Auditing A Practical Approach Robyn Moroney, Fiona Campbell, Jane Hamilton Test Bank

Type:

Test Bank

Resource:

Auditing A Practical Approach

Edition:

1st Edition

Author(s):

Robyn Moroney Fiona Campbell Jane Hamilton

Testbank to accompany

Auditing: a practical approach Prepared by Adrian Klamer

CHAPTER 1 Introduction and overview of auditing

John Wiley & Sons Australia, Ltd 2010

Testbank to accompany Auditing: a practical approach

True/False 1. An auditor can provide a reasonable level of assurance on information other than historical financial information. *a) true b) false 2. A negative expression of opinion is only given when there is a disagreement with management and the auditor. a) true *b) false 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 *a) true b) false 4. An operational audit is an example of a compliance audit. a) true *b) false 5. All modified audit reports are qualified audit opinions. a) true *b) false 6. The most common types of assurance engagements are financial report audits, confirmation audits, performance audits, comprehensive audits and assurance on corporate social responsibility (CSR) disclosures. a) true *b) false 7. The nature of audit procedures refers to the reliance on evidence provided by the client and its management. *a) true b) false 8. A reasonable level of assurance is the highest level of assurance that an auditor can provide. *a) true b) false

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Chapter 1: Introduction and overview of auditing

9. A no assurance engagement is of little use as no assurance is given to the client. a) true *b) false 10. It is the auditors responsibility to prepare the financial statements. a) true *b) false 11. Only current investors (not potential investors) are considered to be users of the financial statements. a) true *b) false 12. Insurance hypothesis is a means whereby the investor can guarantee the success of their investment. a) true *b) false 13. International Auditing and Assurance Standards Board (IAASB) is not responsible for the redrafting of International Auditing Standards (ISAs) to Australian Auditing Standards (ASAs). *a) true b) false 14. You must complete further study after a bachelor’s degree to become a member of either the ICAA, CPA Australia or the NIA. *a) true b) false 15. The expectation gap is caused by unrealistic user expectations such as the auditor providing a moderate level of assurance. a) true *b) false

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Testbank to accompany Auditing: a practical approach

Multiple Choice 1. 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.

2. 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.

3. 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.

3. 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.

4. The wording of a negative expression of opinion generally states that: a. there is nothing wrong with the subject matter. b. there is something wrong with the subject matter. *c. there is nothing that has come to the auditors attention that would lead them to believe that the information being assured is not true and fair. d. there is something that has come to the auditors attention that would lead them to believe that the information being assured is not true and fair.

5. 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.

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Chapter 1: Introduction and overview of auditing

6. 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.

7. Which of the following is not a type of opinion? a. qualified opinion *b. modified opinion c. adverse opinion d. disclaimer of opinion 8. The following can be said about an emphasis of matter: a. it is included when the auditors 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.

9. 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 report. 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 *d. all of the above.

10. 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.

11. 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.

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Testbank to accompany Auditing: a practical approach

12. The largest accounting firms in Australia are known collectively as the a. ‘Big-3’ *b. ‘Big-4’ c. ‘Big-5’ d. ‘Big-6’ 13. Under CLERP9, which of the following is not correct relating to specific disclosures in the directors report? a. details of the amount paid or payable to the company’s auditor for non-audit services (each non-audit service must be listed separately along with the amount paid or payable for that service) b. if the directors are satisfied that auditor independence has not been impacted by the provision of non-audit services, a statement of the directors’ reasons for being satisfied. *c. disclosure of material transactions between auditor and entity during the period under audit. d. a statement whether the directors are satisfied that the provision of non-audit services by the auditor impacts the auditor’s independence 14. Suppliers as a user of the financial statements 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 15. Which of the following is incorrect? A government can be considered to be a user of the general purpose financial reports 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 entities activities d. to assess the entity so that it can provide the entity with grants that will benefit society.

16. Agency theory can be described as the theory of: a. hiring an agency to review the work of the management, in this case it is the auditor. b. when the finance function is outsourced to an outside party, and the auditor is required to audit the outside party’s work. *c. the relationship between the owner and the management of the business when the owner is not the manager of the business. d .none of the above.

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Chapter 1: Introduction and overview of auditing

17. Insurance hypothesis tells us that: *a. investors will demand that financial reports 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.

18. Which of the following regulators do not impact on the audit process? a. Australian Securities and Investments Commission (ASIC) b. National Institute of Accountants (NIA) *c. Auditing Professional and Ethical Standards Board (APESB) d .all of the above have an impact on the audit process.

19. The objective of the Financial Reporting Council does not include: a. to oversee the process used for setting accounting and auditing standards b. to monitor and report regularly on matters concerning auditor independence *c. to be involved in the technical issues around the standard-setting process. d. all of the above are included in the objectives of the Financial Reporting Council 20. Which of the following is correct? The Accounting Professional Ethical Standards Board (APESB): *a. standards are required to be complied with by members of each of ICAA, CPA and NIA. b. issue technical standards to the members of the ICAA, CPA Australia and NIA. c. follows pronouncements issued by the International Accountants Ethics Standards Board (IAESB) d. have not approved any standards that are required by law.

21. Which of the following is incorrect? The Australian Securities and Investments Commission (ASIC) a. registers auditors and processes annual statements from registered auditors *b. requires all auditors’ financial statements to be independently audited annually c. provides a whistleblowing facility for the reporting of contraventions of the Corporations Act d. enforces independence requirements for auditors 22. The Companies and Liquidators Disciplinary Board can respond to applications made by: a. the Australian Securities and Investments Commission (ASIC) b. the Australian Prudential Regulation Authority (APRA) *c. the Australian Securities and Investments Commission (ASIC) or the Australian Prudential Regulation Authority (APRA) d. the general public

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Testbank to accompany Auditing: a practical approach

23. Auditor rotation in CLERP9 states that an auditor cannot perform a significant role in the audit of a client in more than a. two out of five years b. two out of seven years *c. five out of seven years d .six out of seven years 24. The expectation gap is caused by: a. realistic auditor expectations *b. unrealistic user expectations c. realistic user expectations d. unrealistic auditor expectations 25. 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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Chapter 1: Introduction and overview of auditing

Short Answer Questions 1. The main assurance service the general public are familiar with are financial report audits.

Briefly describe the other services that an auditor can provide.

Correct Answer: 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 organisation’s activities A comprehensive audit may encompass elements of a financial report audit, a compliance audit and a performance audit.

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

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

2. 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 Correct Answer: Level of Assurance Reasonable Limited None

Type of Engagement Audit Review Agreed-Upon Procedures

Expression of Opinion Positive Negative None

3. What does pervasive mean? When would an auditor use an audit report that was material and pervasive?

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

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.

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Testbank to accompany Auditing: a practical approach

4. Outline the reasons for the demand for assurance services.

Correct Answer: 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 report 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 dependant upon to make important decisions, it is important that the information being presented is reliable

5. How is the expectation gap caused and how can the effects expectation gap be reduced?

Correct Answer: 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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Chapter 1: Introduction and overview of auditing

Essay Questions 1. There have been a number of high profile corporate collapses in the past decade both in Australia and overseas. What role does society expect from auditors in ensuring this does not happen? What can auditors do to manage this expectation?

