be carried out: a. at an interim date. b. only after year-end. c. only by the audit engagement partner. d. by the client's board of directors.

46.

If the tests of controls confirm the auditor's preliminary evaluation of controls, the planned substantive audit procedures are: a. increased. b. not modified. c. reduced. d. changed.

47.

In trying to determine whether there is a need for additional detailed tests of controls, which of the following factors are considered? a. evidence provided by other tests b. changes in the overall control environment c. results of enquiries and observations d. all of the above

48.

Which of the following statements is correct? a. Tests of account balances can often provide evidence about the continued functioning of controls. b. An ineffective entity-level control environment may allow the auditor to limit their tests of controls to enquiry and observation. c. Auditors do not need to investigate any control exceptions identified during their testing. d. Tests of account balances never provide evidence about the continued functioning of controls.

49.

If inherent risk is high and no assurance has been obtained from controls testing: a. only overall analytical review procedures need to be performed to reduce detection risk to an acceptable level. b. no further substantive testing needs to be performed. c. extensive substantive procedures need to be performed to estimate the dollar value of any error in the account balance. d. none of the above.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

Which of the following would not be included in a test of control working paper? a. the purpose of the test b. a conclusion about whether the account balance is materially misstated c. the work performed d. the findings/results of the testing

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

Ans. a b c b c

Item 21.

22.

23.

24.

25.

Ans. c d a d a

Item 26.

27.

28.

29.

30.

Ans. c d b c a

Item 31.

32.

33.

34.

35.

Ans. d b d c b

Item 36.

37.

38.

39.

40.

Ans. a c b b d

Item 41.

42.

43.

44.

45.

Ans. a c d c a

Item 46.

47.

48.

49.

50.

Ans. b d a c b

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

SHORT ANSWER QUESTIONS SA 51 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) The audit senior was explaining how different controls work: “Detective controls can be applied to each transaction during normal processing to avoid errors occurring.” b) The public accountant was reviewing the audit program and was convinced that the following item did not belong in the IT General Controls (ITGC) part of her audit program: “Program change controls — only appropriately authorized, tested and approved changes are made to applications, interfaces, databases and operating systems. All changes are documented so systems documentation is up to date.” c) The techniques for testing are made up of enquiry, observation, inspection of physical evidence and re-performance. Inspection of physical evidence relies on the auditor testing the physical evidence to verify that a control has been performed properly. d) The manager of a large client realizes that when testing controls, either statistically based sampling techniques or professional judgment can be used to determine the extent of testing. One of the factors to consider when deciding the extent of testing should include the competence of the person who performs the control.

Solution: a) Disagree. The audit senior is describing preventive controls which are designed to avoid errors before the transaction gets processed. Detective controls, on the other hand are designed to discover fraud or errors that may have occurred during transaction processing activities. b)

Disagree. This is one of three key ITGC controls we test for. The other is logical access controls and a third item – other ITGCs - a catch-all for key ongoing operating controls.

c) Agree. Inspection of physical evidence is a technique that relies on the auditor testing the physical evidence to verify that a control has been performed properly. Usually, the objective is to gain evidence that the procedures were properly performed. d)

Agree. The competence and integrity of the employee performing the control, the employee's independence from the related processing procedures, the degree to which the employee is supervised, and the extent of employee turnover all contribute to the perception as to whether the control is operating as intended.

SA 52 Explain the differences between preventive controls and detective controls.

Solution: Tests of controls (or controls testing) are the audit procedures performed to test the operating effectiveness of controls in preventing or detecting and correcting material misstatements at the assertion level. Preventive controls can be applied to each transaction during normal processing to avoid errors occurring. Preventing errors during processing is an important objective of every accounting system. An example of a preventive control is a computer program that will not allow a sale to be processed if a customer has exceeded their credit limit. An absence of effective

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preventive controls increases the risk that errors will occur or fraud may occur and therefore increases the need for controls that are sensitive enough to detect these errors should they occur.

The purpose of detective controls is to discover fraud or errors that may have occurred during transaction processing (in spite of any preventive controls) and to rectify those errors. Generally, detective controls are not applied to each transaction during the normal flow of processing.

Instead, they are applied outside the normal flow of individual transactions to groups of transactions that have been fully or partially processed. It is important that detective controls: 1. completely and accurately capture all relevant data, 2. identify all potentially significant errors, 3. are performed on a consistent and regular basis, 4. include follow-up and correction on a timely basis for any misstatements or issues detected.

Examples of detective controls include management level reviews made of actual performance versus budgets, forecasts, prior periods, competitors (if available) and industry averages (if available).

SA 53 Explain and provide examples of the various techniques commonly used when testing controls.

Solution: Enquiry involves the auditor using questioning skills to determine how the control is completed and whether it appears to have been carried out properly and on a timely basis. For example, the auditor may ask the employee who prepares the bank reconciliation how reconciling items are identified, the reasons for them and the procedures in place to ensure that the accounting records are corrected on a timely basis.

Observation involves the auditor observing the actual control being performed. For example, he may observe the preparation of the bank reconciliation.

Inspection of physical evidence relies on the auditor testing the physical evidence to verify that a control has been performed properly. For example, the auditor may trace certain amounts on the bank reconciliation to the accounting records or to other documents. Re-performance involves the auditor re-performing the control to test its effectiveness. For example, the auditor may test the application controls for cash payments to ensure an unauthorized employee is unable to make cash payments.

SA 54 Discuss the factors that relate to the likelihood that an internal control operates as intended.

Solution: Several factors affect the perception of the likelihood that a control operated as intended throughout the period of reliance. The competence and integrity of the employee performing the control, the employee's independence from the related processing procedures, the degree to which the employee is supervised, and the extent of employee turnover all contribute to the perception as to whether the control is operating as intended. The extent of testing is also impacted by the quality of the control environment with consideration being given to: the likelihood that a control is bypassed during peak processing periods, the potential for management to override a control, the extent to which the internal auditors have performed similar or related tests during the year, and the likelihood in a good control environment that a control will continue to operate as intended throughout the period of reliance.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

Where there have been changes in the accounting system, the auditor considers whether a control may have been less effective during the period when the changes were being implemented and whether the control is still applicable to the new accounting system. When the client cannot provide satisfactory explanations for fluctuations (or the absence of expected fluctuations) in the related account balances, the auditor considers whether they need to revise the extent of their tests of controls. The results of the tests in prior audits and the current audit to date affect the perception of risk. If tests in prior audits indicated that a particular control was ineffective, without improvements in the control, tests of that control in the current audit are not likely to be useful. Similarly, if in prior audits the tests showed that the control was effective, the expectation of errors would be reduced and, therefore, the tests of controls might be less extensive. The auditor also considers whether the changes in the types or volume of transactions could affect the auditor's expectations.

SA 55 What are the factors considered by auditors in determining whether there is a need for additional detailed tests of controls?

Solution: In determining whether there is a need for additional detailed tests of controls, the following factors are considered: Results of enquiries and observations. If, during their enquiries or observations later in the audit process, the auditors identify that significant changes to processes and controls have occurred, their previous tests of controls may no longer provide a basis for relying on those controls.

Therefore, they may need to identify and test other controls, perform additional tests of controls or increase the level of substantive testing performed at year-end. Changes to processes or controls are only significant if they have implications for the continued functioning and effectiveness of controls on which the auditor is relying in the first place.

Evidence provided by other tests. Tests of account balances (substantive testing) can often provide evidence about the continued functioning of controls. For example, when the auditor examines vendors' invoices in support of year-end accounts payable and expense account balances, they learn whether controls relating to the recording of these transactions continue to function. To the extent that their other audit procedures provide evidence of the effectiveness of controls from the date of interim work to the end of the period under audit, additional tests that otherwise might be necessary can be reduced.

Changes in the overall control environment. An effective entity-level control environment may allow the auditor to limit their tests of controls to enquiry and observation during the period between when they tested the controls (interim) and year-end. If they become aware of adverse changes in the overall control environment of the entity, such as a loss of employees and key management who perform key controls and who provide evidence as to the effectiveness of the overall entity control environment, additional tests of controls may be necessary.

SA 56 What are the main items commonly included in tests of controls working papers?

Solution:

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In tests of controls working papers, the auditor would ordinarily set out the purpose of the tests of the controls identified. This assists in carrying out the testing by reminding the auditor of the overall purpose in testing the controls. If the auditors identify any exceptions or issues, they are able to decide if there is an impact on their testing strategy by considering whether the control exception means that the control no longer meets the objective of the test. The auditor also documents the test performed, the actual controls selected for testing and the results of the testing. There needs to be enough detail regarding the controls selected to allow another auditor to review the working paper, re-perform the steps (if necessary) and reach the same conclusion as the auditor who prepared the working paper. The results are often set out in a table to make it easier to review and identify quickly what (if any) exceptions were identified during the testing.

Prior to an overall conclusion being reached for each section of work performed, the results table also assists the person reviewing the working paper to determine if enough work has been performed and if the right conclusion regarding the controls testing has been reached. The working paper should also include a conclusion specific to whether the test results support the overall purpose of the test.

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ESSAY QUESTIONS ES 57 The Committee of Sponsoring Organisations (COSO) of the Treadway Commission has produced guidance for designing and implementing effective internal controls, as well as the effective monitoring of a system of internal controls. Explain the various aspects of this guidance and critically evaluate its impact at enhancing internal controls within companies.

ES 58 CAS 230 Audit Documentation requires auditors to document each stage of the audit in their working papers. What are the specific requirements in CAS 230 regarding the contents of working papers and explain the importance of auditors effectively documenting the tests of controls that they have performed?

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CASE Ca 59 Emile Santiago was anxious to start the selection and testing of controls at Dooley Real Estate Group, a company that specializes in unique coastal properties nestled along the Nova Scotia coastline. A charming collection of coastal communities dots the rocks along the Bay of Fundy.

Buzz Dooley brings years of talent and experience from being an executive in the marketing, technology and finance world to personally owning, renovating, aggregating and subdividing property. Along with investment analysis and extensive contract negotiation experience, clients are expertly represented in every transaction. Buzz imparts a sense of ease and joy to finding the perfect property for each client, making owning beach and coastal property a dream! Emile had two main “big picture” objectives: to prevent or detect misstatements in the financial statements.

Emile was concerned about the following issues: 1) Revenue recognition was the trickiest as many of the transactions took place over longer than one year time frames. Partial payments and deposits are being made and have to be matched up with proper revenue recognition criteria.

2) The entertainment and promotional expenses were high and he was not sure how they compared to industry standards, although they appeared to be consistent with the Dooley Real Estate Group’s profile and the deep pockets of its clientele.

Required: a) What are detective and preventive controls? b) Can Emile use these preventive and detective controls to help him resolve the two issues he is concerned about? c) Which factors will Emile have to consider when determining the “extent” of tests to be performed? d) When would Emile perform substantive testing of revenue?

Solution: a) Preventive controls Preventive controls can be applied to each transaction during normal processing to avoid errors occurring. When designing controls, consideration is given to what can go wrong with the transaction (the risk of material misstatement), which would result in an error.

These are sometimes referred to as WCGWs (what can go wrongs). Effective controls should prevent the WCGWs from occurring (preventive controls), or, if they do occur, that the errors are detected and corrected as quickly as possible (detective controls).

An absence of effective preventive controls increases the risk that errors will occur or fraud may occur and therefore increases the need for controls that are sensitive enough to detect these errors should they occur.

Detective controls The purpose of detective controls is to discover fraud or errors that may have occurred during transaction processing (in spite of any preventive controls) and to rectify those errors.

As discussed above, companies put detective controls in place to assist management in ensuring WCGWs do not occur and that the business is functioning as planned through the design and implementation of its business processes.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

Detective controls are often 'unofficial' procedures that client personnel perform to make sure that the information for which they are responsible is accurate. b)

Emile could integrate preventive and detective controls into the revenue recognition audit program. For example he could check whether revenue transactions were allowed if customers exceeded their credit limits (preventive control) or if the accounting system had captured all the relevant data of a closed sales transaction.

Emile would be hard pressed to use preventive or detective controls over the reasonableness of promotional expenses unless he had standards or benchmarks, such as budgeted amounts that he could compare actual expenses to. c)

The factors to consider when deciding the extent of testing include the following: 1. How often the control is performed.

2. The degree to which the auditor intends to rely on the control as a basis for limiting their substantive tests.

3. The persuasiveness of the evidence produced by the control.

4. The need to be satisfied that the control operated as intended throughout the period of reliance.

5. The existence of a combination of controls that may reduce the level of assurance that might be needed from any one of the controls.

6. The relative importance of the 'what could go wrong' questions or statement being considered.

7. Other factors that relate to the likelihood that a control operated as intended during the period of reliance, including: – The competence of the person who performs the control – The quality of the control environment – Changes in the accounting system – Unexplained changes in related account balances – The auditor's prior-period experiences with the engagement Even though the above factors may reduce the expectation of errors, the auditor's tests of a control need to be sufficiently extensive to provide reasonable assurance that the control operated effectively throughout the period of reliance.

d)

Substantive procedures or substantive tests would be performed at year-end. The tests of controls would be performed during the interim audit.

CHAPTER 9 EXECUTION OF THE AUDIT – PERFORMING SUBSTANTIVE PROCEDURES SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

3 10.

4 13.

8.

3 11.

4 14.

9.

3 12.

4 15.

Multiple Choice Questions 28.

1 34.

2 40.

29.

1 35.

2 41.

30.

1 36.

2 42.

31.

1 37.

2 43.

32.

2 38.

3 44.

33.

3 39.

3 45.

Short Answer Questions 55.

3 56.

3 57.

LO Item

1.

2.

3.

1 1 1

4.

5.

6.

3 2 2

5 5 5

16.

17.

18.

19.

20.

21.

1 1 1 1 1 2

22.

23.

24.

25.

26.

27.

3 2 3 3 3 4

53.

1,2,3

54.

2

Essay Questions 59.

1

60.

3

61.

5 Case

62.

3

LO Item

LO

5

3 3 3 3 3 3

46.

47.

48.

49.

50.

51.

3 4 4 4 5 5

3

58.

4

52.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

TF TF

16.

3.

MC TF

17.

18.

MC MC

5.

6.

TF TF

21.

23.

MC MC

32.

34.

MC MC

4.

7.

8.

9.