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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 2 Ethics, legal liability and client acceptance

John Wiley & Sons Australia, Ltd 2010

Testbank to accompany Auditing: a practical approach

True/False 1. Compliance with the fundamental ethical principles is mandatory for all members of the accounting profession. *a. True b. False 2. Independence in appearance is the ability to act with integrity, objectivity and professional scepticism. a. True *b. False 3. An example of an advocacy threat is encouraging others to buy shares or bonds being sold by the client. *a. True b. False 4. An effective audit committee will enhance the independence of the external audit function. *a. True b. False 5. A famous statement by Lord Justice Lopes in the Pacific Acceptance case was that an auditor "…is a watchdog, but not a bloodhound." a. True *b. False 6. A privity letter acknowledges that the third party intends to rely on the audited financial report. *a. True b. False 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. a. True *b. False © John Wiley and Sons Australia, Ltd 2010

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Chapter 2: Ethics, legal liability and client acceptance

8. Ensuring compliance with auditing regulations will not assist auditors to avoid litigation. a. True *b. False 9. Third parties are anyone other than the client and its shareholders that uses the financial report to make a decision. *a. True b. False 10. Being negligent means not exercising due care. *a. True b. False 11. The judgement in the Esanda case has made it far easier for third parties to establish that a duty of care is owed by the auditor. a. True *b. False 12. Auditors can avoid litigation by implementing policies and procedures that ensure all work is fully documented. *a. True b. False 13. When assessing client integrity, the auditor will consider the appropriateness of the client's interpretation of accounting rules. *a. True b. False 14. An engagement letter sets out the terms of the engagement letter. *a. True b. False

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Testbank to accompany Auditing: a practical approach

15. An engagement letter does not include an overview of the client's responsibility for the preparation of the financial report. a. True *b. False

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Chapter 2: Ethics, legal liability and client acceptance

Multiple Choice 16. Which of the following is a fundamental principle of professional ethics? a. a . confidentiality b. objectivity c. integrity *d. all of the above 17. 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 judgement 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 18. 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 judgement d. ensure that they do not harm the reputation of the accounting profession 19. 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 20. 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

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Testbank to accompany Auditing: a practical approach

21. Threats to the independence of auditors include: a. familiarity threats b. self-interest threats c. advocacy threats *d. all of the above 22. 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 *b. has a financial interest in an audit client c. needs to form an opinion on their own work or work performed by others in the firm d. acts on behalf of its assurance client 23. 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 holdings a senior position with the client 24. What type of threat to independence arises when an accounting firm acts on behalf of its assurance client results? *a. advocacy threat b. self-interest threat c. intimidation threat d. self-review threat 25. 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 26. Safeguards to independence are created by: a. accounting firms b. the profession, legislation or regulation c. clients *d. all of the above © John Wiley and Sons Australia, Ltd 2010

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Chapter 2: Ethics, legal liability and client acceptance

27. 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 28. 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 Corporations Act c. the client's board of directors *d. None of the above 29. The main recipients of the financial report and the attached audit report are acknowledged as: a. the board of directors *b. the shareholders or members c. the audit committee d. the Australian Securities and Investments Commission 30. Examples of board committees include the: a. risk committee b. nomination committee c. remuneration committee *d. all of the above 31. It is the responsibility of the board of directors to: *a. ensure that the financial report is prepared so as to provide a true and fair view b. provide an opinion on the truth and fairness of the financial statements c. direct the auditors to audit specific financial statement accounts d. none of the above 32. 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 © John Wiley and Sons Australia, Ltd 2010

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Testbank to accompany Auditing: a practical approach

33. According to the ASX Corporate Governance Council, an audit committee should: a. not have a formal charter *b. consist of a majority of independent directors c. be chaired by the chairman of the board of directors d. have at least four members 34. 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 35. Under tort law, to prove that and 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 36. Which of the following was an observation or recommendation by Justice Owen in the HIH Royal Commission Report? a. boards of directors should establish an audit committee b. auditor independence is not a critical element in establishing the credibility of an auditor's report *c. an independent and objective audit, conducted with an appropriate degree of professional scepticism, is required d. audit reports should be addressed to shareholders 37. Which of these cases established the legal principle that auditors owe a duty of care to shareholders as a group and not to individual shareholders? a. Esanda *b. Caparo c. Scott Group d. Pacific Acceptance

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Chapter 2: Ethics, legal liability and client acceptance

38. 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 39. 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 40. 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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Testbank to accompany Auditing: a practical approach

Short Answer Questions 41. Explain the five fundamental principles of professional ethics.

Correct Answer: 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 (APES 110, s. 100.4). 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 judgement. 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 professional bodies comply with rules and regulations and ensure that they do not harm the reputation of the profession.

42. Distinguish between independence of mind and independence in appearance.

Correct Answer: 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.

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

Correct Answer: Safeguards are mechanisms that have been developed by the accounting profession, legislators, regulators, clients and accounting firms (APES 110, s. 290). 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 report is 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.

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Chapter 2: Ethics, legal liability and client acceptance

44. Discuss the findings in the Esanda case as they relate to an auditor's liability to a third party.

Correct Answer: The High Court of Australia found in favour of the auditor and ruled that for a third party to be able to establish that an auditor owes them a duty of care they would need to show the following: The report was prepared on the basis that it would be communicated to a third party.

The report was likely to be relied upon by that third party. The third party ran the risk of suffering a loss if the report was negligently prepared.

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

Correct Answer: 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 will confirm the obligations of the client and the auditor in accordance with the Corporations Act. 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 report, the requirement that the auditor have access to all information required, independence considerations and fees.

Essay Questions 46. 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.

47. 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.

48. 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 3 Audit Planning I

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Testbank to accompany Auditing: a practical approach

True/False 1. The planning stage of an audit involves the performance of detailed tests of controls and substantive testing of transactions and accounts. a. True *b. False 2. A client's corporate governance structure is assessed when planning an audit. *a. True b. False 3. Auditors must gain an understanding of their client at the outset of every audit. *a. True b. False 4. The more competitive an audit client's industry, the less pressure is placed on the client's profits. a. True *b. False 5. Fraud is an intentional act to obtain an unjust or illegal advantage through the use of deception. *a. True b. False 6. Misappropriation of assets fraud involves intentionally misstating items or omitting important facts from the financial report. a. True *b. False 7. An example of an attitude or rationalisation used to justify a fraud is high volume of transactions close to year-end. a. True *b. False

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Chapter 3: Audit planning I

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. *a. True b. False 9. Mitigating factors that reduce going concern risk include the ability to raise additional funds via the sale of shares. *a. True b. False 10. Listed companies are required to disclose in their annual reports whether they have complied with the ASX Corporate Governance Council's principles and recommendations. *a. True b. False 11. Under the recommendations of the ASX Corporate Governance Council, the chair of the board of directors should not be an independent director. a. True *b. False 12. ASA 315 requires auditors to gain an understanding of the client's IT systems and the associated risks. *a. True b. False 13. Application controls are policies and procedures that relate to many applications. a. True *b. False 14. An auditor is not concerned with transactions and events being recorded in the correct accounting period. a. True *b. False © John Wiley and Sons Australia, Ltd 2010

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Testbank to accompany Auditing: a practical approach

Multiple Choice 15. Checking the accuracy of accrual's 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 16. The execution stage of an audit involves: a. evaluating the results of the detailed testing and forming an opinion on the truth and fairness of the client's financial report 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 17. Preliminary risk identification can be affected by: a. fraud risk b. corporate governance *c. Both a and b d. None of the above 18. 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 finalising the accounts for an accounting period 19. 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

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Chapter 3: Audit planning I

20. 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 d. The level of government support in the client's industry 21. In assessing the client's relationship with its employees, the auditor will consider: a. The level of unionisation among the workforce b. The attitude of staff to their employer c. How well a client pays its employees *d. All of the above 22. 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 23. 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 24. 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

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Testbank to accompany Auditing: a practical approach

25. Which of the following is an example of a misappropriation of assets fraud? *a. Unauthorised discounts or refunds to customers b. Inappropriate application of accounting principles c. Unrecorded liabilities d. improper asset valuations 26. When assessing the risk of fraud, an auditor can consider: a. Attitudes and rationalisation to justify a fraud b. Incentives and pressures to commit fraud c. Opportunities to perpetuate a fraud *d. All of the above 27. Attitudes and rationalisation to justify a fraud include: a. Significant related party transactions *b. An excessive focus on profit maximisation c. A significant decline in demand for the client's products or services d. A high volume of transactions close to year-end 28. 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 report presents a true and fair view *c. A company will remain in business for the foreseeable future d. A company is a separate legal entity 29. 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 Australian Taxation Office d. Reduce the extent of further audit testing that they undertake

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Chapter 3: Audit planning I

30. 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 31. The ASX Corporate Governance Council's Principle 2 'Structure the board to add value' includes which of the following recommendations? a. The chair should be an independent director b. The board should establish a nomination committee *c. a and b d. None of the above 32. The 'if not, why not' approach of the ASX Corporate Governance Council to its recommendations requires companies to: *a. Disclose whether they have complied with the principles and recommendations b. Establish an audit committee c. Report to ASIC any breaches by their auditor of the Code of Ethics d. Have a majority of the board as independent directors 33. An auditor is usually most concerned with which of the ASX Corporate Governance Council's principles? a. Respect the rights of shareholders *b. Safeguard integrity in financial reporting c. Structure the board to add value d. Remunerate fairly and responsibly 34. Risks associated with information technology include; a. Loss of data b. Errors in programs c. Unauthorised access to computers *d. All of the above

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Testbank to accompany Auditing: a practical approach

35. Unauthorised 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 36. 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 37. Which of the following statements relating to application controls is correct? *a. They impact on the procedures used for data entry, data processing and output b. They include procedures for purchasing new computers c. They are not designed to prevent or detect a material misstatement in the financial report d. They include the use of passwords and other security measures to minimise the risk of unauthorised access 38. Auditors can assess the adequacy of their client's closing procedures by: a. Checking the accuracy of accruals 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 39. 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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Short Answer Questions 40. Explain the three main stages of an audit of financial statements.

Correct Answer: 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 report, performing a risk and materiality assessment and developing an audit strategy. The risk of a material misstatement is the risk that the financial report includes 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 truth and fairness of the client's financial report.

41. Why must auditors gain an understanding of their client at the start of every audit?

Correct Answer: The purpose of auditors gaining an understanding of their client is to assess the risk that the financial report contains 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 the regulatory environment in which the client operates.

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

Correct Answer: Fraud is an intentional act to obtain an unjust or illegal advantage through the use of deception (ASA 240, para. 11; ISA 240, para. 11). 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.

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

Correct Answer: 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 © John Wiley and Sons Australia, Ltd 2010

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Testbank to accompany Auditing: a practical approach

assessment is made of the appropriateness of management disclosures in the notes to the financial report 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.

44. What is corporate governance and what are the eight principles of corporate governance according to the ASX Corporate Governance Council?

Correct Answer: According to the ASX, corporate governance is the rules, systems and processes within companies used to guide and control. The ASX Corporate Governance principles are: · Principle 1 Lay solid foundations for management and oversight · Principle 2 Structure the board to add value · Principle 3 Promote ethical and responsible decision-making · Principle 4 Safeguard integrity in financial reporting · Principle 5 Make timely and balanced disclosure · Principle 6 Respect the rights of shareholders · Principle 7 Recognise and manage risk · Principle 8 Remunerate fairly and responsibly

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Essay Questions 45. ASA 300 Planning an Audit of a Financial Report 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?

46. 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 Australia?

47. 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 4 Audit planning II

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Testbank to accompany Auditing: a practical approach

True/False 1. Audit risk is the risk that a client's system of internal controls will not prevent or detect a material misstatement. a. True *b. False 2. If inherent risk and control risk are low, the auditor can set detection risk as high. *a. True b. False 3. When classifying risks as being significant consideration is given to whether the risk involves simple routine transactions. a. True *b. False 4. Materiality is assessed during the planning stage of every audit. *a. True b. False 5. Information is considered quantitatively material if it exceeds an auditor's preliminary materiality assessment. *a. True b. False 6. By setting a higher planning materiality level, an auditor increases the quality and quantity of evidence that needs to be obtained. a. True *b. False 7. There is an inverse relationship between audit risk and detection risk as set by the auditor. *a. True b. False

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8. A walkthrough involves an auditor tracing a transaction through a client's accounting system. *a. True b. False 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. a. True *b. False 10. Profitability is the ability of a company to pay its debts as they fall due. a. True *b. False 11. Companies enter into debt covenants with lenders when taking on significant loans. *a. True b. False 12. Key performance indicators used by a client to monitor its performance provide an auditor an insight into which accounts are potentially at risk of misstatement. *a. True b. False 13. Trend analysis involves a comparison of account balances to a single line item. a. True *b. False 14. Analytical procedures are conducted at the planning stage of an audit to enhance the understanding of the auditor's client. *a. True b. False

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Testbank to accompany Auditing: a practical approach

15. Inventory turnover measures how many times a year a company collects cash from its debtors. a. True *b. False

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Multiple Choice 16. 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 a financial report is 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 17. When classifying risks as being 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 18. 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 19. 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 assertion 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 20. 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

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Testbank to accompany Auditing: a practical approach

21. 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 report 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 report users 22. 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 23. 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 24. Which of the following is an example of an item considered qualitatively material according to AASB 1031 Materiality? 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 25. 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

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26. 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 conducted detailed substantive testing c. sets the scope, timing and direction of the audit *d. both b and c 27. 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 28. 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 29. 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 30. 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

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Testbank to accompany Auditing: a practical approach

31. Which of the following statements regarding key performance indicators (KPIs) is correct? a. they reflect the success factors of an organisation b. they can be quantified c. some KPIs are common to many clients, including return on assets *d. all of the above 32. Common measures of a company's profitability include: a. price-earnings ratio b. earnings per share *c. both a and b d. quick ratio 33. 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 34. 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 35. 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 36. 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 © John Wiley and Sons Australia, Ltd 2010

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37. 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 38. Which of the following is an example of a liquidity ratio? a. return on shareholders’ equity *b. inventory ratio c. times interest earned d. profit margin 39. What is the formula for calculating inventory turnover? 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

40. 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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Testbank to accompany Auditing: a practical approach

Short Answer Questions 41. Explain audit risk and the three components of the audit risk model.

Correct Answer: Audit risk is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated. This means that an auditor reports that in their opinion the financial report is true and fair when it contains 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.

42. What is the relationship between materiality and audit risk?

Correct Answer: 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 analysing 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.

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

Correct Answer: 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 © John Wiley and Sons Australia, Ltd 2010

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significant risks, this is considered a noteworthy deficiency in a client's system of internal controls.

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

Correct Answer: 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 long-term debt and undertake capital investment.

45. Discuss the purpose and some common examples of profitability ratios.

Correct Answer: 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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Testbank to accompany Auditing: a practical approach

Essay Questions 46. Audit risk is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially stated. Why is the concept of audit risk so important to auditors and what can they do to reduce to an acceptably low level?

47. 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?