TF TF TF TF

22.

24.

25.

26.

MC MC MC MC

33.

38.

39.

40.

MC MC MC MC

10.

11.

TF TF

12.

27.

TF MC

47.

48.

MC MC

13.

TF

14.

TF

15.

TF

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 19.

MC 28.

20.

MC 29.

Study Objective 2 35.

MC 37.

36.

MC 53.

Study Objective 3 41.

MC 45.

42.

MC 46.

43.

MC 53.

44.

MC 55.

Study Objective 4 49.

MC 58.

SA Study Objective 5 50.

MC 51.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC

30.

31.

MC MC

MC SA

54.

SA

MC MC SA SA

56.

57.

60.

62.

SA SA ES Ca

MC

52.

MC

ES = Essay

53.

59.

SA ES

61.

ES

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CHAPTER STUDY OBJECTIVES 1.

Define substantive audit procedures. Substantive audit procedures are procedures designed to obtain direct evidence of the completeness, accuracy, and validity of data, and the reasonableness of the estimates and other information contained in the financial statements. Substantive procedures include inspection, observation, enquiry, confirmation, recalculation, re-performance, analyses of many types, and analytical reviews.

2.

Understand the link between the audit risk model and the nature, timing, and extent of substantive procedures. The combination of inherent risk and control risk determines the level of detection risk the auditor is willing to accept that will still allow them to conclude that the financial statements are not materially misstated. Detection risk is reduced or increased in direct proportion to the amount of substantive testing performed. There are several factors that influence how much substantive testing must be performed, including the nature of the test, the level of assurance necessary, the type of evidence required, and the complexity of the client’s data capturing systems. The timing of substantive procedures is most flexible when controls have been tested and assessed as effective. In that case, the procedures can be performed up to six months before year end. When controls are not tested or are not assessed as effective, the timing of substantive procedures is at or near year end.

3.

Provide examples of different substantive audit procedures. The different types of substantive procedures are key items testing, representative sampling (including representative sampling using audit tables, variables estimation sampling, and attribute or discovery sampling), other tests of transactions/underlying data, and analytical procedures. Different analytical procedures include absolute data comparisons, ratio analysis, trend analysis, common-size financial statements, break-even analysis, and pattern and regression analysis. Substantive analytical procedures are different from those analytical procedures used during the planning phase of the audit.

4.

Explain the different levels of audit evidence obtained when performing substantive procedures. The different levels of audit evidence obtained when performing substantive procedures include persuasive, corroborative, minimal, and general audit evidence.

5.

Describe the documentation of the conclusions reached as a result of performing substantive procedures. Conclusion statements are documented for each significant account (including the execution of the relevant audit program steps), the results, and any significant findings, including any misstatements. The auditor also documents that the financial statements reconcile to the underlying accounting records. Overall conclusions are usually prepared for each audit program step completed, as well as for each significant account and significant assertion.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

TRUE-FALSE STATEMENTS 1.

A significant account is one that could contain material misstatements based upon their materiality and/or relationship to identified inherent and financial statement risks.

2.

Control risk is assessed to be low when there are no internal controls tested or relied upon by the auditor.

3.

Normally, it is more efficient to carry out substantive procedures than to test and rely on controls.

4.

Key item testing is an example of a technique used when conducting substantive procedures.

5.

The timing of substantive procedures is directly influenced by the level of control risk.

6.

Roll-forward procedures are performed during the period between the end of the financial year and the date of the audit report.

7.

Vouching involves tracking a source document back to the underlying accounting records.

8.

Audit sampling is the application of audit procedures to less than 100 per cent of items within a population.

9.

Analytical procedures may not be useful when they are used on a company with significantly diverse operations and geographical segments.

10.

Analytical procedures that provide persuasive or corroborative evidence contribute minimal support for the audit conclusion.

11.

Comparing the number of days purchases in trade payables with prior years would provide persuasive evidence of accounts payable.

12.

Corroborative evidence confirms audit findings from other procedures.

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13.

The lack of significant change in an account balance from one year to the next does not necessarily mean that the auditor can assume the balance is reasonable.

14.

Misstatements can only arise from fraud.

15.

The audit program serves as the instructions for the audit team members to complete the required testing.

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ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. T F F

Item 4.

5.

6.

Ans. T T F

Item 7.

8.

9.

Ans. F T T

Item 10.

11.

12.

Ans. F F T

Item 13.

14.

15.

Ans. Item T F T

Ans. Item

Ans.

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MULTIPLE CHOICE QUESTIONS 16.

Matilda Papas has been asked to lead her audit team in the audit of the Toronto Raptors basketball team. She performed a review of their risks and found that the team’s risks tend to be driven by the nature of certain significant accounts or business activities that the Raptors pursue. This risk is a. audit risk. b. inherent risk. c. control risk. d. detection risk.

17.

Manny Regimbald is concerned about the audit of a high risk client, the Lewiston Stampeders. He believes that there is a high likelihood that because his audit team is inexperienced that the testing procedures will not detect a material misstatement. This is a(n) a. audit risk. b. control risk. c. detection risk. d. none of the above.

18.

Maury Lions is ready to undertake substantive procedures at an educational institution.

Which of the following factors will influence his substantive tests? a. the nature of the test b. the type of evidence required c. the complexity of the client's data capturing systems d. all of the above

19.

After performing a risk assessment of a food processing company, Sean Spino has come to the conclusion that he will require more evidence to be obtained by his audit team from substantive procedures. Which of the factors below led him to this conclusion? a. the level of assurance necessary b. the type of evidence required c. the nature of the test d. the complexity of the client's data capturing systems

20.

Ying Ye believes that she will have to employ sophisticated substantive audit procedures for her client. What contributes to this decision? a. the nature of the client’s accounting system b. the nature of the internal controls c. the complexity of the client's data capturing systems d. none of the above.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

21.

Umberto Levinson has performed a test of controls of a flower shop. He is trying to determine the timing of substantive procedures at year-end. Which factor will determine the timing of his audit procedures? a. timing of the year-end work b. audit risk c. inherent risk d. control risk

22.

Jocelyne Yu is performing procedures and has decided to vouch the balance in the fixed assets ledger of a furniture manufacturing company back to supporting documentation.

She is performing a a. test of details. b. test of controls. c. risk assessment. d. none of the above.

23.

Larry French is trying to determine the extent of testing his team will have to perform in order to determine whether controls are working. How will he decide how much testing to perform? a. He will utilize statistical sampling. b. He will use his professional judgment. c. He will use last year’s results as a basis for this year’s tests. d. None of the above.

24.

Daniel Morency has performed evaluations of financial information and determined whether the fluctuations of his client’s sales figures are consistent with other data he has gathered. He has used this information to predict year-end amounts of sales. This is an example of substantive procedures called a. tests of details. b. computer assisted audit techniques. c. analytical procedures. d. none of these.

25.

Tobias Appel is trying to ensure that he can review controls over purchasing transactions.

In addition he would like to substantiate the dollar amounts he is reviewing. What type of procedures can he perform that will provide evidence as to whether a control is effective as well as if an item is being recorded properly? a. statistical sampling b. dual purpose tests c. test of balances d. test of controls

26.

Stella Zhang has been performing analytical procedures techniques as a substantive test. The techniques that can be used to perform analytical procedures are: a. preparation of common sized financial statements. b. breakeven analysis.

Execution of the audit – performing substantive procedures c. d.

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ratio analysis. all of the above.

27.

Jacqueline Martineau was told by her audit senior to ensure that the evidence she provided through analytical procedures was both persuasive and corroborative. Which of the following evidences are persuasive? a. When reviewing accruals for commissions refer to terms of agreements and payment dates. b. When reviewing trade receivables or sales review the volatility of the customer base and compare with expectations. c. When reviewing sales and commissions expense compare sales commissions or bonuses with related sales. d. When reviewing payroll expense compare payroll tax expenses to the annual payroll times the statutory tax rates.

28.

Inherent risk is: a. assessed as high when there are no internal controls tested or relied upon by the auditor. b. assessed as low when there are good internal controls in place. c. the risk of a misstatement occurring irrespective of any internal controls put in place by management. d. the risk that the auditor's testing procedures will not detect a material misstatement.

29.

Which of the following statements is correct? a. If detection risk is high, significant substantive procedures are necessary to reduce detection risk. b. There is an inverse relation between the auditor's assessed risk of material misstatement and detection risk. c. There is no relation between the auditor's assessed risk of material misstatement and detection risk. d. If detection risk is low, only a small number of substantive procedures are necessary to reduce the detection risk.

30.

The purpose of substantive procedures includes obtaining direct evidence as to: a. the reasonableness of the estimates and other information in the financial statements. b. the completeness, accuracy and validity of data. c. both a and b. d. none of the above.

31.

Substantive testing can be conducted using which of the following procedures? a. enquiry b. confirmation c. analytical review d. all of the above

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

32.

Which of the following factors should not influence the extent and timing of when substantive procedures are performed? a. the type of audit opinion that the client would like the auditor to issue b. the complexity of the client's data capturing systems c. the level of assurance necessary d. the type of evidence required

33.

The nature of substantive procedures normally consists of one or a combination of which of the following techniques? a. analytical procedures b. representative sampling c. key item testing d. all of the above

34.

Typically, substantive testing tends to be performed: a. at the start of the financial year. b. at or near year-end. c. half way through the financial year. d. only when the client's management allows the auditor to conduct the tests.

35.

Roll-forward procedures are performed: a. to update the audit findings from the time of the interim procedures through to year-end. b. to detect fraud in various balance sheet accounts. c. before the end of the financial year. d. none of the above.

36.

Which of the following examples of substantive procedures would often be performed prior to year-end? a. confirming the client's bank balance b. attending the client's annual inventory count c. testing additions and disposals to the fixed asset register d. performing confirmations of accounts receivable

37.

Performing substantive procedures prior to year-end, in the absence of specific effective controls, may be acceptable when: a. the auditor is able to conclude overall that the client's control environment is effective. b. the likelihood of errors or fraud is high. c. the likelihood of errors or fraud is low. d. both a and c.

38.

Vouching involves:

Execution of the audit – performing substantive procedures a. b. c. d.

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tracking a source document through to the underlying accounting records. agreeing the details of a transaction to supporting evidence outside of the company's accounting records. the application of audit procedures to less than 100 per cent of items within a population. none of the above.

39.

Tracing is primarily directed towards verifying which of the following assertions? a. completeness b. existence c. occurrence d. valuation

40.

The primary purpose of vouching is to ensure that: a. the balances or transactions are not understated. b. sufficient information is disclosed in the notes to the financial statements. c. the balances or transactions are not overstated. d. all transactions have been recorded.

41.

Variables estimation sampling is used: a. when the auditor does not expect any errors in an account balance. b. to obtain a level of confidence that key attributes for the sample tested can be inferred to be in existence for the entire population. c. when the auditor conducts tests of controls. d. if the auditor expects more than a few errors in an account balance.

42.

Common examples of substantive procedures related to key items testing and representative sampling include: a. tests of income statement accounts for account classification. b. tests of client prepared schedules. c. tests of underlying data to be used as part of the analytical procedures. d. all of the above.

43.

Analytical procedures may not be used: a. as primary tests of an account balance. b. in testing internal controls. c. to provide at least some minimal level of support for the conclusion. d. as corroborative tests in combination with other procedures.

44.

Which of the following is not a type of analytical procedure? a. confirmation analysis b. ratio analysis c. break-even analysis d. trend analysis

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45.

Which of the following is the first step an auditor performs when performing analytical procedures? a. determine appropriate procedures for investigating the reasons for differences if they are significant b. draw conclusions c. identify the computation, comparison or relationship to be made or investigated d. assess the reliability of any data to be used

46.

Using computer assisted audit techniques (CAATs) makes the audit: a. more comprehensive. b. more expensive. c. more efficient. d. both a and c.

47.

Analytical procedures that provide persuasive evidence include: a. reviewing the cash accounts in the general ledger for unusual items. b. relating average amounts invested to an average interest rate. c. comparing the number of days purchases in trade payables with prior years. d. reviewing the property, plant and equipment account in the general ledger for unusual items.

48.

Comparing sales commissions or bonuses with related sales provides what level of evidence? a. corroborative b. absolute c. minimal d. persuasive

49.

The levels of evidence obtained when performing substantive procedures includes: a. minimal. b. persuasive. c. general. d. all of the above.

50.

Fluctuations in financial data identified by the auditor when planning the audit may be caused by: a. dependent relationships. b. seasonal patterns. c. external decisions directly impacting the business. d. all of the above.

51.

Which of the following statements is correct? a. Misstatements can only arise from fraud. b. Misstatements can only arise from error.

Execution of the audit – performing substantive procedures c. d.

52.

Misstatements can arise from error or fraud.

None of the above.

Overall significant account conclusion statements are captured on: a. audit programs. b. lead sheets. c. confirmation requests. d. minutes of board of directors' meetings.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

21.

Ans. b c d a c a

Item 22.

23.

24.

25.

26.

27.

Ans. a b c b d a

Item 28.

29.

30.

31.

32.

33.

Ans. c b c d a d

Item 34.

35.

36.

37.

38.

39.

Ans. b a c d b a

Item 40.

41.

42.

43.

44.

45.

Ans. c d d b a c

Item 46.

47.

48.

49.

50.

51.

Ans. Item Ans. d 52. b b a d d c

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SHORT ANSWER QUESTIONS SA 53 Indicate whether you agree or disagree with the following statements and explain your reasoning. a. Svetlana Petrova was reviewing the risk profile of Gaz Prom Industries in order to determine detection risk. She concluded: “Both my inherent and control risks are low. I guess I should be willing to accept high detection risk.” b. Boris Ivanov had performed an assessment of the accounts payable system at Magnitogirsk Iron and Steel Works Operations in the Urals. His focus was on the completeness assertion for accounts payable balances. Inherent risk and control risk were both high. He decided that because the overall risk assessment was high he would have to set his detection risk high. c. Jana Novotna, the auditor-in-charge of the Mosenergo petroleum giant, was explaining to Valentin Titov the importance of the timing of substantive procedures: “Although we associate examinations of internal controls with interim work and substantive procedures with year-end work, we can perform substantive procedures before year-end if there exists an effective control environment.” d. Susan Martin, the audit senior at Canadian National Railways, was explaining to the junior auditor how vouching works: “we take a balance or a transaction from the underlying accounting records and agree it to the supporting evidence inside the company.” e. Larisa McCarthy, the auditor-in-charge of the Firestone audit, feels that the large population of sales transactions warrants the use of representative sampling. She mentions to her staff: “Representative sampling using audit risk tables is especially useful when a lot of errors exist in an accounting system and the auditor perceives the risk of understatement to be high.”