48. 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 5 Audit evidence

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Testbank to accompany Auditing: a practical approach

True/False 1. When preparing the financial report, auditors make assertions about each account and related disclosures in the notes. a. True *b. False 2. The cut-off assertion means that the entity holds or controls the rights to assets and liabilities are the obligations of the entity. a. True *b. False 3. Audit evidence is the information that an auditor uses when arriving at their opinion on the truth and fairness of their client's financial report. *a. True b. False 4. Negative confirmations ask the recipient to reply only if they disagree with the information provided. *a. True b. False 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. a. True *b. False 6. Correspondence with the client's lawyers is an example of externally generated evidence sent directly to the auditor. *a. True b. False

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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. *a. True b. False 8. An expert is expected to be less objective if they are not associated with the client. a. True *b. False 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. *a. True b. False 10. The component partner sets out the work to be conducted by the group engagement partner. a. True *b. False 11. Observation is an evidence gathering procedure that involves checking the mathematical accuracy of client records. a. True *b. False 12. Analytical procedures involve an evaluation of financial information by studying plausible relationships among both financial and non-financial data. *a. True b. False 13. The decision of what constitutes sufficient appropriate audit evidence is a matter for professional judgement *a. True b. False

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Testbank to accompany Auditing: a practical approach

14. The permanent file includes client information and documentation that apply to more than one audit. *a. True b. False 15. The permanent file includes detailed descriptions of evidence gathered for a particular year's audit. a. True *b. False

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Multiple Choice 16. Which of the following is not an assertion used for transactions and events? a. cut-off *b. existence c. classification d. occurrence 17. 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 report 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 18. 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 19. 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 20. 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. more 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

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Testbank to accompany Auditing: a practical approach

21. 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 22. 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 23. 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 24. Internally generated evidence held by the client includes: a. bank statements b. correspondence with the client's lawyers *c. copies of invoices sent to customers d. expert valuations 25. 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

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26. An auditor verifies amounts recorded in their client's records using: a. electronic evidence b. verbal evidence c. confirmations *d. all of the above 27. 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 28. When an auditor uses the work of an expert, who has the responsibility for arriving at an overall conclusion regarding the truth and fairness of a client's financial report? *a. the auditor b. the expert c. the client's management d. the client's audit committee 29. 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 30. 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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Testbank to accompany Auditing: a practical approach

31. 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 truth and fairness 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 32. 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 33. 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 34. 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 35. 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

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36. Why do auditors inspect records and documents? a. To check the dates of transactions b. For evidence that management have authorised significant purchases c. To check that a transaction occurred *d. All of the above 37. 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 38. 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 39. Which of the following would not be included in an auditor's permanent file? a. The client's organisational chart b. Copies of long-term contracts *c. Copies of debtors' confirmation letters d. Prior years' audit reports 40. 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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Short Answer Questions 41. Identify and explain the key assertions used for transactions and events, including income statement items, for an accounting period.

Correct Answer: 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.

42. Describe the purpose and examples of external confirmations.

Correct Answer: 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 43. Explain the three broad categories of corroborating evidence.

Correct Answer: 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 © John Wiley and Sons Australia, Ltd 2010

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verify that a client has accurately converted this information into the financial report. 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, debtors' 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.

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

Correct Answer: The major evidence gathering procedures are observation, enquiry, recalculation, re-performance 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.

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

Correct Answer: 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 organisational 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 46. Audit evidence is the information that an auditor uses when arriving at their opinion on the truth and fairness of their client's financial report. Why is evidence so important to a financial report audit?

47. ASA502 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 report?

48. ASA620 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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Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 6 Overview of tests of controls, substantive procedures and sampling

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Testbank to accompany Auditing: a practical approach

True/False 1. An audit plan includes the audit procedures to be used when testing controls and when conducting detailed substantive audit procedures. *a. True b. False 2. Tests of controls are audit procedures designed to detect material misstatements at the assertion level. a. True *b. False 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. *a. True b. False 4. Sampling is required when an audit procedure is tested on an entire group of transactions or all items within an account balance. a. True *b. False 5. Sampling risk is the risk that the sample chosen by the auditor is not representative of the population available for testing. *a. True b. False 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. *a. True b. False

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7. Non-statistical sampling involves random selection and probability theory to evaluate the results. a. True *b. False 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. a. True *b. False 9. Block selection involves the selection of items that are grouped together within the population of items available. *a. True b. False 10. Tolerable error is the minimum error an auditor is willing to accept within the population tested. a. True *b. False 11. An increase in the number of sampling units in the population will result in a decrease in the sample size. a. True *b. False 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. *a. True b. False 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. *a. True b. False © John Wiley and Sons Australia, Ltd 2010

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Testbank to accompany Auditing: a practical approach

14. Stratification of the population will result in less efficient sampling and increase the sample size required. a. True *b. False 15. Projected error refers to the extrapolation of the errors detected when testing a sample to the population from which the sample was drawn. *a. True b. False

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Chapter 6: Overview of tests of controls, substantive procedures and sampling

Multiple Choice 16. Control risk is the risk that: a. an auditor expresses an inappropriate audit opinion when a financial report 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 17. 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 18. 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 19. 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 20. Substantive audit procedures include: a. detailed tests of balances b. analytical procedures c. detailed tests of transactions *d. all of the above

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Testbank to accompany Auditing: a practical approach

21. 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 ASIC 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 22. 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 23. 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 24. 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 25. 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

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Chapter 6: Overview of tests of controls, substantive procedures and sampling

26. 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 c. it is generally used for low risk accounts *d. it involves random selection 27. 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 28. 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 29. 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 30. 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

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Testbank to accompany Auditing: a practical approach

31. 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 their professional judgement to determine the tolerable error and required level of confidence d. an auditor will use their professional judgement when considering what would be considered an error within the population tested 32. Before selecting a sample, an auditor will use their professional judgement to: a. set the required level of confidence b. set the tolerable error rate c. select an appropriate population for testing *d. all of the above 33. 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 34. 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 35. 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

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36. 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 37. 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 38. 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 39. 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 40. 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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Short Answer Questions 41. Explain the differences between the main objectives of tests of controls and substantive procedures.

Correct Answer: Tests of controls are conducted to establish that controls: operate effectively, meaning that the rate of deviation from prescribed control procedures are minimised 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).

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

Correct Answer: 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.

43. Describe the major types of sampling techniques available to auditors.

Correct Answer: There are a range of sampling techniques available to auditors which include random selection, systematic selection, haphazard selection, block selection and judgement 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 © John Wiley and Sons Australia, Ltd 2010

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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. Judgemental selection involves the selection of items that an auditor believes should be included in their sample for testing. When testing controls, judgement may be used to ensure that transactions processed when a new computer is installed are included in the sample. When conducting substantive testing, judgement may be used to include in the sample large or unusual items.

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

Correct Answer: 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.

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Testbank to accompany Auditing: a practical approach

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

Correct Answer: 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 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.

Essay Questions 46. A range of sampling techniques are available to auditors. Evaluate the advantages and disadvantages of the major techniques.