Solution: a. Agree. There is an inverse relation between the auditor's assessed risk of material misstatement and detection risk.

Detection risk is reduced or increased in direct proportion to the amount of substantive testing performed.

If the combined inherent risk and control risk are low, as it is in this case (the client is in a low-risk industry and the account has a lower chance of being materially misstated if there are controls put in place), the amount of detection risk the auditor is willing to accept is high and therefore only a small number of substantive procedures are necessary to reduce the detection risk. b.

Disagree. There is an inverse relation between the auditor's assessed risk of material misstatement and detection risk.

Detection risk is reduced or increased in direct proportion to the amount of substantive testing performed.

If the combined inherent risk and control risk is high this indicates that the client is in a highrisk industry. As a result, the account has a higher chance of being materially misstated if there are no controls put in place and no controls have been tested. Therefore, the amount of detection risk the auditor is willing to accept is low and therefore significant substantive procedures are necessary to reduce the detection risk.

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c.

Agree. The auditor's ability to perform substantive audit procedures at an interim date is generally dependent on the existence of an effective control environment and the effectiveness of controls.

When the control environment is ineffective or there are specific ineffective controls, the auditor considers whether or not it is appropriate to perform substantive procedures at an interim date.

The timing of the substantive procedures is most flexible when controls have been assessed as effective and tested to confirm this assessment. In these circumstances, the substantive procedures may be performed earlier in the year. When controls are assessed as effective but not tested, the substantive procedures may still be performed at an interim date.

d.

Disagree. Vouching is when a balance or transaction is taken from the underlying accounting records and verified by agreeing the details to supporting evidence outside of the accounting records of the company. Typically the details are agreed to external thirdparty information such as a supplier invoice or delivery documentation.

e.

Disagree. The auditor uses this technique when they do not expect errors or they expect a low number of errors. Auditors use representative sampling when the risk of material misstatement has been assessed as low, and their primary concern is with the overstatement in an account balance.

SA 54 Discuss the factors that influence the extent and timing of substantive procedures.

Solution: How much substantive testing is performed and when it is performed are influenced by several factors. The most important factor is the overall risk assessment for the item being tested. Prior to making this assessment, the auditor will have performed planning procedures and controls testing (including testing of any controls identified that the auditor intends to place reliance on).

The results of these planning and interim procedures allow the auditor to make an overall assessment as to how much detection risk still exists prior to any substantive testing being performed. The auditor then designs what they believe are appropriate substantive audit procedures that will allow material errors and exceptions to be identified and rectified before an overall conclusion is made.

There are several other factors (over and above the audit risk assessment) that influence how much (extent) and when (timing) substantive procedures are performed. These include the following: a) The nature of the test. Some tests lend themselves more easily to testing during the yearend visit as opposed to during the interim audit visit(s)). For example, vouching prepayment amounts to their supporting documentation (the invoices that were paid during the year) is easy to perform prior to year-end; verifying the calculation of the split between the amount to be recognized as a prepayment and the amount to be expensed in the income statement is easiest to perform at or after year-end. b)

The level of assurance necessary (reasonable assurance requires more evidence to be obtained from substantive procedures than limited assurance in order to reach a conclusion).

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c)

The type of evidence required (for example, are the procedures designed to provide persuasive, corroborative or minimal audit evidence?

d)

The complexity of the client's data capturing systems (the more complex the systems, the more complex and sophisticated the substantive audit procedures need to be).

SA 55 Explain the difference between vouching and tracing.

Solution: Vouching is when a balance or transaction is taken from the underlying accounting records and verified by agreeing the details to supporting evidence outside of the accounting records of the company (typically the details are agreed to external third-party information such as a supplier invoice or delivery documentation). Because vouching involves testing and verifying information already recorded in the accounting records, the primary purpose of the testing is to ensure the balances or transactions are not overstated (for example, existence and occurrence assertions).

Tracing is when a source document is traced back to the underlying accounting records.

Because tracing involves testing and verifying information outside of the accounting records that is not necessarily recorded (for instance, on a source document such as an invoice), the primary purpose of the testing is to ensure the balances are not understated (for example, completeness assertion).

SA 56 Explain the three common sampling strategies that can be applied when the auditor applies representative sampling.

Solution: When the auditor applies representative sampling, there are three common sampling strategies applied, depending on the auditor's expectations of error and their overall audit objective (overstatement or understatement of the amount being audited).

1. Representative sampling using audit risk tables The auditor uses this technique when they do not expect errors or they expect a low number of errors; that is, the risk of material misstatement has been assessed as low, and their primary concern is with the overstatement in an account balance. This is a common technique used to obtain 'coverage' of a total balance as at year-end and can be used to calculate errors that can then be extrapolated across a total balance.

2.

Variables estimation sampling The auditor uses this technique if they expect more than a few errors in an account balance. This technique can be used when the concern is both understatement and overstatement, and is therefore different to representative sampling.

Variables estimation sampling is usually applied to detect misstatements of the book values (carrying amounts or recorded values) of populations.

3.

Attribute sampling The auditor uses this technique to supplement other substantive procedures to obtain audit assurance related to tests of transactions when they do not expect errors (or they expect a low number of errors). Discovery sampling is used to obtain a level of confidence, based on a statistically valid sample of transactions, that key

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attributes in existence for the sample tested can be inferred to be in existence for the entire population.

SA 57 Identify the steps used by the auditor when performing analytical procedures.

Solution: When performing analytical procedures, the steps the auditor performs can be summarized as follows: 1. Identify the computation, comparison or relationship to be made or to be investigated.

2.

Assess the reliability of any data to be used.

3.

Estimate the probable balance in the account or the probable outcome of the computation.

4.

Make whatever computations are needed using data in the client's records or data from reliable outside sources.

5.

Compare the estimated amount with the computed or recorded amount and evaluate whether the difference, if any, is significant.

6.

Determine appropriate procedures for investigating the reasons for the difference if it is significant.

7.

Perform the procedures.

8.

Draw conclusions.

SA 58 Explain the four different levels of evidence obtained when performing substantive procedures.

Solution: Several different levels of evidence are obtained when performing substantive procedures, depending on the type of substantive procedure performed. Evidence can be persuasive, corroborative, minimal or general.

Persuasive: Analytical procedures can be the primary test of a balance (that is, the primary basis for the conclusion) if they provide persuasive evidence. This would be the case when the procedures generate an amount that the auditor believes is a reasonable estimate of what the balance should be, thus enabling them to conclude whether or not the account balance is free from material errors. The effect of classifying an analytical review procedure as persuasive means that no further substantive procedures need to be performed on the related account balance, even in moderate risk situations.

Corroborative: An analytical procedure provides corroborative evidence if it (1) confirms audit findings from other procedures and (2) supports management representations or otherwise decreases the level of audit skepticism. A corroborative analytical procedure includes comparisons of account balances to expectations developed and documented earlier in the audit. These comparisons generally provide corroborative evidence about an account balance

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and enable the auditor to limit the extent of other procedures in that area.

Minimal: Analytical procedures that do not provide persuasive or corroborative evidence contribute minimal support for the conclusion. In deciding whether a particular analytical procedure or combination of procedures provides corroborative evidence or only minimal support for the conclusion, the auditor evaluates both the extent of their analytical procedures and the quality of the evidence they expect to obtain.

General: Analytical procedures might provide persuasive evidence in one circumstance but not in another. To illustrate, the risk assessment related to investments might indicate a low likelihood of material misstatement related to recording investment income. If a client has a relatively stable investment portfolio, a comparison of the average amount invested to an average market rate of interest or yield may provide the auditor with persuasive evidence to conclude that the amount of investment income recorded for the year is free from material misstatement. On the other hand, another client's portfolio might be more diversified and turn over quite rapidly. In that case, the auditor may need to expand the analytical review by segmenting the client's portfolio and applying the average yield test to the various segments.

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ESSAY QUESTIONS ES 59 There are certain audit procedures that are required to be performed according to various auditing standards. Identify specific examples of such procedures and explain why the procedures are mandatory.

ES 60 Analytical procedures are evaluations of financial information made by a study of plausible relationships among both financial and non-financial data. Discuss why analytical procedures are used by an auditor and explain several of the common types of analytical procedures.

ES 61 Explain and evaluate the 'fuzzy logic' approach to assessing materiality.

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CASE Ca 62 Raisa Alexseev was getting ready to perform analytical procedures at Vulcan Spice Mills. She had made the following notes in her audit file: 1. Review allowance for doubtful accounts.

2. Don’t forget to bring calculator to work.

3. Figure out the probability of $5,000,000 sales commissions threshold of last year.

4. Perform variance analysis.

Required: Can you summarize the steps Raisa will have to go through using analytical procedures before she can draw any conclusions about the subject matter?

Solution: When performing analytical procedures, the steps Raisa will perform can be summarized as follows: 1. Identify the computation, comparison or relationship to be made or to be investigated.

Raisa would compare the allowance or commissions amounts in the current year’s accounts and compare them to the methods and outcomes of previous years.

2.

Assess the reliability of any data to be used. Raisa will ensure that the accounts receivable controls over transactions have been tested and that substantive procedures such as accounts receivable confirmations have been carried out.

3.

Estimate the probable balance in the account or the probable outcome of the computation.

If the client uses percentage of receivables or aging percentages, Raisa will estimate this year’s anticipated balance using the data available.

4.

Make whatever computations are needed using data in the client's records or data from reliable outside sources. Raisa will use her calculator or software to perform computations on the allowance for doubtful account amount or the reasonableness of the commissions expense.

5.

Compare the estimated amount with the computed or recorded amount and evaluate whether the difference, if any, is significant.

6.

Determine appropriate procedures for investigating the reasons for the difference if it is significant. Raisa will have discussions with the client’s personnel such as the credit manager and sales vice president.

7.

Perform the procedures.

8.

Draw conclusions. Based on the procedures applied and her conclusions, Raisa may have to perform more substantive work in order to be satisfied with the reliability of underlying data.

CHAPTER 10 SUBSTANTIVE TESTING AND BALANCE SHEET ACCOUNTS SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

4 10.

5 13.

8.

6 11.

6 14.

9.

5 12.

6 15.

Multiple Choice Questions 28.

4 34.

2 40.

29.

1 35.

3 41.

30.

1 36.

3 42.

31.

1 37.

3 43.

32.

2 38.

7 44.

33.

2 39.

4 45.

Short Answer Questions 56.

2 57.

3 58.

LO Item

1.

2.

3.

1 1 2

4.

5.

6.

2 3 3

7 7 8

16.

17.

18.

19.

20.

21.

1 1 1 1 2 2

22.

23.

24.

25.

26.

27.

3 3 3 3 3 4

54.

3,4,8

55.

1

Essay Questions 60.

3

61.

5

62.

8 Case

63.

3,4,5,6

LO Item

LO

8 8

4 5 5 5 6 6

46.

47.

48.

49.

50.

51.

6 6 7 7 7 7

4

59.

7

52.

53.

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SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

TF TF

16.

17.

MC MC

18.

19.

MC MC

3.

4.

TF TF

20.

21.

MC MC

32.

33.

MC MC

5.

6.

TF TF

22.

23.

MC MC

24.

25.

MC MC

7.

27.

TF MC

28.

39.

MC MC

40.

54.

MC SA

9.

TF

10.

TF

41.

MC

8.

11.

TF TF

12.

44.

TF MC

45.

46.

MC MC

13.

14.

TF TF

38.

48.

MC MC

49.

50.

MC MC

15.

TF

52.

MC

53.

MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 29.

MC 31.

30.

MC 55.

Study Objective 2 34.

MC 56.

SA Study Objective 3 26.

MC 36.

35.

MC 37.

Study Objective 4 58.

SA 63.

Ca Study Objective 5 42.

MC 43.

Study Objective 6 47.

MC 43.

63.

Ca Study Objective 7 51.

MC 59.

SA Study Objective 8 54.

SA 62.

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC SA

MC MC

54.

57.

SA SA

60.

63.

ES Ca

MC

61.

ES

63.

Ca

MC

61.

ES

63.

Ca

ES

ES = Essay

Substantive testing and balance sheet accounts

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CHAPTER STUDY OBJECTIVES 1.

Explain the relationship between the overall risk assessment for a significant account and the extent and timing of substantive procedures. The higher the overall risk of error or misstatement, the higher the level of substantive procedures required, assuming that no controls have been tested or that controls cannot be relied on. When controls are effective and the overall risk assessment is therefore lower, limited substantive testing is ordinarily required to be performed. The timing of substantive procedures is affected by the detection risk—the lower the detection risk, the more work will need to be done nearer to year end.

2.

Design and understand how to execute substantive procedures to address audit risk related to cash. The most important audit assertions in the audit of cash are existence, completeness, and classification. The transactions that form the basis of the cash balance are cash receipts and cash payments, and if controls are tested and found to be effective, it is unlikely that significant additional tests related to these transactions would be performed. The auditor would perform the minimum substantive tests for the cash balance at year end.

3.

Design and understand how to execute substantive procedures to address audit risk related to trade receivables. The most important assertions for the audit of trade receivables are existence, and valuation and allocation. Positive confirmations are usually used to test for existence, but they do not provide audit evidence as to the valuation and allocation assertion. Subsequent receipts are the most common procedure to test valuation and allocation, supplemented by analytical procedures such as comparing the aging of trade receivables to the prior period. The three important transactions that affect the balance of trade receivables are sales, sales returns and allowances, and cash receipts.

4.

Design and understand how to execute substantive procedures to address audit risk related to inventory. The two key assertions for inventory are existence, and valuation and allocation. Testing of client inventory counts is an important procedure for gathering evidence about existence. Such testing can also help inform tests of valuation and allocation through observation of the condition of inventory. Rights and obligations can be an important assertion where specific rights are attached to the items. Inventory balances are affected by purchases, cash payments, and inventory processes.

5.