47. An auditor uses their professional judgement 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.

48. 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 7 Gaining an understanding of the client's system of internal controls

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Testbank to accompany Auditing: a practical approach

True/False 1. Internal control is intended to provide reasonable assurance about the achievement of an entity's objectives. *a. True b. False 2. Audit risk is the risk that an entity's internal control system will not prevent or detect material misstatements. a. True *b. False 3. The inherent limitations of internal control include the possibility of collusion by two or more individuals to circumvent a control. *a. True b. False 4. The internal control objective of 'valued' refers to controls in place to ensure that transactions are recorded in the correct accounting period. a. True *b. False 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 organisation. *a. True b. False 6. One of the elements of an entity's control environment is management's philosophy and operating style. *a. True b. False

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7. Control risk refers to the risk that the auditor's testing procedures will not be effective in detecting a material misstatement. a. True *b. False 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. *a. True b. False 9. In larger entities, there are often limitations surrounding the entity's ability to put effective internal controls in place. a. True *b. False 10. Narratives involve the auditor describing in words each step of the flow of transactions from start to finish. *a. True b. False 11. Checklists and preformatted questionnaires are particularly helpful in industries that the auditor may not personally be familiar with auditing. *a. True b. False 12. Internal control weaknesses decrease the risk of material misstatements being undetected by management's processes and controls. a. True *b. False 13. An internal control exception is an observed condition that provides evidence that the control being tested did not operate as intended. *a. True b. False © John Wiley and Sons Australia, Ltd 2010

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Testbank to accompany Auditing: a practical approach

14. The purpose of an auditor's management letter is to inform the client of the auditor's recommendations for improving its internal controls. *a. True b. False 15. Significant professional judgement is never required to decide whether an identified internal control weakness is significant enough to warrant communicating to management. a. True *b. False

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Chapter 7: Gaining an understanding of the client's system of internal controls

Multiple Choice 16. When internal controls are effective: a. there will be a increased reliance on substantive tests of transactions and account balances b. control risk will also be high *c. the organisation is more likely to achieve its strategic and operating objectives d. the organisation is less likely to achieve its strategic and operating objectives 17. Internal control encompasses which of the following elements of an organisation: a. processes b. culture c. systems *d. all of the above 18. 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 organisation d. Internal control provides reasonable assurance about the achievement of the entity's objectives 19. The generally accepted objectives of internal control do not include: *a. efficiency b. classified c. recorded d. timely 20. 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 organisation 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

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Testbank to accompany Auditing: a practical approach

21. Which assertion is not specifically addressed by internal control objectives? a. Cut-off *b. Presentation and disclosure c. Completeness d. Existence 22. 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 23. 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 24. 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 25. 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

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Chapter 7: Gaining an understanding of the client's system of internal controls

26. 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 27. 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 28. 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 29. 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 organisation's objectives d. They have various objectives and are applied at various organisational and functional levels 30. Performance reviews are control activities that include: a. authorisation for access to computer programs b. segregating incompatible duties *c. reviews of actual performance versus budgets d. periodic counting and comparison with amounts shown on control records

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Testbank to accompany Auditing: a practical approach

31. 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 organisation's policies are being applied c. whether adequate safeguards are in place to prevent unauthorised access to or destruction of documents, records and assets *d. all of the above 32. 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 33. 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 and dispatch document 34. 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 stocktake c. the wrong labour costs are added to the cost of individual inventory items *d. the wrong amount is paid against an invoice 35. 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

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Chapter 7: Gaining an understanding of the client's system of internal controls

36. Flowcharts involve: *a. the auditor summarising 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 c. both a and b d. none of the above 37. 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 38. 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 39. 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 of disagreements with management *d. the client of the auditor's recommendations for improving its internal controls 40. Which of the following statements is correct? a. Significant professional judgement 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 judgement 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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Short Answer Questions 41. Explain the seven generally accepted objectives of internal control activities and identify the relevant assertions.

Correct Answer: 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 organisation (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 organisation (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).

Summarised - there are controls in place to ensure that the transactions in the books and records are summarised 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).

42. Explain the key elements of the control environment.

Correct Answer: The control environment also 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 organisation and making sure that staff with the required skills are hired and matched to the right jobs.

Participation by those charged with governance. The organisation'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. 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.

Organisational structure - The client's organisational structure provides the framework within which its activities for achieving entity-wide objectives are planned, executed, controlled and monitored. © John Wiley and Sons Australia, Ltd 2010

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Organisational structure - The client's organisational 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, counselling, promoting and compensating employees.

43. What are control activities and explain the major categories of them?

Correct Answer: 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 organisation's objectives. Generally, control activities that may be relevant to an audit may be categorised 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 authorisation 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 authorisation 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 both to perpetrate and to hide errors or fraud in the normal course of their duties. In general, the principle duties that are incompatible and should be segregated are: - authorisation or approval of transactions affecting assets - custody of assets - recording or reporting of transactions.

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

Correct Answer: 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 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 summarising (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. © John Wiley and Sons Australia, Ltd 2010

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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.

45. What is a management letter and what are its major purposes?

Correct Answer: 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 judgement 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 judgement 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.

Essay Questions 46. What have been the major impacts on companies and auditors of section 404 of the SarbanesOxley Act (2002)? Has this section improved the quality of companies' internal controls?

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

48. ASA260 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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Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 8 Execution of the audit − testing of controls

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Testbank to accompany Auditing: a practical approach

True/False 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. *a. True b. False 2. The purpose of prevent controls is to discover fraud or errors that may have occurred during transaction processing and to rectify those errors. a. True *b. False 3. An example of a purely manual control is a locked stock cage for high dollar-value items. *a. True b. False 4. IT general controls are driven by the particular software application being used. a. True *b. False 5. Enquiry involves the auditor observing the actual control being performed. a. True *b. False 6. Re-performance involves the auditor re-performing the control to test its effectiveness. *a. True b. False 7. Tracing certain amounts on the bank reconciliation to the accounting records is an example of inspection of physical evidence. *a. True b. False

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8. To improve efficiency, auditors test only those controls that they believe are critical to their opinion. *a. True b. False 9. The greater the degree of reliance on an internal control, the less they test the control to provide the required assurance. a. True *b. False 10. Attribute sampling is a sampling technique used to reach a conclusion about the total dollar amount of misstatement in an account balance. a. True *b. False 11. Benchmarking is an audit strategy that can be used to carry forward the benefit of certain application controls testing into future audit periods. *a. True b. False 12. Tests of account balances can often provide evidence about the continued functioning of controls. *a. True b. False 13. If the tests of controls confirm the auditor's preliminary evaluation of controls, the planned substantive audit procedures are not modified. *a. True b. False 14. The more complex the client's operations and its internal controls, the less experienced the auditor who performs the work needs to be. a. True *b. False © John Wiley and Sons Australia, Ltd 2010

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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. a. True *b. False

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Chapter 8: Execution of the audit － testing of controls

Multiple Choice 16. The two main objectives of internal controls are: a. to support the automated parts of the business in the functioning of the controls in place. b. to prevent or detect misstatements in the financial report *c. both a and b d. None of the above 17. Controls can be classified as: a. information technology general controls. b. automated controls. c. manual controls. *d. All of the above.

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

19. Which of the following is an example of a prevent 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.

20. 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. prevent control. b. test of controls. c. detect control. d. substantive procedure.

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21. It is important that detect 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.

22. Which of the following is an example of a detect control? a. Account coding on purchase orders being checked by the computer to a table of valid account numbers. *b. Quarterly reviews of credit balances in accounts receivable to determine their causes. c. Amounts are not able to be paid to employees without first matching a valid tax file number to the employee master file. d. None of the above.

23. Manual controls: a. generally rely on the client's IT applications in some way. b. support the ongoing functioning of the programmed aspects of prevent and detect 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.

24. 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 authorised by the IT manager. d. All of the above.

25. Tests of controls do not include which of the following auditing techniques? a. Re-performance *b. Confirmation c. Enquiry d. Observation

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Chapter 8: Execution of the audit － testing of controls

26. 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.

27. 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 28. 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. *b. the employee may perform the control procedure more diligently when they know they are being observed. c. Both a and b. d. None of the above.

29. 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.

30. 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 auditor intends 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

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31. 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 operated 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 operated effectively. d. The results of the tests in prior audits and the current audit to date affect the perception of risk.

32. 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.

33. 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.

34. 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 35. 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.

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36. 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.