Design and understand how to execute substantive procedures to address audit risk related to property, plant, and equipment. Property, plant, and equipment (PPE) are also known as fixed assets. Key assertions for PPE are existence, and valuation and allocation. The auditor usually tests for existence by looking at the physical assets and testing additions to, and disposals from, the fixed asset register. The auditor also considers whether management decisions have affected the values of PPE items.

Analytical procedures are useful in testing depreciation expense, and rights and obligations are usually tested by reviewing purchase or leasing documentation.

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6.

Design and understand how to execute substantive procedures to address audit risk related to payables. The key assertions for payables are usually completeness, and valuation and allocation. Completeness is critical because the risk is that the balance is understated, so the auditor usually uses subsequent payments testing and cut-off testing to search for unrecorded payables. The transactions impacting the payables balance are cash payments and purchasing.

7.

Understand how substantive testing is used for other balance sheet accounts.

Other balance sheet account balances include prepayments, investments, intercompany, taxation, provisions, leases, long-term liabilities, and equity. It is usually easier to test these balances fully substantively, with limited or no controls testing.

8.

Understand how to assess the results of substantive procedures to determine whether additional substantive tests are necessary. When procedures performed identify errors or exceptions, it is important to continue testing, either until the error can be accurately quantified or until the balance has been fully tested to an extent that it proves a material error can no longer exist within the balance.

.

Substantive testing and balance sheet accounts

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TRUE-FALSE STATEMENTS 1.

When the assessment of inherent risk and control risk is low, the amount of substantive testing required to reduce the detection risk to an acceptable level is significant.

2.

The timing of substantive testing is dependent on the risk assessment of the significant account in question.

3.

A pledge is something delivered as security for the payment of a debt or the fulfilment of a promise.

4.

Testing the mathematical accuracy of the cash disbursement journal relates to the existence assertion.

5.

When trade receivables is a significant account in an entity's balance sheet, the two audit assertions that are considered most important are existence and valuation and allocation.

6.

Evaluating the adequacy of the allowance for doubtful accounts account is an example of a substantive test of trade receivables that is always performed.

7.

The two key assertions for inventory are completeness and rights and obligations.

8.

Accounting for the numerical sequence of cheques issued during a specific period is a substantive test relating to the purchases process.

9.

A fixed assets register is used to capture additions and disposals of fixed assets, as well as calculating depreciation charges.

10.

Physically sighting fixed assets enables the auditor to test the rights and obligations assertion.

11.

The typical procedures performed to search for unrecorded payables are referred to as subsequent payments testing and cut-off testing.

12.

Ensuring that accounts payable are stated at the amounts owed at year-end relates to the rights and obligations assertion.

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13.

Prepayments are audited by vouching the balance to the supporting invoices.

14.

Provisions can be easily audited by controls testing alone.

15.

The key objective when performing substantive procedures is to determine whether there are material misstatements within an account balance.

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ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. F T T

Item 4.

5.

6.

Ans. F T T

Item 7.

8.

9.

Ans. F F T

Item 10.

11.

12.

Ans. F T F

Item 13.

14.

15.

Ans. Item T F T

Ans. Item

Ans.

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MULTIPLE CHOICE QUESTIONS 16.

Based on her review, Joyce Yu found both inherent risk and control risk at a major research facility to be high. One would expect that her amount of substantive testing required would be: a. high. b. low. c. medium. d. impossible to determine without more data.

17.

Martin Bellefeuille was asked by his audit manager to perform an evaluation of the operating effectiveness of controls in preventing material misstatements at the assertion level. In complying with the request, what did he do? a. He evaluated control risk. b. He determined audit risk. c. He determined inherent risk. d. None of the above.

18.

Miriam Bakeman recently performed procedures to evaluate whether client’s internal control system is preventing or detecting a material misstatement. This is an example of a. testing detection risks. b. testing inherent risks. c. testing internal controls. d. establishing materiality.

19.

Natalya Rovinescu, the external auditor at Nautilus Minerals, was trying to determine whether she could rely on the relevant work of the internal audit department. She would place most confidence if the internal auditor reported to the a. Treasurer. b. President. c. Board of Directors. d. Chief Financial Officer.

20.

Priscille White was performing the review of cash transactions at Banker’s Trust. Which three assertions are the most important when ensuring that there are no material misstatements for cash at Banker’s Trust? a. existence, completeness, valuation and allocation b. existence, valuation and allocation, rights and obligations c. existence, completeness, classification d. none of the above

21.

Can you help Rosa Chaput determine why there is some effort put into testing cash when the cash account is not material? a. because cash can be stolen easily

Substantive testing and balance sheet accounts b. c. d.

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because cash has to be valued properly at year-end because so many transactions flow through cash none of the above

22.

Lynn Kevorkian was not sure which customers of her client to send confirmations. Who should she send confirmations to? a. to the customers who will be most likely to reply b. to the customers with the largest balances c. to the customers with the oldest balances d. both b and c

23.

George Malinowski was trying to check whether the receivables of Cosentino Distributors were being carried at their net realizable value. His objective was to fulfill which assertion? a. completeness b. valuation and allocation c. existence d. none of the above

24.

Theresa Bamboukian started her sales process audit and was accounting for the numerical sequence of sales invoices, sales orders and shipping documents. In addition she performed a reconciliation of billings with shipping documents. Which assertions was she fulfilling? a. existence, accuracy b. completeness, cutoff c. existence, valuation and allocation d. none of the above

25.

Celestino Minotti tested the posting of individual credit memos to the sales returns and allowances ledger and to the trade receivables sub-ledger. Which assertion was he fulfilling? a. classification b. existence c. completeness d. cutoff

26.

Anna Monticello tested the postings of the totals in the cash receipts journal to the general ledger, trade receivables sub-ledger and other subsidiary ledgers. Which assertion(s) was she fulfilling? a. completeness b. valuation and allocation c. accuracy d. none of the above

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27.

When Costa Zimbalist observes the inventory count at a client to establish that the client’s personnel are complying with inventory count instructions, which assertions are in play? a. completeness, cutoff, rights and obligations b. completeness, cutoff c. existence, classification d. existence, completeness, valuation and accuracy

28.

When Silvana Mathews reviewed the physical inventory compilation she performed a procedure that included tracing the cut-off information obtained during the physical inventory observation to the accounting records of sales and purchases. Which assertion did this procedure satisfy? a. valuation and accuracy b. completeness c. existence d. all of the above

29.

Accounts that are clearly trivial or immaterial are usually ignored or only subjected to: a. tests of controls. b. analytical procedures. c. confirmations. d. observations.

30.

When the assessment of inherent and control risk is low: a. the level of substantive procedures is limited. b. there are lots of controls that have been tested and found to be effective. c. both a and b. d. none of the above.

31.

The additional opportunities for influencing the timing of the work include: a. reviewing provisions prior to year-end. b. leveraging off the activities of the internal audit function. c. reviewing activity in the period to date. d. all of the above.

32.

The three audit assertions particularly important to enable the auditor to conclude that there are no material misstatements in cash as at year-end are: a. existence, completeness and classification. b. rights and obligations, cut-off and occurrence. c. occurrence, completeness and accuracy. d. classification, occurrence and valuation.

33.

Which of the following is not an example of a substantive test of cash payments transactions? a. test the account classifications of cash payments

Substantive testing and balance sheet accounts b. c. d.

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account for the numerical sequence of cheques issued during a specified period test the mathematical accuracy of the cash receipts ledger determine whether the signatures on paid cheques are authorized

34.

Which of the following substantive tests of cash account balances are always performed? a. Test cut-off of cash receipts, cash payments and transfers at year-end b. Confirm cash held by others c. Examine the client's bank reconciliations d. All of the above

35.

Existence of trade receivables is usually verified by: a. examining copies of sales invoices sent to the client's customers. b. sending confirmations to the client's customers. c. calculating changes in the receivables balance from one year to the next. d. evaluating the adequacy of the provision for doubtful accounts.

36.

Which are the two audit assertions considered most important to the auditor concluding there are no material misstatements in trade receivables at year-end? a. valuation and allocation, and rights and obligations b. existence and occurrence c. occurrence and rights and obligations d. existence and valuation and allocation

37.

Which of the following is a substantive test of the trade receivables balance that is always performed? a. testing the accounting classification of sales transactions b. testing the mathematical accuracy of the cash receipts ledger c. evaluating the adequacy of the provision for doubtful accounts d. none of the above

38.

Which of the following statements regarding a share register is incorrect? a. It is a list of all the items of inventory that a company has. b. It is used to capture purchases and sales of shares. c. It is essentially the sub-ledger reconciled to the general ledger account for share capital. d. It is prepared by the auditor.

39.

The rights and obligations assertion for inventory relates to which of the following audit objectives? a. Inventory is properly classified, described and disclosed in the financial statements. b. The entity owns, or has the legal right to, all of the inventory on the balance sheet. c. All inventory on the inventory listing is included in the financial statements. d. All inventory owned by the entity at year-end is included on the balance sheet.

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40.

Observing the client's inventory taking enables the auditor to establish that: a. count tags, sheets or cards are properly controlled. b. the client's personnel are complying with the instructions for inventory counts. c. items belonging to the client are accurately counted and recorded. d. all of the above.

41.

Auditors usually test for the existence of property, plant and equipment by: a. physically sighting the assets on the fixed assets register in the first year the client is audited. b. vouching to supporting documentation. c. re-performing depreciation calculations. d. performing analytical review procedures.

42.

Completeness of property, plant and equipment is usually not a major issue for most entities because: a. completeness tests tend to focus on the potential understatement of fixed assets. b. the auditor is typically most concerned with the overstatement of assets. c. both a and b. d. none of the above.

43.

Ensuring that all property, plant and equipment owned by the entity at year-end are included on the balance sheet relates to which assertion? a. rights and obligations b. completeness c. classification d. existence

44.

What are the key assertions for payables? a. completeness and valuation and allocation b. existence and completeness c. completeness and rights and obligations d. classification and valuation and allocation

45.

The typical procedures performed to verify that the client has not omitted any amounts from the payables balance include: a. vouching recorded payables to supporting documentation. b. performing analytical review procedures. c. performing confirmations of payables accounts. d. subsequent payments testing.

46.

Which of the following are substantive tests of payables balances that are always performed?

Substantive testing and balance sheet accounts a. b. c. d.

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performing a search for unrecorded liabilities examining the client's bank reconciliations testing the cut-off by inspecting the payments ledger and supporting documents to determine that transactions are recorded in the correct period all of the above.

47.

The valuation and allocation assertion relates to which of the following audit objectives? a. All accounts payable on the balance sheet are real accounts payable for goods received or services performed. b. All accounts payable owed by the entity at year-end are included on the balance sheet. c. Accounts payable are stated at the amounts owed at year-end. d. Accounts payable are properly classified, described and disclosed in the financial statements.

48.

Investments can be vouched to supporting external documentation such as: a. shares prices on the stock exchange. b. investment statements from a bank. c. both a and b. d. none of the above.

49.

Which of the following account balances are typically audited fully or substantially with limited or no controls testing? a. Investments b. Intercompany balances c. Prepayments d. All of the above

50.

Which of the following statements is incorrect? a. Equity typically does not move much in any given year. b. Retained earnings is a complex calculation. c. Provisions are difficult to audit via controls testing alone. d. Intercompany balances are vouched to the related entity or to intercompany confirmations.

51.

Which type of leases are not recorded on the balance sheet? a. operating b. finance c. direct financing d. sale and leaseback

52.

When performing substantive procedures, the key objective is to determine whether: a. there are immaterial misstatements within the balance being investigated. b. the client's internal controls are operating effectively. c. there are material misstatements within the balance being investigated.

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53.

none of the above.

When substantive tests performed identify errors or exceptions, the first response is to: a. qualify the audit report. b. understand why the exception or error has arisen. c. report the client to CRA. d. perform additional substantive testing.

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

20.

21.

Ans. a d c c c c

Item 22.

23.

24.

25.

26.

27.

Ans. d b b a a d

Item 28.

29.

30.

31.

32.

33.

Ans. c b c d a c

Item 34.

35.

36.

37.

38.

39.

Ans. d b d c d b

Item 40.

41.

42.

43.

44.

45.

Ans. d a c b a d

Item 46.

47.

48.

49.

50.

51.

Ans. Item Ans. d 52. c c 53. b c d b a

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SHORT ANSWER QUESTIONS SA 54 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Paula Padgett was performing substantive tests of trade receivables at Neu Lion. She indicated to her staff member, Leona Marshall: “At this client accounts receivable are material in amount. The two assertions that are the most important are the occurrence and accuracy assertions.” b) Emilio Boulrice, CGA was returning from an audit conference where he had entertained his many friends with his musical talents. As he sat in his aisle in the Air Canada flight back home to Montreal, he turned to his friend and said: “Although there is no specific requirement for us to confirm receivables anymore, existence of trade receivables is usually verified by sending confirmations to the client's customers.” c) Mike Gallagher was preparing his staff for the audit of inventory at a major client. He said to his staff: “ The two key assertions for inventory are proper cutoff and accuracy.” d) Mona Lincolnshire was assessing the results of her staff’s substantive testing procedures.

She said: “When performing substantive procedures, the key objective is to determine whether there are material misstatements within the balance being investigated and to quantify the amount of any errors if they exist.”

Solution: a) Disagree. When accounts receivable are a significant account in an entity's balance sheet there are two audit assertions that are considered most important to ensure the auditor has gained sufficient and appropriate audit evidence on which to conclude that there are no material misstatements in the balance as at year-end. They are the existence and valuation and allocation assertions. b) Agree. While there is no specific requirement for the auditor to confirm accounts receivable, this is a frequently used procedure as it provides third party external evidence over the existence assertion. c)

Disagree. The two key assertions for inventory are existence and valuation and allocation.

d)

Agree. When tests performed identify errors or exceptions, the first response is to understand why the exception or error has arisen. Unless the total error in the balance is able to be quantified without performing additional testing, an increase in the sample size may be required to ensure there are no other errors. Additional testing may also be an appropriate response to confirm and quantify the errors. It is important when errors are identified to continue testing until the error can either be accurately quantified or the balance has been fully tested to an extent that proves a material error can no longer exist within the balance.

SA 55 Discuss the specific issues that auditors should consider when designing substantive procedures.

Solution:

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When deciding on the nature of test to perform, it is essential to understand the specific risks driving the risk assessment for that account assertion. For example, one client has significant overseas accounts receivable, which increases the inherent risk for the valuation of receivables.

If controls testing indicates that control risk is low for this assertion, substantive testing can be reduced. Another client may have trade receivables valuation risk assessed as low due to a lower inherent risk because of a significant number of very small receivables that make up the balance but higher control risk due to poor controls being in place. Both overall risk assessments are the same; however, the audit strategy for each will be different due to the controls risk assessment made.

Before the auditor begins their year-end work, it is important to remember that procedures have already been performed to assess control and inherent risks, and interim substantive procedures also may have been completed. The auditor needs to ensure that they take credit for this work and that the 'mindset' with which they approach their year-end work is appropriate and fully reflects their risk assessment and expectation of the likelihood of material misstatements occurring.

The threshold for what the auditor considers important will vary depending on the overall risk assessment and the context in which they make the judgment. Thresholds should be challenged in the context of the client and the overall risk assessment, and agreed with the engagement executives to ensure the audit team is performing the right level of testing for each significant account. Determining the extent of testing prior to year-end will allow more time during the yearend visit to focus on performing the required procedures.

SA 56 Identify and explain the key audit assertions relating to cash.

Solution: The three audit assertions that are particularly important when auditing cash are existence, completeness and classification. Firstly, existence of cash is usually verified by the receipt of a confirmation from the client's bank. The bank should also confirm whether there are any additional bank accounts, loans, pledges, lease facilities or other banking facilities. The second significant assertion is completeness, with a particular focus on whether the balance completely reflects all cash transactions. Substantive tests usually focus on testing the client's bank reconciliation as well as the cut-off of cash transactions. The auditor tests the bank reconciliation by vouching any differences between cash as per the bank statement and cash as per the general ledger to supporting documentary evidence. The third significant assertion is classification. Classification is important because of the additional information related to the cash account that is required to be disclosed in the financial statements, including unused credit facilities and other information that is part of the statement of cash flow disclosure requirements.

SA 57 What are the principal objectives in auditing trade receivables?

Solution: The principal objectives in auditing trade receivables are: Existence: All receivables on the balance sheet are real claims of the entity.

Completeness: All real claims of the entity for amounts receivable are included on the balance sheet.

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Valuation and allocation: Receivables are carried at their net realizable (collectable) value (i.e. the gross receivables are properly stated with appropriate allowances provided for uncollectable accounts, discounts, returns, warranties and similar items).

Rights and obligations: The entity owns, or has legal right to, all the receivables on the balance sheet at year-end. All receivables are free from liens, pledges or other security interests or, if not, such liens, pledges or other security interests are identified.

Classification and understandability: Receivables are properly classified, described and disclosed in the financial statements, including the notes, in conformity with prescribed accounting principles (IFRS).

SA 58 Explain examples of substantive tests of inventory that are always performed.

Solution: Examples of substantive tests of inventory that are always performed are: a) Observe the client’s inventory count to establish that: - the client's personnel are complying with the instructions for inventory taking, items belonging to the client, or belonging to others but for which the client is responsible, are accurately counted and recorded.

- items to be excluded from inventory (no-value items, non-inventory items, items belonging to others) are either subject to satisfactory control and excluded from the counting process or are accurately counted and recorded, including a clear description of their non-inventory status - count tags, sheets or cards are properly controlled. b) Perform tests of the client's counts (from the floor to recorded counts and from recorded counts to the floor); record sufficient information to be able to trace the test counts into the inventory compilation at a later date; record selected information concerning the tags, sheets or cards that are used, partially used, unused and voided. c) Inspect shipping, receiving, and transfer documents and the related inventory items, when appropriate, to establish the numbers of the last documents used and other information needed for subsequently verifying cut-off in the accounting records.

SA 59 Explain how substantive testing is used for prepayments, investments and intercompany balances.

Solution: Each of these accounts is typically audited fully substantively (with limited or no controls testing) as they tend to be easier to audit substantively at year-end. Prepayments are audited by vouching the balance to the supporting invoices and ensuring the split between what has been expensed and what remains in the balance sheet is correctly calculated. Investments are able to be vouched either to supporting external documentation, such as investment statements (from a bank), share prices per the stock exchange (for listed investments) or supporting financial statements (for investments in subsidiaries or associates). These sorts of investments (in subsidiaries) are also able to be supported by the testing performed on the subsidiary's trial balance (among other tests), and so may in fact be reliant on controls testing of the subsidiary.

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Intercompany balances are vouched to the related entity or to intercompany confirmations. In addition, the auditor needs to ensure that the intercompany balances eliminate on consolidation to the extent owned by the parent entity.

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ESSAY QUESTIONS ES 60 The collapse of Worldcom in 2002 caused commentators to question the company's financial reporting practices. Explain the major problems with the company's financial reporting that contributed to the company's collapse.

ES 61 Discuss why valuation and allocation is a key assertion for property, plant and equipment and explain how auditors verify the reliability of the valuations of such assets.

ES 62 Explain how auditors evaluate the results of substantive procedures and describe the procedures employed by auditors when the procedures identify errors or exceptions.

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CASE Ca 62 Moore Packaging is a manufacturer of corrugated products servicing all of Ontario. It’s annual audit was in progress and the senior on the audit, Ray Radcliffe, was reviewing procedures over accounts receivable, inventory, property plant and equipment and accounts payable.

The accounts receivable accounts were deemed to be key when it came to possible material misstatements. The preliminary work on test of controls had indicated higher than usual exceptions of shipments of goods to customers without the appropriate credit checks being performed.

The property plant and equipment account had not changed significantly over the last 5 years, and it was anticipated that there would be little extra effort required to audit this account. Last year’s balance - net of amortization was $7,600,000. The preliminary amount – net of amortization for this year was $7,700,000.

Total accounts payable was $2,200.000. The accounts payable amounts seemed to be all zero balances or relatively low balances. The exceptions consisted of two major suppliers to whom the company owed $1,800,000.

The inventory taking was missed this year at two of the three locations as local flooding had prevented the auditors from attending the annual inventory. The company keeps perpetual records for 90% of its inventory values. Year-end inventory balances tend to be in the $10,000,000-$12,000,000 range.

Materiality has been set at $2,000,000 for the Moore Packaging audit.

Required: a) What are the key assertions that Ray Radcliffe will need to focus on for accounts receivable? b) What work will Ray Radcliffe’s audit team be doing to substantiate the accounts receivable valuation at Moore Packaging? c) What procedures can be taken for the substantive tests of inventory, given the fact the company keeps perpetual records. d) What work will the auditors have to perform to substantiate the inventory valuation at Moore Packaging? e) What are the two key assertions for payables? Discuss their importance and the techniques used to ensure they are fulfilled. f) Where should the auditors focus their confirmation procedures for accounts payable at Moore Packaging? g) What substantive procedures will Ray Radcliffe’s team have to consider for Property Plant & Equipment accounts?

Solution: a) When accounts receivable is a significant account in an entity's balance sheet there are two audit assertions that are considered most important to ensure the auditor has gained sufficient and appropriate audit evidence on which to conclude that there are no material

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misstatements in the balance as at year-end. They are the existence and valuation and allocation assertions. b)

The best way of ensuring the balance is valued correctly at Moore Packaging is by the full receipt of the cash by the client after year-end.

Note: There can be confusion as to whether a trade receivables confirmation provides assurance over the existence or valuation and allocation (or both) assertions. A positive confirmation only provides audit evidence as to the existence of the debt. It does not provide any assurance as to whether the client will recover all of the balance.

c)

Similar to accounts receivable, the two key assertions for inventory are existence and valuation and allocation.

Because the auditors were not able to perform an inventory taking at two of the three sites, they will use alternative means to determine existence at the balance sheet date. They will determine how accurate the perpetual records are, check whether there is a program of cyclical counts to ensure the existence and accuracy of inventory quantities, and review any adjustments that have been made on the company books. If the controls over the perpetual records and cyclical counts are excellent, the auditors will be able to place reliance on the existence assertion.

d)

Typical substantive procedures that Moore Packaging’s auditors can carry out for valuation and allocation, would be to focus on the initial cost recorded (by vouching to supporting invoices), the value recovered for any sales (by vouching to sales invoices), and any provision for impairment calculations for excess, slow-moving or obsolete inventory on hand at year-end. Allocation to raw materials, work-in-process and finished goods categories as well as write offs to cost of goods sold of obsolete inventory, will be performed as part of the compilation procedures.

Notes on completeness, rights and obligations, and classification assertions: Completeness of inventory is ordinarily not a major issue for most entities as the auditor is typically most concerned with the overstatement of assets, and completeness tests tend to focus on the potential understatement of inventory on hand. However, for some clients, it is a significant assertion. For example, for clients selling to retail outlets, the retailer often does not take ownership or title of the goods held in-store until the goods are actually sold. It is not until the sale has occurred that the supplier (our client in this example) is able to recognize the sale. That is important information not only for the auditor to understand but also for the users of the financial statements to be aware of, as it gives information about the risks of whether the client is likely to receive the cash (that is, in the example given it is highly dependent on the customer's ability to sell the goods, not on anything the client can necessarily do). It also represents the type of inventory that may be inadvertently omitted from the balance.

Rights and obligations is tested for particular types of rights that attach to the inventory held by a client. For example, if inventory is owned by the client as soon as it is shipped from the manufacturer, the goods in transit need to be recognized as inventory before it is actually received into the client's warehouse. Ownership of inventory is only subject to a high risk of error at very few, very specific types of companies that purchase or sell goods with specific rights attached to the items.

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Classification is generally addressed by testing the inventory listing. Therefore, verifying the amounts included in the disclosures in the financial statements is relatively straightforward, as the disclosures are often found within the listing (that is, the split of total inventory between raw materials, work in progress (WIP) and finished goods). e)

The key assertions for payables are completeness, and valuation and allocation.

Completeness is critical because, as with any liability account balance, the risk is that the balance is understated. While auditing the balance recorded is relatively simple to perform, the bigger risk is that the client has omitted amounts from the balance, and it is therefore understated because it is not complete. The typical procedures performed are often referred to as subsequent payments testing and cut-off testing to search for unrecorded payables.

Subsequent payments testing involves vouching a sample of payments made after yearend to supporting invoices to ensure that if the amount relates to invoices dated prior to year-end, they have been correctly included in payables at that date. If the amount paid relates to invoices after year-end, the testing is to ensure they have been correctly excluded from payables at year-end.

Cut-off testing involves selecting a sample of purchases either side of year-end and verifying that each has been correctly included or excluded from payables based on the invoice date. This testing involves testing a sample of invoices on hand but not yet processed by the client to ensure the client is not 'holding back' invoices that should be recorded in payables at year-end.

Notes on existence and rights and obligations assertions: Existence and rights and obligations are not usually significant assertions for payables. It is highly unlikely that the client records payables that do not exist or that they do not have the obligation to pay. Classification is only important if there are related party transactions and balances, lease commitments, loan facilities, debt agreements or other forms of finance included within the payables balance.

Payables can include the account referred to as accruals. Accruals are those amounts that the client may not have received the invoice for but for which they know they have incurred an obligation to pay as at year-end. Accruals are tested in the same way as payables, that is, by subsequent payments testing. If the amount has not been paid prior to the audit testing being performed, another test to verify the amount as materially correct is to vouch the accrual amount to the invoices received.

f)

Because the biggest risk is that a client may have omitted to record a balance (completeness objective), we would focus on subsequent payments testing. The Moore auditors would perform tests of account balances that are always performed for most organizations: (i) Examining the client’s bank reconciliations (completeness) (ii) Testing the cut-off by inspecting the cash disbursement journal, receiving reports, suppliers' invoices and other supporting documents immediately before and after the cut-off date and determining that the transactions were recorded in the proper period; comparing payables cut-off to cut-off in related areas (e.g. inventory). (completeness, valuation and allocation) (iii) Performing a search for unrecorded liabilities at year-end by selecting subsequent payments, unpaid invoices on hand but not yet recorded in the ledger (completeness) (iv) Performing analytical procedures focusing on investigating unexpected changes such as new suppliers, account aging, absence of expected changes, ratio changes (completeness and valuation and allocation).

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In addition, the Moore Packaging auditors would probably stratify the accounts payable confirmations along the following lines: Positive confirmations would be sent to the two major suppliers that account for $1,800,000.

Use both positive and negative confirmation procedures for the other $400,000, depending on the number of vendors and the distribution of zero balances among the vendors. g)

The two key significant assertions for property, plant and equipment (PPE) are existence, and valuation and allocation.

Existence is important because the assets the company has recorded in its fixed assets register (which flows into the general ledger and finally into the financial statements) need to actually exist. Auditors usually test for existence by physically looking at the assets listed in the fixed asset register in the first year that a client is audited. In subsequent years, the existence procedures tend to focus on additions to and disposals from the fixed asset register. It is important to physically look at the fixed assets on a periodic basis as this provides insights into not only whether the asset exists but also whether there appear to be any assets that may be damaged, obsolete, impaired or excess to the client's needs, providing important evidence for the valuation and allocation assertion.

The Moore Packaging auditors will have to look for net additions to PPE accounts in the current year, as the net amount is slightly higher – even after additional amortization credits that would have been posted in the current year.

Valuation and allocation is the other significant assertion tested by auditors in relation to PPE as it is important that assets are recorded at the appropriate carrying value, or fair value as it is described and defined by IFRSs, in particular IAS 16 Property, Plant and Equipment. Valuation also becomes very important when a company changes processes or structures as the decisions made by management and those charged with governance will often impact the values that items of PPE should be carried at. For example, if an entity decides to close down a factory site, it is likely that the value of the fixed assets at that site will be impaired and may need to be written down to their fair value (or nil).

Typical substantive procedures to test valuation focus on the initial cost recorded (by vouching to supporting invoices), the value recovered for any disposals (by vouching to cash received or trade-in amounts obtained), and depreciation and impairment calculations for each asset and whether there are any additional write-down or depreciation amounts required for the period. Procedures to test depreciation include performing reasonableness testing of the depreciation charge compared to the cost base of the assets, assessing the useful lives of the assets and comparing these to the depreciation rate used and, in the case of property, having an external valuation performed.

Notes on completeness, rights and obligations, and classification assertions Completeness is usually not a major issue for most entities as the auditor is typically most concerned with the overstatement of assets, and completeness tests tend to focus on the potential understatement of fixed assets.