37. 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 38. 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.

39. 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.

40. 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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Short Answer Questions 41. Explain the differences between prevent controls and detect controls.

Correct Answer: 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. Prevent 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 prevent 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 prevent 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 detect controls is to discover fraud or errors that may have occurred during transaction processing (in spite of any prevent controls) and to rectify those errors. Generally, detect 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 detect 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 detect controls include management level reviews are made of actual performance versus budgets, forecasts, prior periods, competitors (if available) and industry averages (if available).

42. Explain and provide examples of the various techniques commonly used when testing controls.

Correct Answer: 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, hey 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 unauthorised employee is unable to make cash payments.

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Chapter 8: Execution of the audit － testing of controls

43. Discuss the factors that relate to the likelihood that an internal control operates as intended.

Correct Answer: Several factors that 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 operated 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 the likelihood in a good control environment that a control will continue to operate as intended throughout the period of reliance.

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.

44. What are the factors considered by auditors in determining whether there is a need for additional detailed tests of controls?

Correct Answer: 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 auditor identifies 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 yearend. 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 creditors 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

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Testbank to accompany Auditing: a practical approach

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.

45. What are the main items commonly included in tests of controls working papers?

Correct Answer: 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 their overall purpose in testing the controls. If the auditor identifies 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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Chapter 8: Execution of the audit － testing of controls

Essay Questions 46. 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.

47. The Australian Securities and Investments Commission (ASIC) inspects audit firms' compliance with audit quality and auditor independence requirements. Explain the process used

by ASIC in conducting these inspections and critically evaluate their effectiveness at enhancing audit quality.

48. ASA 230 Audit Documentation requires auditors to document each stage of the audit in their working papers. What are the specific requirements in ASA 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 9 Execution of the audit − performing substantive procedures

John Wiley & Sons Australia, Ltd 2010

Testbank to accompany Auditing: a practical approach

True/False 1. A significant account is one that could contain material misstatements based upon their materiality and/or relationship to identified inherent and financial report risks. *a. True b. False 2. Control risk is assessed to be low when there are no internal controls tested or relied upon by the auditor. a. True *b. False 3. Normally, it is more efficient to carry out substantive procedures than to test and rely on controls. a. True *b. False 4. Key item testing is an example of a technique used when conducting substantive procedures. *a. True b. False 5. The timing of substantive procedures is directly influenced by the level of control risk. *a. True b. False 6. Roll-forward procedures are performed during the period between the end of the financial year and the date of the audit report. a. True *b. False 7. Vouching involves tracking a source document back to the underlying accounting records a. True *b. False

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Chapter 9: Execution of the audit − performing the substantive procedures

8. Audit sampling is the application of audit procedures to less than 100 per cent of items within a population. *a. True b. False 9. Analytical procedures may not be useful when they are used on a company with significantly diverse operations and geographical segments. *a. True b. False 10. Analytical procedures that provide persuasive or corroborative evidence contribute minimal support for the audit conclusion. a. True *b. False 11. Comparing the number of days purchases in trade payable with prior years would provide persuasive evidence of accounts payable. a. True *b. False 12. Corroborative evidence confirms audit findings from other procedures. *a. True b. False 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. *a. True b. False 14. Misstatements can only arise from fraud. a. True *b. False

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Testbank to accompany Auditing: a practical approach

15. The audit program serves as the instructions for the audit team members to complete the required testing. *a. True b. False

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Chapter 9: Execution of the audit − performing the substantive procedures

Multiple Choice 16. 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.

17. 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.

18. The purpose of substantive procedures includes obtaining direct evidence as to: a. the reasonableness of the estimates and other information in the financial report. b. the completeness, accuracy and validity of data. *c. Both a and b d. None of the above 19. Substantive testing can be conducted using which of the following procedures? a. Enquiry b. Confirmation c. Analytical review *d. All of the above 20. 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 © John Wiley and Sons Australia, Ltd 2010

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21. 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 22. 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.

23. Roll-forward procedures are performed: *a. to update the audit findings from the time of the interim procedures through to yearend. b. to detect fraud in various balance sheet accounts. c. after the end of the financial year. d. None of the above 24. 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 stocktake *c. Testing additions and disposals to the fixed asset register d. Performing confirmations of accounts receivables 25. 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

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Chapter 9: Execution of the audit − performing the substantive procedures

26. Vouching involves: a. tracking a source document through to the underlying accounting records. *b. agreeing the details of a transaction to supporting evidence outside of the company's accounting records. c. the application of audit procedures to less than 100 per cent of items within a population. d. None of the above 27. Tracing is primarily directed towards verifying which of the following assertions? *a. Completeness b. Existence c. Occurrence d. Valuation 28. 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 .

29. 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.

30. 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

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31. 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.

32. Which of the following is not a type of analytical procedure? *a. Confirmation analysis b. Ratio analysis c. Break-even analysis d. Trend analysis 33. 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 34. Using computer assisted audit techniques (CAATs) makes the audit: a. more comprehensive. b. more expensive. c. more efficient. *d. Both a and c 35. 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.

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Chapter 9: Execution of the audit − performing the substantive procedures

36. Comparing sales commissions or bonuses with related sales provides what level of evidence? *a. Corroborative b. Absolute c. Minimal d. Persuasive 37. The levels of evidence obtained when performing substantive procedures includes: a. minimal b. persuasive c. general *d. All of the above 38. 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 39. Which of the following statements is correct? a. Misstatements can only arise from fraud b. Misstatements can only arise from error *c. Misstatements can arise from error or fraud d. None of the above 40. 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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Short Answer Questions 41. Discuss the factors that influence the extent and timing of substantive procedures.

Correct Answer: 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: The nature of the test. Some tests lend themselves more easily to testing during the year-end 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 recognised as a prepayment and the amount to be expensed in the income statement is easiest to perform at or after year-end.

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).

The type of evidence required (for example, are the procedures designed to provide persuasive, corroborative or minimal audit evidence?

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).

42. Explain the difference between vouching and tracing.

Correct Answer: 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). © John Wiley and Sons Australia, Ltd 2010

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Chapter 9: Execution of the audit − performing the substantive procedures

43. Explain the three common sampling strategies that can be applied when the auditor applies representative sampling.

Correct Answer: 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 attributes in existence for the sample tested can be inferred to be in existence for the entire population.

44. Identify the steps used by the auditor when performing analytical procedures.

Correct Answer: When performing analytical procedures, the steps the auditor performs can be summarised 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.

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45. Explain the four different levels of evidence obtained when performing substantive procedures.

Correct Answer: 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 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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Chapter 9: Execution of the audit − performing the substantive procedures

Essay Questions 46. 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.

47. 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.

48. Explain and evaluate the 'fuzzy logic' approach to assessing materiality.

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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 10 Substantive testing and balance sheet accounts

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Testbank to accompany Auditing: a practical approach

True/False 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. a. True *b. False 2. The timing of substantive testing is dependent on the risk assessment of the significant account in question. *a. True b. False 3. A pledge is something delivered as security for the payment of a debt or the fulfilment of a promise. *a. True b. False 4. Testing the mathematical accuracy of the cash payment ledger relates to the existence assertion. a. True *b. False 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. *a. True b. False 6. Evaluating the adequacy of the allowance for doubtful debts account is an example of a substantive test of trade receivables that is always performed. *a. True b. False

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Chapter 10: Substantive testing and balance sheet accounts

7. The two key assertions for inventory are completeness and rights and obligations. a. True *b. False 8. Accounting for the numerical sequence of cheques issued during a specific period is a substantive test relating to the purchases process. a. True *b. False 9. A fixed assets register is used to capture additions and disposals of fixed assets, as well as calculating depreciation charges. *a. True b. False 10. Physically sighting fixed assets enables the auditor to test the rights and obligations assertion. a. True *b. False 11. The typical procedures performed to search for unrecorded payables are referred to as subsequent payments testing and cut-off testing. *a. True b. False 12. Ensuring that accounts payable are stated at the amounts owed at year-end relates to the rights and obligations assertion. a. True *b. False 13. Prepayments are audited by vouching the balance to the supporting invoices. *a. True b. False

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Testbank to accompany Auditing: a practical approach

14. Provisions can be easily audited by controls testing alone. a. True *b. False 15. The key objective when performing substantive procedures is to determine whether there are material misstatements within an account balance. *a. True b. False

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Chapter 10: Substantive testing and balance sheet accounts

Multiple Choice 16. 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.