The rights and obligations assertion is tested during the first-year audit procedures and then again periodically depending on the type of assets in the fixed asset register.

Property is easily verified by reviewing the titles related to each property. Fixed assets

Substantive testing and balance sheet accounts

10 – 25

also comprise items of equipment, plant and machinery, vehicles and office equipment.

Ownership of these items is not subject to a high risk of error unless there are items that are leased (rather than owned). Owned items are able to be verified to either registration papers or original purchase invoices, which will have been tested as part of the valuation assertion. Leased items will be verified to leasing documentation signed by the business when it entered into the lease. While not always specifically testing for rights and obligations, the risk has already been addressed when testing for valuation and allocation.

Classification is generally addressed by testing the fixed asset register. Therefore, verifying the amounts included in the disclosures in the financial statements is relatively straightforward, as the disclosures are found within the fixed asset register (the key one being depreciation).

CHAPTER 11 SUBSTANTIVE TESTING AND INCOME STATEMENT ACCOUNTS SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 7.

2 10.

3 13.

8.

2 11.

3 14.

9.

3 12.

3 15.

Multiple Choice Questions 24.

2 28.

2 32.

25.

2 29.

2 33.

26.

2 30.

2 34.

27.

2 31.

2 35.

Short Answer Questions 43.

2 44.

3 45.

LO Item

1.

2.

3.

1 1 1

4.

5.

6.

1 2 2

3 4 4

16.

17.

18.

19.

1 1 1 1

20.

21.

22.

23.

1 1 1 1

41.

1

42.

2

Essay Questions 46.

2

47.

3

48.

2

3 3 3 3 4

36.

37.

38.

39.

LO Item

LO

3 3 3 3

4

40.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

Type

1.

2.

TF TF

3.

4.

TF TF

16.

17.

MC MC

5.

6.

7.

TF TF TF

8.

24.

25.

TF MC MC

26.

27.

28.

MC MC MC

9.

10.

11.

TF TF TF

12.

13.

32.

TF TF MC

33.

34.

35.

MC MC MC

14.

TF

15.

TF

40.

MC

Note: TF = True-False MC = Multiple Choice

Item Type Item Study Objective 1 18.

MC 20.

19.

MC 21.

Study Objective 2 29.

MC 42.

30.

MC 43.

31.

MC 46.

Study Objective 3 36.

MC 39.

37.

MC 44.

38.

MC 47.

Study Objective 4 45.

SA

SA = Short Answer Ca = Case

Type Item

Type Item Type

MC MC

22.

23.

MC MC

SA SA ES

48.

ES

MC SA ES

ES = Essay

41.

SA

Substantive testing and income statement accounts

11 – 3

CHAPTER STUDY OBJECTIVES 1.

Explain the relationship between the overall risk assessment for a significant account and the extent and timing of substantive procedures, and the differences between auditing income statement and balance sheet accounts. The higher the overall risk of error or misstatement, the higher the level of substantive procedures required, assuming that no controls have been tested or can be relied on. When controls are effective and the overall risk assessment is therefore lower, limited substantive testing is ordinarily required. Revenue and expense account balances reflect the entire reporting period, and auditors typically use substantive analytical procedures coupled with some tests of details.

2.

Design and understand how to execute substantive procedures to address audit risk related to revenue. Sales revenue is typically significant due to its size, volume of transactions, and high inherent risk. The most important audit assertions for revenue are occurrence, accuracy, and cut-off. The two significant accounting processes that impact on the sales revenue account balance are sales and sales returns and allowances. It is normally efficient and effective to perform at least some controls testing over these processes.

3.

Design and understand how to execute substantive procedures to address audit risk related to cost of sales and other significant expenses. Cost of sales and expenses are generally significant accounts. The key audit assertions for these accounts are accuracy, completeness, and cut-off. Typical procedures include vouching recorded amounts to supporting documentation, and testing of depreciation expense as part of the testing of property, plant, and equipment on the balance sheet. Opening and closing inventory is part of inventory testing. Purchases testing is most efficiently tested as part of controls testing. Incentives to achieve particular levels of profit could lead to a company deferring the recognition of expenses incurred before year end to the following period. Special consideration may be given to the payroll balances.

4.

Understand how to assess the results of the substantive procedures to determine whether additional substantive tests are necessary. When tests performed identify errors or exceptions, it is important to continue testing until the error can be accurately quantified or until the balance has been fully tested to an extent that it proves a material error can no longer exist within the balance.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

TRUE-FALSE STATEMENTS 1.

Substantive procedures are designed to detect material misstatements at the assertion level.

2.

Testing the balance sheet substantively will provide reasonable assurance on the income statement accounts.

3.

Control risk is the risk that an auditor expresses an inappropriate audit opinion when a financial statement is materially misstated.

4.

When inherent risk and control risk are assessed to be low, the level of substantive procedures required to address any remaining detection risk is limited.

5.

Sales revenue is typically not significant due to its size.

6.

The completeness assertion relates to the audit objective that sales and other revenues are stated in the profit and loss at the appropriate amounts.

7.

Testing the pricing and mathematical accuracy of sales invoices is an example of a substantive test of transactions in the sales process.

8.

Testing the account classification of credit memos tests the accuracy assertion for the sales returns process.

9.

The key audit assertions for cost of sales and expenses are rights and obligations and occurrence

10.

Purchases testing is performed most efficiently by the use of controls testing.

11.

Occurrence is not typically a significant assertion as the primary objective in testing for occurrence is to ensure that costs and expenses are not overstated.

12.

The classification assertion relates to ensuring that all costs and expenses in the income statement are properly supported as charges against the entity.

Substantive testing and income statement accounts

11 – 5

13.

An example of a substantive test always performed for costs and expenses is obtaining detailed analysis of selected accounts and tracing the details to the source data.

14.

The auditor uses their professional judgment, knowledge of the client and risk assessment for each significant account to determine the timing and extent of testing.

15.

The key objective when performing substantive testing is determining whether the client's internal controls are effective at preventing and detecting material misstatements.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

3.

Ans. T T F

Item 4.

5.

6.

Ans. T F F

Item 7.

8.

9.

Ans. T F F

Item 10.

11.

12.

Ans. T T F

Item 13.

14.

15.

Ans. Item T T F

Ans. Item

Ans.

Substantive testing and income statement accounts

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MULTIPLE CHOICE QUESTIONS 16.

Substantive procedures are also known as: a. tests of details. b. compliance tests. c. tests of subsequent events. d. tests of controls.

17.

Which type of substantive procedure do auditors ordinarily use when testing income statement accounts? a. confirmations b. recalculations c. analytical procedures d. observations

18.

Analytical procedures involve: a. the investigation of identified fluctuations and relationships that are inconsistent with other information. b. evaluations of financial information made by a study of plausible relationships among financial and non-financial data. c. both a and b. d. none of the above.

19.

The risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated is known as: a. engagement risk. b. audit risk. c. client business risk. d. detection risk.

20.

Control risk is: a. the susceptibility of an assertion to a misstatement that could be material assuming there are no related controls. b. the risk that a client's system of internal controls will not prevent or detect a material misstatement. c. the risk that the auditor's testing procedures will not be effective in detecting a material misstatement. d. the risk that fraud has occurred.

21.

When the inherent risk and control risk assessment is high: a. there are no controls tested or relied upon. b. minimal substantive tests are performed. c. the amount of substantive testing is significant. d. both a and c.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

22.

The level of substantive procedures will be limited when: a. the inherent and control risk assessment is low. b. there are no controls tested or relied upon. c. the inherent and control risk assessment is high. d. the client requests the auditor to perform limited procedures.

23.

The additional opportunities for influencing the timing of work performed include: a. leveraging off internal audit. b. performing general audit procedures prior to year-end. c. performing procedures on activities in the period to date. d. all of the above.

24.

Sales revenue is typically significant due to: a. the overall inherent risk associated with revenue. b. the volume of transactions that flow through the account. c. its size. d. all of the above.

25.

The three audit assertions that are important to ensure the auditor has gained sufficient and appropriate audit evidence for sales revenue are: a. completeness, accuracy and occurrence. b. occurrence, accuracy and cut-off. c. cut-off, accuracy and completeness. d. classification, accuracy and completeness.

26.

A simple way of testing which period a sale should be recorded in is to: a. trace the sale through to the accounting records. b. observe the account receivable clerk record the sale. c. vouch the sale to the delivery documentation for the sale of goods. d. none of the above.

27.

Which assertion is generally not significant for sales revenue? a. completeness b. accuracy c. occurrence d. cut-off

28.

The occurrence assertion for sales relates to which of the following audit objectives? a. Sales and other revenues are properly classified, described and disclosed in the financial statements. b. Sales and other revenues are stated in the profit and loss at the appropriate amounts.

Substantive testing and income statement accounts c. d.

11 – 9

All sales and other revenues that accrued to the entity during the period are included in the income statement.

All sales included in the income statement represent the exchange of goods or services with customers during the period.

29.

Which of the following assertions relates to the audit objective that all sales and other revenues that accrued to the entity during the period are included in the income statement? a. classification b. occurrence c. completeness d. accuracy

30.

Testing the postings of the sales ledger to the general ledger and the trade receivables sub-ledger relates to which assertion? a. occurrence b. completeness c. accuracy d. none of the above

31.

Which of the following are examples of substantive procedures in auditing revenue that are always performed? a. testing the cut-off of revenues b. comparing the monthly income statements to budget and investigating any unexpected fluctuations c. both a and b d. none of the above

32.

The key audit assertions when auditing cost of sales and expenses include: a. cut-off. b. completeness. c. accuracy. d. all of the above.

33.

The accuracy of cost of sales and expenses is verified by: a. vouching recorded amounts to supporting documentation. b. sending confirmation requests to the client's creditors. c. tracing supporting documentation to the accounting records. d. all of the above.

34.

Bad debts expense is ordinarily tested as part of the testing of the valuation of: a. trade payables. b. trade receivables. c. cash at bank. d. inventory.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

35.

The audit objective that costs and expenses are stated in the income statement at the appropriate amounts relates to which assertion? a. completeness b. occurrence c. classification d. accuracy

36.

The two important types of transactions that impact on the costs and expenses balances are: a. interest and dividends. b. sales and interest. c. purchases and payroll. d. depreciation and purchases.

37.

Comparing supplier/creditor invoices to the initial record of entry relates to which assertion? a. completeness b. accuracy c. cut-off d. existence

38.

Which of the following substantive tests of payroll transactions does not relate to the accuracy assertion? a. reconciling the accrued payroll balance to the amount in the payroll ledger for the corresponding balance b. testing the postings of totals in the payroll ledger to the general ledger c. testing the extensions of wage rates times the hours worked d. comparing the hours paid with the record of hours worked

39.

Substantive tests of costs and expenses that are always performed include: a. reviewing interim financial statements and investigating fluctuations or the absence of expected changes. b. comparing the current year's expenses to the prior year's actual and the current year's budgeted amounts. c. obtaining detailed analysis of selected costs and expense accounts and tracing the details to the source data. d. all of the above.

40.

When substantive tests performed identify errors or exceptions, the auditor's first response is to: a. qualify the audit report. b. report the client to CICA. c. understand why the exception or error has arisen. d. none of the above.

Substantive testing and income statement accounts

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ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 16.

17.

18.

19.

Ans. a c c b

Item 20.

21.

22.

23.

Ans. b d a d

Item 24.

25.

26.

27.

Ans. d b c a

Item 28.

29.

30.

31.

Ans. d c b c

Item 32.

33.

34.

35.

Ans. d a b d

Item 36.

37.

38.

39.

Ans. Item Ans. c 40. c a b d

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

SHORT ANSWER QUESTIONS SA 41 Explain the various components of risk in the audit risk model and the interrelationship between the various components.

Solution: Audit risk is a function of inherent risk, control risk and detection risk. Audit risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Inherent risk is the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming there are no related controls. Control risk is the risk that a client's system of internal controls will not prevent or detect a material misstatement. Detection risk is the risk that the auditor's testing procedures will not be effective in detecting a material misstatement. When the inherent risk and control risk assessment is high, there are no controls tested or relied upon and therefore the amount of substantive testing required to reduce the detection risk to an acceptable level is significant. When the inherent and control risk assessment is low, there are lots of controls that have been tested and found to be effective, therefore allowing reliance to be placed on them to ensure that material misstatements do not occur. Therefore, the level of substantive procedures required to address any remaining detection risk is limited. It follows that when the inherent and control risk assessment is medium, there is some audit evidence obtained from tests of controls (or controls testing) and some from substantive testing.

SA 42 What are the three audit assertions that are important to ensuring that the auditor has gained sufficient and appropriate audit evidence for sales revenue?

Solution: The three audit assertions that are important to ensure the auditor has gained sufficient and appropriate audit evidence for sales revenue are occurrence, accuracy and cut-off. Testing of the occurrence assertion needs to ensure that the sales recorded in the general ledger are in fact bona fide sales and have 'occurred'. Substantive tests for the accuracy assertion focus on ensuring that the sales have been recorded at the correct amount (or value) and have not been overstated. The cut-off assertion is important because there is a risk that an entity will record sales that occur after year-end in the year being audited. The pressure to achieve sales targets and budgets can lead to companies recording sales that occur after year-end in the results prior to year-end. As a result, procedures are designed to test material transactions either side of year-end or all sales in the last week before year-end to ensure that all sales are recorded in the correct period.

SA 43 Discuss the importance of the completeness assertion as it relates to auditing sales revenue.

Solution: Completeness is generally not a significant assertion as the risk with sales revenue is that the client has overstated the balance. Completeness testing focuses on ensuring all sales revenue that occurred has been recorded to ensure sales revenue has not been understated.

Substantive testing and income statement accounts

11 – 13

Understatement of sales revenue is not a risk for most clients; however, in certain industries and circumstances, this may be a key concern, and may therefore require substantive procedures to be developed to address this risk. For example, sometimes entities that have already achieved their budgeted results (and therefore may have earned substantial bonuses) may defer the recognition of sales until after year-end to give them a 'head start' on meeting the following year's budgeted sales. In this instance, testing is performed to ensure revenue in the current year is not understated. During difficult economic times, however, this risk is low.