17. 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 18. 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 19. 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.

20. Which of the following is not an example of a substantive test of cash payments transactions? a. Test the account classifications of cash payments b. Account for the numerical sequence of cheques issued during a specified period *c. Test the mathematical accuracy of the cash receipts ledger d. Determine whether the signatures on paid cheques are authorised

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Testbank to accompany Auditing: a practical approach

21. 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 22. Existence of trade receivables is usually verified by: a. examining copies of sales invoice 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 debts.

23. 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 24. 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 debts d. None of the above 25. Which of the following statements regarding a stock 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 stock c. It is essentially the sub-ledger reconciled to the general ledger account for inventory *d. It is prepared by the auditor

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Chapter 10: Substantive testing and balance sheet accounts

26. The rights and obligations assertion relates to which of the following audit objectives? a. Inventory is properly classified, described and disclosed in the financial report *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 report d. All inventory owned by the entity at year-end is included on the balance sheet 27. Observing the client's stocktake 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 stocktakes. c. items belonging to the client are accurately counted and recorded. *d. All of the above 28. 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.

29. 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 30. 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

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Testbank to accompany Auditing: a practical approach

31. 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 32. 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.

33. Which of the following are substantive tests of payables balances that are always performed? a. Perform a search for unrecorded liabilities b. Examine the client's bank reconciliations c. Test the cut-off by inspecting the payments ledger and supporting documents to determine that transactions are recorded in the correct period *d. All of the above 34. The valuation and allocation assertion relates to which of the following audit objectives? a. All accounts payable on the balance sheet are real debts 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 report 35. 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

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Chapter 10: Substantive testing and balance sheet accounts

36. Which of the following account balances are typically audited fully substantially with limited or no controls testing? a. Investments b. Intercompany balances c. Prepayments *d. All of the above 37. 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 vouches to the related entity or to intercompany confirmations 38. Which type of leases are not recorded on the balance sheet? *a. Operating b. Finance c. Direct financing d. Sale and leaseback 39. 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. d. None of the above 40. 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 ASIC. d. perform additional substantive testing.

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Testbank to accompany Auditing: a practical approach

Short Answer Questions 41. Discuss the specific issues that auditors should consider when designing substantive procedures.

Correct Answer: 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 debtors, 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 debtors 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 judgement. 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 year-end visit to focus on performing the required procedures.

42. Identify and explain the key audit assertions relating to cash.

Correct Answer: 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 report, including unused credit facilities and other information that is part of the statement of cash flow disclosure requirements.

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Chapter 10: Substantive testing and balance sheet accounts

43. What are the principal objectives in auditing trade receivables?

Correct Answer: 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. · Valuation and allocation: Receivables are carried at their net realisable (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 report, including the notes, in conformity with prescribed accounting principles (IFRSs).

44. Explain examples of substantive tests of inventory that are always performed.

Correct Answer: Examples of substantive tests of inventory that are always performed are: · Observe the counting of physical inventory (stocktake) to establish that: the client's personnel are complying with the instructions for stocktakes 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. · 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. · 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.

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Testbank to accompany Auditing: a practical approach

45. Explain how substantive testing is used for prepayments, investments and intercompany balances.

Correct Answer: 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 reports (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. 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.

Essay Questions 46. 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.

47. 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.

48. 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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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 11 Substantive testing and income statement accounts

John Wiley & Sons Australia, Ltd 2010

True/False 1. Substantive procedures are designed to detect material misstatements at the assertion level. *a. True b. False 2. Testing the balance sheet substantively will provide reasonable assurance on the income statement accounts. *a. True b. False 3. Control risk is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated. a. True *b. False 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. *a. True b. False 5. Sales revenue is typically not significant due to its size. a. True *b. False 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. a. True *b. False 7. Testing the pricing and mathematical accuracy of sales invoices is an example of a substantive test of transactions in the sales process. *a. True b. False

Chapter 11: Substantive testing and income statement accounts

8. Testing the account classification of credit memos tests the accuracy assertion for the sales returns process. a. True *b. False 9. The key audit assertions for cost of sales and expenses are rights and obligations and occurrence. a. True *b. False 10. Purchases testing is performed most efficiently by the use of controls testing. *a. True b. False 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. *a. True b. False 12. Ensuring that all costs and expenses in the income statement are properly supported as charges against the entity relates to the classification assertion. a. True *b. False 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. *a. True b. False 14. The auditor uses their professional judgement, knowledge of the client and risk assessment for each significant account to determine the timing and extent of testing. *a. True b. False

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Testbank to accompany Auditing: a practical approach

15. The key objective when performing substantive testing is determining whether the client's internal controls are effective at preventing and detecting material misstatements. a. True *b. False

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Chapter 11: Substantive testing and income statement accounts

Multiple Choice 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 a financial report is materially misstated is known as: a. engagement risk. *b. audit risk. c. client business risk. d. detection risk.

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Testbank to accompany Auditing: a practical approach

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 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

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Chapter 11: Substantive testing and income statement accounts

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 sale 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 report b. Sales and other revenues are stated in the profit and loss at the appropriate amounts c. All sales and other revenues that accrued to the entity during the period are included in the income statement *d. 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

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Testbank to accompany Auditing: a practical approach

30. Testing the postings of the sales ledger to the general ledger and the trade receivables subledger 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. trad payables. *b. trade receivables. c. cash at bank. d. inventory.

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Chapter 11: Substantive testing and income statement accounts

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 ane 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. Resting 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 reports 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 trace the details to the source data. *d. All of the above

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Testbank to accompany Auditing: a practical approach

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 ASIC. *c. understand why the exception or error has arisen. d. None of the above

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Chapter 11: Substantive testing and income statement accounts

Short Answer Questions 41. Explain the various components of risk in the audit risk model and the interrelationship between the various components.

Correct Answer: 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 a financial report is 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.

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?

Correct Answer: 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.

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Testbank to accompany Auditing: a practical approach

43. Discuss the importance of the completeness assertion as it relates to auditing sales revenue.

Correct Answer: 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. 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.

44. Explain the principal objectives in auditing costs and expenses.

Correct Answer: The principal objectives in auditing costs and expenses are: · 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, pre-paid expenses, deferred charges or property, plant and equipment. · Completeness: All costs related to the current period's revenues and all expenses of the current period are included in the income statement. · Accuracy and cut-off: Costs and expenses are stated in income statement at the appropriate amounts. · Classification, Classification and understandability: Costs and expenses are properly classified, described and disclosed in the financial report, including the notes.

45. Explain the key objective of substantive testing and the responses from auditors when errors or exceptions are identified during testing.

Correct Answer: 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 ASA 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 ASA 330 (ISA 330) and ASA 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. © John Wiley and Sons Australia, Ltd 2010

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Chapter 11: Substantive testing and income statement accounts

Essay Questions 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?

47. Explain the nature of and motivations for various approaches for companies to manipulate their profits through the use of expenses.

48. Identify situations where the understatement of sales can be a risk for certain clients and how auditors should react to such risk.

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Testbank to accompany

Auditing: a practical approach Prepared by Peter Baxter

CHAPTER 12 Completion and reporting of the audit

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True/False 1. Subsequent events procedures are normally performed through to and including the date of the auditor's report. *a. True b. False 2. Sufficiency relates to the quality of audit evidence gathered. a. True *b. False 3. Generally, the further into the future an event is likely to take place, the greater the uncertainty surrounding the event. *a. True b. False 4. A type 1 subsequent event provides evidence with respect to conditions that developed subsequent to year-end. a. True *b. False 5. The uninsured loss of inventory as a result of fire subsequent to year-end is an example of a type 2 subsequent event. *a. True b. False 6. An error is an intentional misstatement in the client's financial report. a. True *b. False

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Chapter 12: Completion and reporting of the audit

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. *a. True b. False 8. The final phase of an audit is to assess all of the audit evidence obtained and determine whether it is sufficient and appropriate. *a. True b. False 9. The auditor's responsibility for the financial report includes selecting and applying appropriate accounting policies. a. True *b. False 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. *a. True b. False 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 auditor's report being prepared on a revised financial report. *a. True b. False 12. Breaches of accounting standards are not considered to be significant contraventions of the Corporations Act. a. True *b. False

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Testbank to accompany Auditing: a practical approach

13. Under section 311 of the Corporations Act, auditors are required to report to ASIC any actual or suspected contraventions of the Act within 28 days of an event. *a. True b. False 14. Matters of governance that the auditor may wish to discuss with those charged with governance include any practical difficulties encountered in performing the audit. *a. True b. False 15. As soon as practicable, the auditor should communicate weaknesses in internal controls to management or those charged with governance. *a. True b. False

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Chapter 12: Completion and reporting of the audit

Multiple Choice 16. 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 17. 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 18. 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 ASIC. d. express an unqualified opinion with an emphasis of matter.

19. 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.

20. Which of the following factors is not relevant when management is assessing the going concern assumption? *a. Whether the auditor specialises 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

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21. 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 audit completes the tests of controls d. after the auditor signs the audit engagement letter 22. 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 report. 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 report. *d. the financial report is adjusted for any material changes in estimates from these types of events.

23. 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 report. c. reading minutes of the meetings of the board of directors. *d. All of the above 24. 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.

25. Which of the following statements regarding judgemental 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 judgement by the client and the auditor

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26. 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 report *c. Both a and b d. None of the above 27. 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. *d. determining whether the audit evidence obtained is sufficient and appropriate to reduce the risk of material misstatements in the financial report to an acceptably low level.

28. Management's responsibilities for the financial report do not include which of the following: a. selecting and applying appropriate accounting policies. *b. expressing an opinion on the financial report. c. establishing and maintaining internal controls. d. making reasonable accounting estimates.

29. Which of the following are included in the main components of the auditor's report? a. Management's responsibility for the financial report b. The auditor's opinion on whether the financial report gives a true and fair view c. The date of the audit report *d. All of the above 30. 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.

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31. 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.

32. 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.

33. 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 report 34. An unqualified audit opinion with an emphasis of matter should be given where there is: a. inconsistent other information. b. additional disclosures with which the auditor concurs. c. a subsequent event that results in a new auditor's report on a revised financial report. *d. All of the above 35. 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. The auditor's responsibility for the financial report 36. 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 report is true and fair. © John Wiley and Sons Australia, Ltd 2010

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37. Contraventions of the Corporations Act that are considered significant include: a. fraud by officers or employees of the entity. b. breaches of accounting standards. c. insolvent trading. *d. All of the above 38. Under section 311 of the Corporations Act auditors are required to report any actual or suspected contraventions of the Act to: a. the Auditing and Assurance Standards Board. *b. the Australian Securities and Investments Commission. c. the Financial Reporting Council. d. the Australian Securities Exchange.

39. 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 40. 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 report of any material risks and exposures. c. expected modifications to the audit report. *d. All of the above

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Short Answer Questions 41. Discuss the factors that are relevant when management is assessing the going concern assumption.

Correct Answer: 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 Australia, this is typically 12 months from the date of the directors' report and audit opinion. · Any judgement about the future is based on information available at the time at which the judgement is made. Subsequent events can contradict a judgement 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 judgement regarding the outcome of events or conditions.

42. Explain the difference between type 1 and type 2 subsequent events and provide examples of each type of event.

Correct Answer: Type 1 subsequent events are events that can affect the estimates inherent in the financial report or indicate that the going concern assumption in relation to the whole or a part of the entity is not appropriate. The financial report is 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 report) include: · the bankruptcy of a customer subsequent to year-end, which would be considered when evaluating the adequacy of the provision for uncollectable trade receivables · an amount received in respect of an insurance claim that was in the course of negotiation as at year-end · 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 report.

Type 2 subsequent events are those events that do not result in changes to amounts in the financial report. However, these events may be of such significance as to require disclosure in the financial report. Examples of type 2 subsequent events (that do not require adjustment but may require disclosure in the financial report) include: · the uninsured (or underinsured) loss of plant or inventory as a result of a fire or flood subsequent to year-end · the purchase of a business · the issuance of shares or debt securities.

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43. Identify quantitative and qualitative considerations that are taken into account when the auditor evaluates whether misstatements either cause financial reports to be materially misstated or requires additional disclosure.

Correct Answer: Examples of quantitative and qualitative considerations include: · the risk of additional misstatements remaining undetected · the effects of identified misstatements on the client's compliance with covenants under debt or similar agreements · whether the proposed corrections result from an error or are the result of a judgemental misstatement between the client's and the auditor's application of accounting policies · the turnaround effect on the current year's financial report of uncorrected misstatements identified in the prior year · the likelihood that recurring differences, which currently are immaterial, will have a material effect in the future · 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 · the significance of the financial report elements affected by the misstatements · 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) · 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 · the effects of offsetting misstatements in different financial report captions (or balance names within the financial report, for example, cash at bank, prepayments, payables).

44. Explain the difference between management's and the auditor's responsibility for the financial report.

Correct Answer: Management's responsibility includes establishing and maintaining internal controls relevant to the preparation and fair presentation of a financial report 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 report 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.

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45. What are examples of matters of governance interest that the auditor may wish to discuss with those charged with governance.

Correct Answer: Matters of governance interest that the auditor may wish to discuss with those charged with governance include: · the general approach and overall scope of the audit, including any expected limitations thereon, or any additional requirements · the selection of, or changes in, significant accounting policies and practices that have, or could have, a material effect on the entity's financial report. · the potential effect on the financial report of any material risks and exposures, such as pending litigation, that are required to be disclosed in the financial report · misstatements, whether or not recorded by the entity that have, or could have, a material effect on the entity's financial report · material uncertainties related to events and conditions that may cast significant doubt on the entity's ability to continue as a going concern · disagreements with management about matters that, individually or in aggregate, could be significant to the entity's financial report or the audit report. These communications include consideration of whether the matter has, or has not, been resolved and the significance of the matter · expected modifications to the audit report. · any practical difficulties encountered in performing the audit · any irregularities or suspected non-compliance with laws and regulations that came to the auditor's attention during the audit · 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. · any other matters agreed upon in the terms of the audit engagement.

Essay Questions 46. 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.

47. 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.

48. Explain the potential threats to independence relating to audit fees and how auditor can safeguard against these threats.

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