SA 44 Explain the principal objectives in auditing costs and expenses.

Solution: The principal objectives in auditing costs and expenses are: a) Occurrence: All costs and expenses in the income statement are properly supported as charges against the entity in the period. Costs and expenses applicable to future periods are carried forward as inventory, prepaid expenses, deferred charges or property, plant and equipment. b)

Completeness: All costs related to the current period's revenues and all expenses of the current period are included in the income statement.

c)

Accuracy and cut-off: Costs and expenses are stated in the income statement at the appropriate amounts.

d)

Classification and understandability: Costs and expenses are properly classified, described and disclosed in the financial statements, including the notes.

SA 45 Explain the key objective of substantive testing and the responses from auditors when errors or exceptions are identified during testing.

Solution: When performing substantive testing, the key objective is to determine whether there are material misstatements within the account balance and to quantify the amount of any misstatement if it exists. When tests performed identify errors or exceptions, the first response is to understand why the exception or error has arisen. It may require an increase to the sample size (as per CAS 530 (ISA 530) Audit Sampling) to ensure there are no other errors in the balance unless the total error in the balance is able to be quantified without performing additional testing (as per CAS 330 (ISA 330) The Auditor’s Responses to Assessed Risks and CAS 500 (ISA 500) Audit Evidence). Additional testing (using the example substantive tests provided in this chapter) may also be an appropriate response to confirm and quantify the misstatement. It is important when errors are identified to continue testing until the error can either be accurately quantified or the balance has been fully tested to an extent that proves a material error can no longer exist within the balance.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

ESSAY QUESTIONS ES 46 Explain the nature of the accounting fraud that was committed by the Sunbeam Corporation in the 1990s. What procedures can auditors use to detect such fraud?

ES 47 Explain the nature of and motivations for various approaches for companies to manipulate their profits through the use of expenses.

ES 48 Identify situations where the understatement of sales can be a risk for certain clients and how auditors should react to such risk.

CHAPTER 12 COMPLETING AND REPORTING ON THE AUDIT SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES Item

LO

Item

LO Item

LO Item LO Item True-False Statements 5.

4 7.

5 9.

6.

5 8.

6 10.

Multiple Choice Questions 24.

9 29.

2 34.

25.

1 30.

4 35.

26.

1 31.

4 36.

27.

8 32.

4 37.

28.

2 33.

5 38.

Short Answer Questions 50.

4 51.

5 52.

LO Item

LO Item

LO

1.

2.

1 1

3.

4.

2 4

7 8

11.

12.

8 9

13.

9

14.

15.

16.

17.

18.

1 1 3 4 4

19.

20.

21.

22.

23.

4 8 8 8 7

5 5 6 7 7

39.

40.

41.

42.

43.

8 8 8 8 8

44.

45.

46.

47.

7 8 9 9

48.

1,4,5,8 49.

2

7

53.

9

Essay Questions 54.

5

55.

1

56.

1 Case

57.

1,2

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

SUMMARY OF LEARNING OBJECTIVES BY QUESTION TYPE Item

Type Item

Type Item

1.

2.

TF TF

14.

15.

MC MC

25.

26.

3.

TF

28.

MC

29.

16.

TF

4.

5.

TF TF

17.

18.

MC MC

19.

30.

6.

7.

TF TF

33.

34.

MC MC

35.

48.

8.

TF

36.

MC

Type

Item Type Item Study Objective 1 MC 48.

SA 56.

MC 55.

ES 57.

Study Objective 2 MC 49.

SA 57.

Study Objective 3 Study Objective 4 31.

MC 48.

MC MC 32.

MC 50.

Study Objective 5 MC 51.

SA 54.

ES SA Study Objective 6

9.

TF

23.

MC

37.

MC

10.

11.

TF TF

20.

21.

MC MC

22.

27.

MC MC

12.

TF

13.

TF

24.

MC

Note: TF = True-False MC = Multiple Choice

Study Objective 7 38.

MC 44.

Study Objective 8 39.

MC 41.

40.

MC 42.

Study Objective 9 46.

MC 47.

SA = Short Answer Ca = Case

Type Item

Type Item Type

ES Ca Ca

SA SA

MC

52.

SA

MC MC

43.

45.

MC MC

MC

53.

SA

ES = Essay

48.

SA

Completing and reporting on the audit

12 – 3

CHAPTER STUDY OBJECTIVES 1.

Explain the procedures performed as part of the engagement wrap-up, including gathering and evaluating audit evidence. During the engagement wrap-up, the auditor reviews planned audit procedures to ensure they are completed, finalizes any open items (including review notes and to-do items), ensures that all necessary documentation is in the working paper files and removes any unnecessary documentation, reconsiders their risk assessment and fraud risk, reconsiders materiality, performs analytical procedures, assesses misstatements, and performs subsequent events procedures.

2.

Understand the considerations when assessing the going concern assumption used in the preparation of the financial statements. The auditor is required to consider whether the going concern assumption is the correct basis upon which the financial statements have been prepared. That is, is the entity viewed by the auditor, management, and those charged with governance as continuing into the foreseeable future with neither the intention nor the need to liquidate, to cease trading, or to seek protection from creditors?

3.

Understand the purpose of and the procedures performed in the review for contingent liabilities and commitments. It is the auditor’s responsibility to perform procedures to verify that there are no unrecorded or undisclosed lawsuits or claims that could result in the financial statements being materially misstated.

4.

Compare the two types of (material) subsequent events to determine what effect they have on the financial statements (if any). There are two types of subsequent events. Type 1 subsequent events are those that provide additional evidence with respect to conditions that existed at year end. These are required to be adjusted for in the financial statements. Type 2 subsequent events are those that provide evidence with respect to conditions that developed subsequent to year end; these are not required to be recorded in the financial statements, but are considered for inclusion as a disclosure note.

5.

Analyze misstatements and explain the difference between quantitative and qualitative considerations when evaluating misstatements. Quantitative and qualitative considerations of misstatements include the risk of undetected errors remaining, the effect of the misstatements on compliance with covenants or agreements, whether the misstatements are errors or judgemental misstatements, whether any priorperiod unadjusted misstatements exist and could affect the current period’s results, the likelihood that these differences will become material in the future, the sensitivity of the misstatements, the significance of the misstatements for the known users of the financial statements, the effect of off setting differences in financial statement captions, and the dollar amount (quantity) of the misstatements.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

6.

Evaluate conclusions obtained during the performance of the audit and explain how these conclusions link to the overall opinion formed on the financial statements. The final phase of the audit is to assess all of the audit evidence obtained and determine whether it is sufficient and appropriate to reduce the risk of material misstatement in the financial statements to an acceptably low level. Based on the evidence gathered, the audit opinion on the financial statements will be determined.

7.

Describe the components of an audit report. The audit report includes a title, addressee, introductory paragraph, management’s and the auditor’s responsibility for the financial statements, audit opinion, other matters including other reporting responsibilities, auditor’s signature, date of the report, and auditor’s address.

8.

Identify the types of modifications to an audit report. The overall conclusion reached at the end of the audit can be unmodified, unmodified with an emphasis of matter, modified with a qualification, modified with an adverse opinion, or modified with a disclaimer of opinion.

9.

Explain what reporting is required to management and those charged with governance. All audit matters of governance interest, that is items that are important and relevant to those charged with governance in overseeing the financial reporting and disclosure process, should be reported to management and those charged with governance by the auditor. This is a required communication that can be provided verbally or in writing, with written communications (or evidence of such communications) preferred.

Completing and reporting on the audit

12 – 5

TRUE-FALSE STATEMENTS 1.

Subsequent events procedures are normally performed through to and including the date of the auditor's report.

2.

Sufficiency relates to the quality of audit evidence gathered.

3.

Generally, the further into the future an event is likely to take place, the greater the uncertainty surrounding the event.

4.

A type 1 subsequent event provides evidence with respect to conditions that developed subsequent to year-end.

5.

The uninsured loss of inventory as a result of fire subsequent to year-end is an example of a type 2 subsequent event.

6.

An error is an intentional misstatement in the client's financial statements.

7.

The client's compliance with contractual requirements of operating agreements is an example of a qualitative factor that may cause misstatements of quantitatively immaterial amounts to be considered material.

8.

The final phase of an audit is to assess all of the audit evidence obtained and determine whether it is sufficient and appropriate.

9.

The auditor's responsibility for the financial statements includes selecting and applying appropriate accounting policies.

10.

A limitation on the scope of the auditor's work could result from an inability to perform procedures or an imposition by the entity.

11.

An unqualified audit report with an emphasis of matter should be issued if a subsequent event has occurred that has resulted in a new audit report being prepared on a revised financial statement.

12.

Matters of governance that the auditor may wish to discuss with those charged with governance include any practical difficulties encountered in performing the audit.

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13.

Test Bank for Auditing: a practical approach, 1st Canadian Edition

As soon as practicable, the auditor should communicate weaknesses in internal controls to management or those charged with governance.

Completing and reporting on the audit

12 – 7

ANSWERS TO TRUE-FALSE STATEMENTS Item 1.

2.

Ans. Item T 3.

F 4.

Ans. Item T 5.

F 6.

Ans. Item T 7.

F 8.

Ans. Item T 9.

T 10.

Ans. Item F 11.

T 12.

Ans. Item T 13.

T

Ans. T

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

MULTIPLE CHOICE QUESTIONS 14.

Syed Hussein, the partner on the Rimouski Copper audit called a meeting of his senior staff during the engagement wrap-up. Which of the following areas would be the least likely to be covered during the wrap up? a. consideration of the amount used for materiality b. removal of all unnecessary documentation from the engagement files c. performing analytical procedures on the adjusted financial statements d. preparation of budgets for the following year’s audit

15.

Ron Nucci is trying to gather sufficient appropriate evidence. Which of these are factors to consider in evaluating the sufficiency and appropriateness of audit evidence? a. audit risk b. control risk c. quality of information obtained d. none of the above

16.

When Paul Sliz was reviewing existing or possible obligations on the balance sheet, he was told that the outcome for these obligations was uncertain and that the company was awaiting a future event. Paul Sliz was reviewing a. accruals. b. going concern. c. materiality. d. contingent liabilities.

17.

At year-end Marissa Albion sent out accounts receivable confirmations. One of the major customers of her client confirmed that they would not be able to pay off the receivable. The client subsequently went bankrupt and an aggrieved shareholder of Marissa’s client sued her firm. What type of subsequent event was this? a. Type 1 b. Type 2 c. Type 1 and 2 d. this was not a subsequent event

18.

When Eddie Okulicz released the audit report of C Corp. he did not anticipate that there would follow an announcement two days later that several days after year-end his client’s foreign subsidiary had been nationalized by Libya for non-compliance to environmental laws of the country. What type of subsequent event was this? a. Type 1 b. Type 2 c. Type 1 and 2 d. this was not a subsequent event

Completing and reporting on the audit

12 – 9

19.

When Samantha Dieter was training her staff about the auditor’s responsibility for subsequent events she made the two following statements: (i) Type 2 subsequent events are those events that do not result in changes to financial statements. (ii) Type 1 subsequent events do not require adjustments to financial statements.

Which of the above statements, if any is true? a. (i) b. (ii) c. (i) and (ii) d. neither (i) nor (ii)

20.

When Sydney Burns was unable to perform work on inventory because of a client’s insistence that she not perform an inventory taking, what kind of audit opinion would she most likely consider? a. adverse opinion b. emphasis of matter c. limitation of scope d. disclaimer of opinion

21.

When Olena Vardon mentioned that the financial statements were materially misstated, what kind of opinion was this? a. disclaimer b. emphasis of matter c. adverse d. limitation of scope

22.

Manuel DeSousa knew that the nature of his concern about a client matter would not require a qualification. What kind of audit report was he considering? a. qualified opinion b. emphasis of matter c. compilation d. none of the above

23.

When Greg Hill was preparing the audit report of his client, he did not include one of the following items in the report. Which item did he exclude? a. report date b. introductory paragraph c. management’s responsibility for the financial statements d. compliance with CICA Handbook

24.

Which items are matters of governance interest that an auditor would wish to discuss with those charged with governance? a. the general approach and overall scope of the audit b. the potential effect on the financial statements of any material risks and exposures

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Test Bank for Auditing: a practical approach, 1st Canadian Edition c. d.

material uncertainties related to events and conditions that may cast significant doubt on the entity’s ability to continue as a going concern all of the above

25.

Which of the following are areas normally covered during the wrap-up of an audit engagement? a. Perform subsequent events procedures. b. Consider the amount used for materiality. c. Reconsider the assessments of internal control at the entity level and the risk of fraud. d. All of the above.

26.

When misstatements or deviations from controls are found in planned procedures, consideration should always be given to: a. the need to modify or perform further audit procedures. b. the reason for the misstatement or deviation. c. both a and b. d. none of the above.

27.

If it is not possible to obtain sufficient appropriate audit evidence, the auditor should: a. express an unqualified opinion. b. express a qualified, adverse or disclaimer of opinion. c. report the client to CICA. d. express an unqualified opinion with an emphasis of matter.

28.

Under the going concern assumption: a. an entity is viewed as not likely to continue in operation for the foreseeable future. b. an entity's assets and liabilities are recorded at liquidation values. c. an entity is viewed as continuing in business for the foreseeable future. d. an entity is considered to be a separate legal entity from its owners.

29.

Which of the following factors is not relevant when management is assessing the going concern assumption? a. whether the auditor specializes in the client's industry b. the time into the future that an event is likely to take place c. the nature and condition of the entity's business d. the size and complexity of the entity

30.

A subsequent event occurs: a. before the end of the financial year. b. between the client's financial year-end and the date of the auditor's report. c. after the auditor completes the tests of controls. d. after the auditor signs the audit engagement letter.

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31.

Which of the following statements is correct regarding a type 1 subsequent event? a. They are events that do not result in changes to amounts in the financial statements. b. They occur before the end of the client's financial year. c. They may be of such significance as to require disclosure in the financial statements. d. The financial statements are adjusted for any material changes in estimates from these types of events.

32.

Procedures used by an auditor when conducting a subsequent events review include: a. assessing continued compliance with borrowing limits and loan covenants. b. enquiring of those charged with governance as to whether any subsequent events have occurred that may affect the financial statements. c. reading minutes of the meetings of the board of directors. d. all of the above.

33.

When an error or exception is identified during substantive testing, the first response is to: a. qualify the audit report. b. understand why the error or exception has arisen. c. increase the sample size. d. report the error or exception to the audit committee.

34.

Which of the following statements regarding judgmental misstatements is incorrect? a. They are the same as errors. b. They can arise as a result of a difference in underlying assumptions by the client and the auditor. c. They are not the same as errors. d. They can arise as a result of a difference in the application of judgment by the client and the auditor.

35.

Which of the following are examples of qualitative considerations that may cause misstatements of quantitatively immaterial amounts to be considered material? a. the client's compliance with contractual requirements of operating or other agreements b. key ratios monitored by analysts or other key users of the financial statements c. both a and b d. none of the above

36.

The final phase of an audit includes which of the following? a. performing substantive tests of account balances b. gaining an understanding of the client's internal control system c. confirming the terms of the audit engagement with the auditor

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Test Bank for Auditing: a practical approach, 1st Canadian Edition d.

determining whether the audit evidence obtained is sufficient and appropriate to reduce the risk of material misstatements in the financial statements to an acceptably low level

37.

Management's responsibilities for the financial statements do not include which of the following? a. selecting and applying appropriate accounting policies b. expressing an opinion on the financial statements c. establishing and maintaining internal controls d. making reasonable accounting estimates

38.

Which of the following are included in the main components of the auditor's report? a. management's responsibility for the financial statements b. the auditor's opinion on whether the financial statements are fairly presented c. the date of the audit report d. all of the above

39.

If the auditor is not able to obtain sufficient appropriate audit evidence, the appropriate audit opinion will either be: a. a qualified opinion or an unqualified opinion. b. a disclaimer of opinion or an emphasis of matter. c. a qualified opinion or disclaimer of opinion. d. an emphasis of matter or a qualified opinion.

40.

A limitation on the scope of the auditor's work may result from: a. damage to accounting records. b. lack of access to key personnel. c. absence of adequate accounting records. d. all of the above.

41.

Material disagreements with management will result in either: a. a qualified opinion or adverse opinion. b. an emphasis of matter or adverse opinion. c. an adverse opinion or an unqualified opinion. d. an unqualified opinion or a qualified opinion.

42.

Which of the following is not an area of disagreement with those charged with governance that may result in a modified audit opinion? a. the acceptability of accounting policies selected b. the terms of the audit engagement c. the method of application of accounting policies d. the adequacy of disclosures in the financial statements

43.

An unqualified audit opinion with an emphasis of matter should be given where there is:

Completing and reporting on the audit a. b. c. d.

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inconsistent other information. additional disclosures with which the auditor concurs. a subsequent event that results in a new auditor's report on revised financial statements. all of the above.

44.

Which of the following would not be included in an audit report? a. The auditor's address b. An introductory paragraph c. The audit fee charged to the client d. Management’s responsibility for the financial statements

45.

The auditor's report will not require a modified opinion where: a. there is a disagreement with those charged with governance. b. a limitation of scope of the engagement exists. c. a significant uncertainty exists. d. the financial statements are presented fairly.

46.

Those charged with governance are accountable for ensuring that the entity achieves its objectives with regard to which of the following? a. compliance with applicable laws b. the reliability of financial reporting c. both a and b d. none of the above

47.

Matters of governance interest that the auditor may wish to discuss with those charged with governance include: a. any practical difficulties encountered in performing the audit. b. the potential effect on the financial statements of any material risks and exposures. c. expected modifications to the audit report. d. all of the above.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

ANSWERS TO MULTIPLE CHOICE QUESTIONS Item 14.

15.

16.

17.

18.

Ans. d c d a b

Item 19.

20.

21.

22.

23.

Ans. a c c b d

Item 24.

25.

26.

27.

28.

Ans. d d c b c

Item 29.

30.

31.

32.

33.

Ans. a b d d b

Item 34.

35.

36.

37.

38.

Ans. a c d b d

Item 39.

40.

41.

42.

43.

Ans. c d a b d

Item 44.

45.

46.

47.

Ans. c d c d

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SHORT ANSWER QUESTIONS SA 48 Indicate whether you agree or disagree with the following statements and explain your reasoning. a) Steven Bischoff, the senior auditor at Martineau, Hellman and Nathan made the following statement to his audit team: “What constitutes sufficient appropriate audit evidence is a matter of judgment.” b) Metropolitan Poultry Company operates as a specialty food distributor. Gordon Atkins, auditor, has told his staff that the bankruptcy of a customer at year-end should not be considered a type 1 event. c) Mississauga Ice Pucks auditor Dave Ganesh found an omission of a disclosure in the financial statements of the hockey team. He called this an error. d) Stacey Kurvers was told by the client that a limitation in the scope of his work would require a modification to the audit report.

Solution: a) Agree. What constitutes sufficient appropriate evidence is ultimately a matter of professional judgment. It will be based on the satisfactory performance of audit procedures designed to address the assessed risk of material misstatement. b)

Disagree. Type 1 subsequent events require changes of amounts in the financial statements. This includes bankruptcies of customers subsequent to year-end, which would be considered when evaluating the adequacy of the allowance for doubtful accounts.

c)

Agree. An error is an unintentional misstatement in the financial misstatements, including the omission of an amount or a disclosure.

d)

Agree. The opinion paragraph requires modification under different circumstances. A limitation in the scope of the engagement is one valid reason for qualifying the audit report.

SA 49 Discuss the factors that are relevant when management is assessing the going concern assumption.

Solution: The following factors are relevant when management is assessing the going concern assumption: a) Generally, the further into the future an event is likely to take place, the greater the uncertainty surrounding that event. For that reason, most financial reporting frameworks specify the period management is required to assess all available information when making their going concern assessment. In Canada, this is typically 12 months from the date of the directors' report and audit opinion. b) Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events can contradict a judgment that was reasonable at the time it was made. Management of clients in industries subject to frequent change face more difficulty when assessing the going concern assumption.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors all affect judgment regarding the outcome of events or conditions.

SA 50 Explain the difference between type 1 and type 2 subsequent events and provide examples of each type of event.

Solution: Type 1 subsequent events are events that can affect the estimates inherent in the financial statements or indicate that the going concern assumption in relation to the whole or a part of the entity is not appropriate. The financial statements are adjusted for any material changes in estimates resulting from these types of events up to the date of the auditor's report. Examples of type 1 subsequent events (that require changes of amounts in the financial statements) include: a) the bankruptcy of a customer subsequent to year-end, which would be considered when evaluating the adequacy of the provision for uncollectable trade receivables, b) an amount received in respect of an insurance claim that was in the course of negotiation as at year-end, c) deterioration in operating results and financial position after year-end that is so significant that it may indicate the going concern assumption is not appropriate to use in the preparation of the financial statements.

Type 2 subsequent events are those events that do not result in changes to amounts in the financial statements. However, these events may be of such significance as to require disclosure in the financial statements. Examples of type 2 subsequent events (that do not require adjustment but may require disclosure in the financial statements) include: a) the uninsured (or underinsured) loss of plant or inventory as a result of a fire or flood subsequent to year-end, b) the purchase of a business, c) the issuance of shares or debt securities.

SA 51 Identify quantitative and qualitative considerations that are taken into account when the auditor evaluates whether misstatements either cause financial statements to be materially misstated or require additional disclosure.

Solution: Examples of quantitative and qualitative considerations include: a) the risk of additional misstatements remaining undetected b)

the effects of identified misstatements on the client's compliance with covenants under debt or similar agreements

c)

whether the proposed corrections result from an error or are the result of a judgmental misstatement between the client's and the auditor's application of accounting policies

d)

the turnaround effect on the current year's financial statements of uncorrected misstatements identified in the prior year

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e)

the likelihood that recurring differences, which currently are immaterial, will have a material effect in the future

f)

the sensitivity of the circumstances surrounding the misstatements, for example, the implications of differences involving fraud and possible illegal acts, or violations of contractual provisions

g)

the significance of the financial statement elements affected by the misstatements

h)

the significance of the misstatements relative to known user needs, for example, the magnifying effects of the misstatements on the calculation of a purchase price in a transfer of interests (buy/sell agreement)

i)

the effect of the misstatements on segment information or on another portion of the client's business that has been identified as playing a significant role in the client's operations or profitability

j)

the effects of offsetting misstatements in different financial statement captions (or balance names within the financial statements, for example, cash at bank, prepayments, payables)

SA 52 Explain the difference between management's and the auditor's responsibility for the financial statements.

Solution: Management's responsibility includes establishing and maintaining internal controls relevant to the preparation and fair presentation of financial statements that are free from material misstatements, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances.

The auditor must state that the responsibility of the auditor is to express an opinion on the financial statements based on the audit, state that the audit was conducted in accordance with auditing standards (including compliance with relevant ethical requirements), describe the audit and state that the auditor believes that the audit evidence obtained is sufficient and appropriate to provide a basis for the auditor's opinion.

SA 53 What are examples of matters of governance interest that the auditor may wish to discuss with those charged with governance.

Solution: Matters of governance interest that the auditor may wish to discuss with those charged with governance include: a) the general approach and overall scope of the audit, including any expected limitations thereon, or any additional requirements b)

the selection of, or changes in, significant accounting policies and practices that have, or could have, a material effect on the entity's financial statements.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

c)

the potential effect on the financial statements of any material risks and exposures, such as pending litigation, that are required to be disclosed in the financial statements

d)

misstatements, whether or not recorded by the entity that have, or could have, a material effect on the entity's financial statements

e)

material uncertainties related to events and conditions that may cast significant doubt on the entity's ability to continue as a going concern

f)

disagreements with management about matters that, individually or in aggregate, could be significant to the entity's financial statements or the audit report. These communications include consideration of whether the matter has, or has not, been resolved and the significance of the matter

g)

expected modifications to the audit report

h)

any practical difficulties encountered in performing the audit

i)

any irregularities or suspected non-compliance with laws and regulations that came to the auditor's attention during the audit

j)

comments on the design and operation of the internal controls and suggestions for their improvement, particularly if the auditor has identified material weaknesses in internal control during the audit

k)

any other matters agreed upon in the terms of the audit engagement

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ESSAY QUESTIONS ES 54 Demand for forensic accounting has grown following the collapses of Enron and Worldcom.

Explain the important characteristics of forensic accountants and the main techniques they use to investigate fraud.

ES 55 Explain why the global financial crisis has resulted in the number of potential and actual legal liability insurance claims and explain how auditors can deal with the risk of litigation in tough economic times.

ES 56 Explain the potential threats to independence relating to audit fees and how an auditor can safeguard against these threats.

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Test Bank for Auditing: a practical approach, 1st Canadian Edition

CASE Mark Danyluk, the partner in charge of the Bombardier Aerospace audit, was reviewing the work his team had completed.

Bombardier is a Canadian company. They used to be involved in recreational equipment such as Ski-Doo snowmobiles and Sea-Doo watercraft. Their Aerospace division, however, is probably their best known operating segment and is known as a leading manufacturer of commuter jets containing 50-100 seats.

Bombardier’s operations were by far the largest of the aerospace companies in Montreal and several of the new programs were very ambitious and very risky. It seemed to Mark that every review he performed had material misstatement possibilities.

Mark was thinking that an audit of this magnitude was challenging his abilities in evaluating what was sufficient and appropriate audit evidence.

When Mark started the audit of the current year’s operations, he was surprised with the events that took place in 2011 at the Bourget and Farnborough air shows. The anticipation for Bombardier’s new CSeries aircraft turned out to be less than positive as other manufacturers seemed to pile up the orders. Airbus executives had also been claiming for months that their company’s introduction of a new engine option (NEO) for the A320 narrowbody voided the business case for the CSeries.

Although Bombardier has been able to get commitments up to 100 aircraft, the company is only one-third of the way to its goal of 300 orders for the CSeries scheduled service entry in late 2013. This also still leaves Bombardier 350 aircraft short of the sales required for the project to break even.

As Bombardier attempts to expand its aircraft product line into medium-sized aircraft (100-149 seats), it is entering a space that is getting very close to the market segment dominated by industry giants, Boeing and Airbus. While those companies tend to focus on even larger aircraft, they may want to protect themselves by defending against Bombardier in the mediumsized aircraft segment because Bombardier could later expand into the lucrative large-aircraft segment. Bombardier’s $3.4-billion bet on the market for narrow-bodied aircraft faces a potential threat: a price war instigated by Boeing Co. and Airbus SAS. Mark Danyluk had an uneasy feeling about the viability of the Aerospace sector of the company’s operations.

Required: a) Describe the factors that Mark Danyluk and his firm will have to consider in evaluating the sufficiency and appropriateness of audit evidence at Bombardier Aerospace. b) What factors are relevant when management assesses the going concern issue at Bombardier?

Solution: a) Some of the factors to consider in evaluating sufficiency and appropriateness of audit evidence at Bombardier Aerospace include: • materiality of misstatements • management responses

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• • • • •

previous experience results of audit procedures performed quality of information obtained persuasiveness of the audit evidence whether the evidence obtained supports or contradicts the results of the risk assessment procedures.

If it is not possible to obtain sufficient appropriate audit evidence, Mark Danyluk will have to express a qualified opinion, adverse opinion, or disclaimer of opinion. b)

The following factors are relevant when management is assessing the going concern assumption: • Generally, the further into the future an event is likely to take place, the greater the uncertainty surrounding that event. For that reason, most financial reporting frameworks specify the period management is required to assess all available information when making their going concern assessment. In Canada , this is typically 12 months from the date of the directors' report and audit opinion.

• Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events can contradict a judgment that was reasonable at the time it was made. Management of clients in industries subject to frequent change face more difficulty when assessing the going concern assumption.

• The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors all affect judgment regarding the outcome of events or conditions.

CAS 570 requires that the auditor considers the appropriateness of management's use of the going concern assumption in the preparation of the financial statements .

Consideration of management's use of the going concern assumption is based on knowledge of conditions or events obtained through planning and performing the audit.

The auditor considers whether their procedures identify conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity's ability to continue as a going concern.

They also consider whether there are material uncertainties about the entity's ability to continue as a going concern that need to be disclosed in the financial statements.

Usually, material uncertainties relate to an entity's inability to meet obligations as they become due without substantial disposals of assets outside the ordinary course of business, restructuring of debt or equity, or major operational improvements.